What is trade finance?

Trade finance is the term used to describe the tools, techniques, and instruments that facilitate trade and protect both buyers and sellers from trade-related risks. The purpose of trade finance is to make it easier for businesses to transact with each other. It also helps to reduce the risks involved in global trade, for both buyers and sellers.

How does trade finance work?

When a trade transaction takes place, the buyer and seller incur different types of risk. For the buyer, there is a risk that the goods purchased will not arrive on time or will fall short of the expected quality or volume. The seller, meanwhile, faces the risk that payment will not be received on the agreed terms for the goods provided.

These risks are exacerbated in an international trade transaction, as resolving any disputes can be time consuming and difficult – particularly when the markets involved have different cultures and regulatory climates.

To mitigate these risks, there are different ways of structuring trade transactions, including open account, payment in advance and letters of credit.

Open account

The simplest and most common way of structuring a trade finance agreement is with open account terms, whereby the buyer (importer) pays for goods after they have been received. This protects the buyer from the risk of paying for goods that do not meet required standards, but does not protect the seller (exporter). As such, open account terms are only recommended for trusted or low-risk trading relationships.

That said, the risk associated with open account transactions can be mitigated using trade finance techniques such as export credit insurance. Another option is factoring, a receivables financing technique whereby suppliers sell their accounts receivable to a factor, which then takes on the responsibility for obtaining outstanding payments.

Supply chain finance is another type of solution used to finance receivables, but unlike factoring it is initiated by the buyer rather than the supplier. The cost of finance is based on the buyer’s credit rating rather than the suppliers, meaning that suppliers typically receive funding at a more favorable rate.

Payment in advance

At the opposite end of the spectrum to open account terms is payment in advance (or cash in advance), whereby the buyer pays the supplier before goods have been received. While this trade finance method protects the supplier from the risk of non-payment, it does not protect the buyer from the risk that goods will not be received on time and as expected.

Letters of credit

In other cases, transactions may be structured around different trade finance techniques. These include letters of credit (LCs or L/Cs), which are often used to guarantee and finance international trade, particularly in higher-risk transactions. The use of LCs is governed by rules published by the International Chamber of Commerce, known as the Uniform Customs and Practice for Documentary Credits. The current version, UCP 600, came into effect on 1st July 2007.

In a letter of credit transaction, the buyer’s bank provides a letter guaranteeing that the seller will be paid in full and on time, as long as the necessary documentary conditions are met. The documents required may include bills of lading, insurance certificates and commercial invoices. If the buyer is unable to make the payment, the bank will pay on the buyer’s behalf.

As such, trade risks are mitigated for both the buyer and seller. The seller receives a guarantee that they will receive payment as long as goods are received as agreed, while the risk to the buyer is addressed by the need for documentary proof that goods have been received. However, LCs also have some drawbacks: they can be costly to arrange, and documentary requirements and bureaucracy can result in considerable delays.

Many different types of LC are used in international trade, including:

• Confirmed letter of credit – a letter of credit which includes an additional guarantee of payment from a second bank (the confirming bank).
• Revolving letter of credit – a single letter of credit that can be used to cover multiple transactions over a period of time.
• Standby letter of credit – a letter of credit that provides assurance the buyer is able to pay the buyer, in the expectation that the LC will not need to be used.
• Back-to-back letter of credit – two letters of credit used to connect the buyer and seller via an intermediary.
• Sight letter of credit – payment is made immediately once the necessary documents have been reviewed by the bank.

Documentary collection

Documentary collection is similar to a letter of credit, in that documents are presented to the buyer’s bank before the seller is paid. However, a key difference is that the buyer has the right to reject the goods provided. Documentary collection is also a less expensive trade finance technique than a letter of credit.

Trade finance gap

Trade finance plays an important part in facilitating global trade. However, according to the Asian Development Bank, unmet demand means there is a trade finance gap of as much as $1.5 trillion, with smaller businesses disproportionately affected.

Developments such as blockchain and distributed ledger technology may play a role in facilitating trade finance transactions in the future. In addition, solutions like supply chain finance can play an important role in helping suppliers access the finance they need to do business.

Benefits of trade finance

As well as mitigating the risk inherent in certain trade transactions, such as the risk of nonpayment, trade finance can also enable sellers to access the short-term finance they need to do business. As such, it plays an important role in facilitating international trade, improving cash flow and supporting business growth.