Trade finance embodies financial instruments and products to facilitate international trade and commerce. Trade finance covers many financial products that banks and companies use to make trade dealings possible.
Trade finance creates feasible import and export transactions for entities, ranging from a small business importing overseas, multi-national corporations that ventures importing or exporting a large volume of products around the globe.
Often, small businesses have limited access to loans and other forms of financing to cover the cost of goods for buying or selling. Despite that there are confirmed order for products, most banks won’t provide loans or overdraft for these types of transactions.
For the Business owners, it is vital that their limited allocations will not focus too much on logistics such as shipments and transportation of goods.
On one side, companies that do exportation of a large volume of goods cannot afford to wait until their products to arrive in the expected destination weeks later, before they receive the payment. There are over 80 percent of global trade depends on trade financing. It only shows that trade finance helps the goods to keep moving even when companies have limited cash flow to finance the logistical needs.
Understanding Trade Finance
The primary function of trade finance is to facilitate a third-party to transactions to remove the payment risk and the supply risk. Trade finance will provide the exporter with receivables or payment according to the agreement. Meanwhile, the importer can have an extension of credit to fulfill the trade order.
There are parties involved in trade finance:
- Trade finance companies
- Importers and exporters
- Export credit agencies and service providers
Trade financing is not like other conventional financing or credit platforms. Traditional financing will manage solvency or liquidity, but trade financing does not necessarily look at a buyer’s lack of funds or lack of liquidity. Instead, trade finance is for the protection against international trade’s risks, such as currency fluctuations, political instability, issues of non-payment, or the creditworthiness of one of the parties involved.
The financial instruments used in trade finance:
- Banks can give lending lines of credit for both importers and exporters.
- Letters of credit can reduce the risk associated with global trade because the bank of the buyer will guarantee the payment to the seller for the shipment of the goods. Nevertheless, the buyer is also protected because the payment will not be made unless the terms in the letter of credit are satisfied.
- Factoring is applied when companies are paid according to the percentage of their accounts receivables.
- Exporters can access export credit or working capital.
- Shipping and delivery of goods can use insurance. It can also protect the exporter from nonpayment by the buyer.
Although, trade finance helps international trading to reach its advancement even though trading is in existence for centuries. Trade finance is a contributing factor in the growth and widespread global trade dynamics.
Trade Finance Reduces Payment Risk
In the early years of international trading, the greatest challenge is the assurance of exporters if the importers would pay them for the goods they deliver. Over time, exporters find ways to reduce the non-payment risk from importers. Meanwhile, the importers were also not assured about making prior payments for goods from an exporter because they have no guarantee whether the seller could be able to ship the good.
Trade finance will address all of these risks by accelerating payments to exporters. It assures importers that all the goods are on its shipment. The importer’s bank provides the exporter with a letter of credit to the exporter’s bank as payment once shipment documents are presented.
The risks to consider
As international trade happens by air, land, and sea in all borders of the globe, there are various risks to deal:
- Payment risks
Assurance if the exporter is paid in full and on time. The guarantee if the importer gets the goods they wanted?
- Country risk
These are a collection of risks associated with doing business with a foreign country. These risks could be in the exchange rate, politics, and sovereignty issues that affect trading dynamics. For example, a company may stop exporting goods a country with a corrupt political situation, a deteriorating economy and lack of legal structures
- Corporate concerns
The risks associated with the company doing either importation or exportation of goods. It looks on the credit rating performance. It also includes looking at the history of non-payment of credits.
To reduce these risks, banks – and other financiers – have stepped in to provide trade finance products.