In the past, international trade wasn't as widespread as it is today. Importers were cautious about advance payments due to concerns about the reliability of exporters.
They needed a mechanism to protect their financial commitments.
Trade finance services emerged as a response, facilitating global trade through various financial instruments.
How Does Trade Finance Work?
The importer's bank prepares a letter of credit (LC) to share with the lender in trade finance.
Trade finance companies and financial institutions act as intermediaries, sharing financial risks between parties in such international trade transactions.
This has contributed to global business growth, and with the rise of less-than-container-load (LCL) shipping, the complexity of trade financing is expected to increase.
What is the Trade Finance Process?
Here is a breakdown of the trade finance process:
Trade finance applicants must submit a credit application to the lending company with information about the company, its directors and the justification for the need for debt financing.
Lenders typically demand proof of historical trading revenue, making trade finance more appropriate for companies currently engaged in domestic or international commerce.
A trade finance company like Drip Capital, will thoroughly assess the applicant's credit risk by examining the applicant's financial documents, collateral and business ties.
Businesses can negotiate with lenders when asking for trade finance to acquire financing on factors such as fees, charges and interest rates.
After submitting the required documents, the approval stage is the next step in the trade finance process.
It will be passed on to the account manager for credit and risk analysis. If everything is found satisfactory, the loan is approved.
The last step is loan repayment to maintain trust between all parties involved.
Example of Trade Finance
Let's assume ABC Imports, a US-based company, receives a purchase order from their overseas buyer for $100,000 worth of goods. ABC Imports approaches a trade finance company, XYZ Co., to finance the purchase order.
They submit an application to XYZ Co., along with the required documents, such as the purchase order, sales contract and other relevant trade documents.
XYZ Co. then assesses the creditworthiness of ABC Imports and the risk associated with the trade transaction.
Based on the evaluation, XYZ Co. offers ABC Imports a trade finance facility of up to $90,000, which is 90% of the purchase order value.
The trade finance facility will cover the cost of goods, allowing ABC Imports to fulfill the purchase order and meet its working capital needs. The agreement outlines the terms and conditions of the trade finance facility, including the interest rate, fees, repayment terms and any other relevant clauses.
After the trade finance agreement is executed, XYZ Co. disburses the approved amount of $90,000 to ABC Imports, who can now use the funds to pay their suppliers for the goods and fulfill the purchase order.
Once the trade transaction is completed, ABC Imports receives payment from the overseas buyer and repays the trade finance facility to XYZ Co. as per the agreed-upon repayment terms, which may include interest and fees.
The repayment is typically made from the proceeds received from the overseas buyer. In this example, XYZ Co. acted as an intermediary, providing financing options and mitigating risks for ABC Imports, thus helping them successfully complete the trade transaction.
Which Parties Are Involved in Trade Finance?
To facilitate global trade transactions, several stakeholders collaborate in trade finance.
Importers are companies or individuals who purchase goods or services from overseas suppliers. They are the buyers in the transaction and may be required to provide payment upfront before receiving the goods.
Exporters are companies or individuals who sell goods or services to overseas buyers. They are the sellers in the transaction and may require payment before shipping the goods.
Banks play a crucial role in trade finance by providing financing and financial guarantees to importers and exporters. Banks may issue letters of credit or give funding to help facilitate trade transactions.
These are third-party companies that facilitate trade transactions between importers and exporters.
These companies may provide trade financing, risk mitigation and other services to help ensure that trade transactions are completed successfully.
Insurance companies provide risk mitigation services to importers and exporters by offering insurance policies that protect against loss or damage to goods during transportation.
Who are the Providers of Trade Finance?
Many organizations and companies can be providers of trade finance.
1. Trade Finance Companies
Trade finance companies are specialized financial institutions that play a crucial role in international trade transactions by providing financing options, mitigating risk, facilitating payments and providing trade information.
These companies support businesses by offering solutions, assisting them in overcoming challenges that may arise in cross-border trade and successfully navigating the complex world of global trade.
2. Government Organizations
Government-backed organizations, are other sources to offer finance and insurance to facilitate domestic trade and import transactions.
They typically aid domestic businesses in competing on international markets and may provide direct loans and other trade funding solutions.
3. Other Financial Institutions
Export credit agencies (ECAs), factoring firms, banks, multilateral development banks (MDBs) are also utilized for trade finance sources.
Additionally, banks may also provide trade finance services such as supply chain financing, currency hedging and trade risk mitigation.
International financial organizations, also known as multilateral development banks, offer funding to help economic growth in developing nations.
They might provide trade finance services, such as financing for SMEs and trade-related infrastructure projects, to assist import and export transactions.
Is Trade Finance an Investment?
It is a trillion-dollar asset class supported by the exchange of tangible goods and services, reducing its vulnerability to changes in the financial markets.
Compared to other credit products, trade finance products often have lower default rates and faster time to recoup losses in the event of a default.
What Instruments Are Used in Trade Finance?
Buyers and suppliers in trade finance make use of the following instruments:
1. Invoice Financing
Here, the debtor owes the financing company rather than the seller and the seller receives a cash advance on future invoices.
2. Letter of Credit
An LC, commonly offered by banks, is widely utilized as a trade finance instrument to safeguard international trade transactions.
3. Supply Chain Finance (SCF)
This form of financing covers the post-shipment stage of a business's supply chain process, enabling the release of funds that may be tied up in the supply chain process such as forwarding and intermediaries.
SCF enhances the efficiency of import-export activities in trade finance by streamlining the flow of funds throughout the supply chain.
How Does Trade Finance Reduce Financial Risk?
Trade finance can mitigate the risk associated with global trade by addressing the conflicting demands of an exporter and an importer.
An exporter may desire advance payment from the importer to reduce the risk of non-payment. Yet, this may result in non-delivery.
The importer's bank may send an LC to the exporter's bank to address this issue.
As soon as the exporter provides proof of shipment, payment is guaranteed. The buyer's financial stability is guaranteed by shifting payment responsibility to the buyer's bank through the LC.
This facilitates trade and contributes to developing trust among the parties to the transaction.
What Are the Benefits of Trade Finance?
Trade finance can enhance your business efficiency and increase your revenue by guaranteeing payment from the buyer's bank and ensuring the timely shipment of goods.
Importers and exporters can better manage their cash flow due to fewer payment and shipment delays.
Trade finance enables competitiveness, giving access to capital that might not otherwise be possible.
Additionally, it provides the means to create new products or enter new markets that can aid enterprises in remaining competitive.
Trade finance facilitates global trade by mitigating financial risks and unlocking funds in the supply chain process.
Through various financial instruments, trade finance enables importers and exporters to confidently engage in international trade, contributing to economic growth and development.