What is trade finance?
A summary of international trade finance solutions
How does trade finance work?
Trade finance is the financing of international trade flows. It exists to mitigate, or reduce, the risks involved in an international trade transaction.
This article will go through a high level review on how different financing options work.
There are two players in a trade transaction:
an exporter, who requires payment for their goods or services, and
an importer who wants to make sure they are paying for the correct quality and quantity of goods.
Secure trade finance depends on verifiable and secure tracking of physical risks and events in the chain between exporter and importer. The advent of new information and communication technologies allows the development of risk mitigation models which have developed into advance finance models. This allows very low risk of advance payment given to the Exporter, while preserving the Importer's normal payment credit terms and without burdening the importer's balance sheet. As trade transactions become more flexible and increase in volume, demand for these technologies has grown.
As international trade takes place across borders, with companies that are unlikely to be familiar with one another, there are various risks to deal with. These include:
Payment risk: Will the exporter be paid in full and on time? Will the importer get the goods they wanted?
Country risk: A collection of risks associated with doing business with a foreign country, such as exchange rate risk, political risk and sovereign risk. For example, a company may not like exporting goods to certain countries because of the political situation, a deteriorating economy, the lack of legal structures, etc.
Corporate risk: The risks associated with the company (exporter/importer): what is their credit rating? Do they have a history of non-payment?
To reduce these risks, banks – and other financiers – have stepped in to provide trade finance products.
Types of Trade Finance Products
The market distinguishes between short-term (with a maturity of normally less than a year) and medium to long-term trade finance products (with tenors of typically five to 20 years).
These are the different types of trade finance products out there:
- Letter of credit
- Supply chain finance
- Bank Guarantee
- Structured trade and commodity finance
- Export and agency finance
- Trade credit and political risk insurance
New Developments in Trade Finance
Trade finance is going through a revolution. New technologies and development are energizing traditional players, transforming their offerings and pulling trade into the 21st century. One of the main developments is the introduction of blockchain technology into the trade finance ecosystem. The promise of blockchain is that it has the ability to streamline the trade finance process. In the past, trade finance has been provided primarily by financial institutions, unchanged for years, with many manual processes on old-legacy systems that are expensive and costly to update. Such structures are mostly managed manually or through antiquated systems, which are not scalable and result in higher operational costs for financial institutions.
Blockchain technology can provide enormous benefits to solve these technological challenges in trade finance. It can be used to provide the basic services that are essential in trade finance. At its core, blockchain relies on a decentralized, digitalized ledger model, which by its nature is more robust and secure than the proprietary, centralized models which are currently used in trade finance. As a consequence, blockchain it can lead to radical simplification and cost reduction for large parts of transactions in trade finance, whilst making it more secure and reliable. It keeps an immutable record of all the transactions, back to the originating point of a transaction, also known as the provenance, which is essential in trade finance as it allows financial institutions to review all transaction steps and reduce the risk of fraud. One of the blockchain’s advantages is the speeding up of transaction settlement time which currently takes days, increasing transparency between all parties, and unlocking capital that would otherwise be tied up waiting to be transferred between parties in the transaction.
Trade Finance - Methods of Payment
Popular methods of payment used in international trade include:
Cash with order(CWO): the buyers pay cash when he places an order.
Cash on delivery(COD): the buyer pays cash when the goods are delivered.
Documentary credit(L/C): a Letter of credit (L/C) is used; gives the seller two guarantees that the payment will be made by the buyer: one guarantee from the buyer's bank and another from the seller's bank.
Bills for collection (B/E or D/C): here a Bill of Exchange (B/E)is used; or documentary collection (D/C) is a transaction whereby the exporter entrusts the collection of the payment for a sale to its bank (remitting bank), which sends the documents that its buyer needs to the importer’s bank (collecting bank), with instructions to release the documents to the buyer for payment.
Open account: this method can be used by business partners who trust each other; the two partners need to have their accounts with the banks that are correspondent banks.
An in-depth knowledge of all these issues is essential be able to choose the right trade finance solution with the best financier. If you have any questions, please feel free to call us directly on 1300 96 25 95.
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