What is Trade Finance?
Trade finance refers to the funds that help fill the payment gap created between the supply of the goods and the receipt of the same by customers. Offering such funds makes sure the movement of goods and services from one end to the other remains smooth and free of financial struggles.
Through trade finance, every party involved in the trade process knows it won’t have to suffer from financial risks and frauds. From a seller to the buyer and the finance giver, each element in the process remains safe with respect to the trade transactions involved.
Table of contents
- Trade finance is about financing a trade where the exchange of goods, products, commodities, and different financial instruments occurs between sellers/exporters and buyers/importers.
- Trade financing is a mechanism through which the gap between the shipment of a product or commodity from one market to its arrival in another is efficiently bridged.
- It helps mitigate various risks related to products, manufacturing, transport, and currency.
- Letter of Credit, supply chain financing, receivables financing, export contract, etc., are some methods adopted for effective trade financing.
Trade Finance Explained
Trade finance is facilitated and taken care of by multiple providers in the market, be it a banking institution or a financial entity. It is a de-risk strategy applied to tackle the trust issues that might arise between two parties/nations involved in a trade. While many businesses receive supplies on credit, a few suppliers may not trust their clients or customers to an extent where they could allow them to trade on creditTrade On CreditThe term "trade credit" refers to credit provided by a supplier to a buyer of goods or services. This makes it is possible to buy goods or services from a supplier on credit rather than paying cash up front., observed most prominently in international trade. Through trade funding, however, this balance in financing remains well-maintained without hampering the flow of goods during imports and exports.
Global trade finance involves financing financial instrumentsFinancial InstrumentsFinancial instruments are certain contracts or documents that act as financial assets such as debentures and bonds, receivables, cash deposits, bank balances, swaps, cap, futures, shares, bills of exchange, forwards, FRA or forward rate agreement, etc. to one organization and as a liability to another organization and are solely taken into use for trading purposes. and products that companies launch or issue to undertake international trade and commerce. The trades carried out by small and medium-sized businesses using trade funds are meant to access working capital. Hence, these finances may include serving purposes, like making an investment, paying suppliers, or paying salaries.
When people buy groceries from a physical store, they take the items and pay for them immediately. As a result, there is no time gap between the service delivery, receipt of it, and payment for it. However, there are trade scenarios where payment is not real-time. To assure on-time payment, buyers ask financers to pay for their purchases. This payment is used by sellers/suppliers to produce and sell the ordered goods. If the funds are not offered to suppliers, the production will be affected.
Trade finance makes that payment available to the parties that require it instantly or treated as a payment assurance for further deals. In short, these financing options help fill the transaction gap from the product supply to the receipt of payment involved in the entire trade.
Types of Trade Finance
There are several methods to achieve trade financing. However, the most common is the Letter of CreditLetter Of CreditA Letter of Credit (LC) is issued by a buyer’s bank to ensure timely, full payment to the seller. If the buyers default, the bank pays the sellers on their behalf., a document banks offer to protect global trading activities. This international trade finance option is available in different forms, given the purpose for which the fund is required, whether personal or commercial.
Supply chain financingSupply Chain FinancingSupply Chain Finance, also called Reverse Factoring, is an arrangement in which the supplier gets advance payment for receivables through a financier on behalf of the buyer. It provides significant benefits for both the buyer & the supplier. (SCF) is the method that keeps the supply chain efficient. Some exporters do not agree to offer goods on credit to importers, which might delay the meeting of customer demands in the market. Through SCF, the export-import process remains uninterrupted as the trade finance providers pay exporters on importers’ behalf. In addition to the supply chain funding method, export-import efficiency can also be controlled using the export contract, which a bank provides as proof of loanLoanA loan is a vehicle for credit in which a lender will give a sum of money to a borrower or borrowing entity in exchange for future repayment. offered to exporters.
Then, there comes the purchase order financing, a pre-shipment funding alternative. Through purchase orderPurchase OrderA Purchase Order (PO) serves as a legal document between buyer and seller, wherein, the buyer sends this contract that details the goods and services, date of delivery, payment terms as per the contract etc., the lender pays an upfront amount, a certain percentage of the total cost of supplies. The finance is received by suppliers directly.
The next on the list is invoice discounting, which is one of the most popular forms of trade finance, especially in the United States. Under this option, the invoice ownership is transferred to sellers, who make debtorsDebtorsA debtor is a borrower who is liable to pay a certain sum to a credit supplier such as a bank, credit card company or goods supplier. The borrower could be an individual like a home loan seeker or a corporate body borrowing funds for business expansion. liable to the financing company directly. In short, the funding and repayment occur between the buyers and the lenders. The sellers are present nowhere in the process.
Last but not least is receivables financing which is a claim for repayment. It signifies the company’s right to receive the amount another party owes. It is a legally enforceable document that businesses hold for products and services sold.
Multiple providers help in the risk-mitigating process, and numerous borrowers are awaiting fund disbursal when needed. In addition, some providers and users participate in making trade finance an effective finance solution for global trade and commerceCommerceCommerce is the accumulation of several transactions for a given industry. A transaction is a one-time event where an entity exchanges anything of value with a different entity..
While banking institutions, syndicates, and trade finance houses are the finance providers, manufacturers, exporters, and importers use the funds offered to maintain efficiency in facilitating smoother trade and commerce.
Customer demand for Brand A’s sugar was significantly increasing in the market. As a result, the company ordered supplies from Supplier B. The supplier, however, was recently cheated by a buyer who did not pay for the supplies. Thus, it developed some trust issues with other bands.
Thus, the supplier doesn’t agree to deliver the items until the amount is paid. Due to the bulk order, Brand A could not pay the supplier. As a result, it connects with XYZ Bank and asks to pay the supplier on its behalf. The bank pays Supplier B, and the brand gets its supplies as promised.
With the sale of the product, the buyer repays the lender. This is how trade finance works.
Trade finance saves buyers from delayed receipt of supplies that might hamper the demand for their products in the market. In addition, the same helps in reducing risks in the international trade market. As the participants involved in the trade are unfamiliar with each other, it is difficult and doubtful to say if the exporters/sellers are supplying goods and importers/buyers are receiving those items in return.
In the event of delivery issues, the repayment might become doubtful. Plus, the poor credit ratingCredit RatingCredit rating process is the process in which a credit rating agency (preferably third party) analyzes a security and rates it accordingly so that the stakeholders can make their investing decisions. of the borrower might be another major factor. Above all, the fluctuating market conditions, which affect the currency exchange rates, are always a matter of concern.
Trade finance enables trading parties to reduce such risks. Therefore, the ones interested in trade finance jobs must know of the risks associated while dealing with exporters and importers. This, in turn, will help them assist the market players in the best possible way.
Frequently Asked Questions (FAQs)
It is a process of funding a trade involving the exchange of goods, commodities, and financial instruments between two parties via financial or banking institutions. The financing option helps establish a profound and long-term relationship between a buyer and a seller as it lays the foundation of mutual trust and understanding.
In banking, the option involves issuing a Letter of Credit to help exporters and importers involved in trade without any financial interruption, which might cause a gap between supplying items and paying for them.
It offers amazing growth prospects with respect to careers. One can either stick to the job and become a specialist or even get an opportunity to switch between different banking roles to find the most suitable one.
This article is a guide to what is Trade Finance & its meaning. Here we explain its role in banking & global/international trade, its types, examples, and risks. You may also have a look at the following articles –