Trade Finance Introduction – for Businesses
What is trade finance and why may I need it?
There are many definitions of trade finance, varying by organization and purpose. Trade finance includes the financial instruments and products used by companies to finance international trade, importing and exporting. Trade finance covers a wide range of financial products and can help companies increase the volume of transactions they make, help them satisfy large contracts, scale and grow internationally. (See Trade Finance Global’s Trade Finance Explained.)
Many firms do not have the necessary working capital to self-finance exports where payment might only be received after the goods arrive at the purchaser, or to pay up-front for imported goods that are being shipped from abroad. Because of the time between purchase and delivery and the many possibilities for disruption that can occur due to transportation mishaps, purchaser demand, or economic and political events, international trade has many risks that can be alleviated through trade finance.
Trade finance and Incoterms are highly related. Incoterms is an abbreviation for “International Commercial Terms.” Issued by the International Chamber of Commerce (ICC) and globally recognized, Incoterms define the obligations between buyers and sellers. (See the Trade4MSMEs Guide on Incoterms).
What are the different types of trade finance arrangements directly between buyer and seller?
Trade Credit: This is the least expensive arrangement for the buyer (importer). Normally, the buyer has to pay for the product within a set timeframe after shipment is complete, often ranging between one to three months. This can leave the seller (exporter) with a high level of risk of non-payment. The seller often takes out insurance in case the buyer fails to comply.
Cash Advances: This involves the payment of unsecured funds to the exporting business before the goods are shipped. Like trade credit, it is often based on trust, however, cash advances take the risk from the seller (exporter) and place it on the buyer (importer), as the seller receives payment immediately. Risks can include shipping delays or non-delivery.
What are other types of trade finance and methods of payment?
By using different types of financing, like letters of credit and receivable finance, suppliers can not only reduce their risk for non-payment but can also receive early payment for their invoices and other documents, thereby decreasing the risk of supply disruptions and increasing working capital.
Letter of credit (LC): These are contractual commitments issued by banks or specialist trade finance institutions. An LC guarantees that the seller will be paid on behalf of the buyer if the terms specified in the LC are fully met. Letters of Credit are created to protect both exporters and importers.
Bank payment obligation (BPO): This is similar to a letter of credit and requires a bank to pay if appropriate documents, in this case digital, are presented. BPO is an irrevocable undertaking given by one bank to another that payment will be made on a specified date after successful electronic matching of data according to industry-wide rules set by the International Chamber of Commerce Banking Commission (ICC)
Documentary collection: Documentary collection is an exchange between banks, where the seller/exporter requests payment by presenting its export documentation, including shipping and collection documents to their remitting bank. These documents are presented to the buyer/importer’s bank and the exporter’s bank will be credited by the importers. Unlike a letter of credit, no payment guarantee is made, no document verification is made, and no credit or country risks are assumed by the bank. Payment is solely based on the available funds of the buyer.
Bill of exchange or promissory note: These are documents between two transacting parties that confirm a financial transaction has been agreed.
Open account transactions: These are arrangements for buyers to pay sellers within a certain amount of time (typically 30-90 days), with no additional formalities. This type of payment is very beneficial to buyers but leaves sellers with more risk.
- Supply chain finance: is a cash flow solution that businesses can adopt to help free up working capital stuck in global supply chains (see the Trade4MSMEs guide on supply chain finance).
Other forms of financing: There are other types of financing tools that firms can also consider for trade, including equity finance, leasing, asset-backed finance, or even fintech like crowdfunding or peer-to-peer financing.
Term loans: These are also a longer-term financing option permitting the borrowing of a determined amount for a specific period of time from a bank or other financial institutions. They come with a specified repayment schedule and fixed or floating interest rate payments.
What type of trade finance is right for me?
It is important to understand the costs and benefits of using trade finance to help you decide if it would be a good option for your business. You may have the cash to enable a transaction without additional finance, but It’s worth considering if the additional assurances and guarantees that trade finance provides could help you free up working capital for other business development and expansion.
Links to Supporting Information
Trade Finance Global’s Trade Finance Explained, a guide for MSME importers and Exporters. This guide is co-authored by Trade Finance Global, the ITC, the Federation of Small Businesses (FSB), the Institute of Export & International Trade (IOE&IT), the British Exporters Association (BExA), the Forum of Private Business (FPB), and the International Finance Corporation (IFC).
International Trade Centre’s (ITC) How to Access Trade Finance information on types of trade finance and how to access it.
International Chamber of Commerce (ICC) Academy’s What is Export Finance Guide Export Finance
UNECE United Nations Economic Commission for Europe Bank payment obligation – Trade Facilitation Implementation Guide on Bank Payment Obligation
International Chamber of Commerce ICC-Guidelines-for-the-Creation-of-BPO-Customer-Agreements
Trade Finance Global Documentary Collections (DCs) | Trade Finance Global [UPDATED 2023]
Trade4MSMEs guide Trade Insurance
Trade4MSMEs guide Incoterms
Trade4MSMEs guide Supply Chain Finance
The International Trade Centre’s (ITC) How to Access Trade Finance guide, written for small exporters to understand how to access trade finance.
The ITC SME Trade Academy ITC SME Trade Academy – Summary of Export Finance and Payments training course on Export Finance and Payments
The International Chamber of Commerce (ICC) offers a trade finance online training and certificate.
The Global Trade Helpdesk can also suggest potential trade finance providers