What is trade finance?
There are many definitions of trade finance, which vary by organization and purpose. According to a trade finance paper issued by the Bank for International Settlement’s Committee on the Global Financial System, trade finance refers to bank products that help businesses manage their international payments and associated risks when undertaking cross-border trade transactions.
Trade finance products are typically of a short-term nature, but longer-term options are available in the market. One of the most common and standardised trade finance instruments is a letter of credit, which enables a bank to pay an exporter on behalf of an importer once the delivery of the goods is confirmed through required documentation. For more information on the different types of trade finance and how to access it, see the International Trade Centre’s (ITC) How to Access Trade Finance, the International Chamber of Commerce (ICC) Academy’s What is Export Finance, and Trade Finance Explained, an SME Guide for Importers and Exporters, 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).
Why does trade finance matter for small business to engage in trade?
Estimates suggest that 80-90% of global trade relies on some form of trade and supply chain finance. Financing trade matters because of the various roles that international trade plays in sustaining livelihoods, creating employment, and improving development conditions worldwide, especially in developing countries. Trade finance covers a wide range of financial products and can aid companies in increasing the volume of transactions, fulfilling large contracts, and scaling operations internationally. Yet there is a global trade finance gap of USD 1.7 trillion as of 2020, a 15% increase from two years earlier.
Firms face a variety of obstacles in obtaining access to trade finance. For example, many companies do not have the necessary working capital to self-finance exports in those instances where payment might only be received after the goods arrive at the purchaser. They may also be unable to pay up-front for imported goods that are being shipped from abroad. Another concerning factor is the high rejection rates of trade finance requests observed among some firm groups, with small businesses and women-owned firms reporting 40% and 70% of their applications being totally or partially rejected. 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.
What are different types of trade finance payment terms?
- A letter of credit (LC): Letters of credit are defined by Trade Finance Global as “financial, legally binding instruments, 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 fulfilled.” For more detailed information, see Trade Finance Global’s guide on Letters of Credit.
- A Bank payment obligation (BPO): This is similar to a letter of credit and obliges a bank to pay if appropriate documents, in this case digital, are presented. According to the United Nations Economic Commission for Europe (UNECE), a ” 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).” For more information, see the UNECE website.
- Documentary collection: This mostly involves interaction between banks. In the case of a documentary collection, the seller/exporter) will request payment by presenting its shipping and collection documents to their remitting bank.” These documents are then forwarded 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 upon.
- 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 can leave sellers open to risk of non-payment.
Where can policymakers access other resources on policy guidelines and frameworks?
- The International Finance Corporation’s (IFC) Global Trade Finance Program: This offers partial or full guarantees that cover payment risk on banks in emerging markets for trade related transactions. Visit the IFC website.
- The International Monetary Fund’s (IMF) Towards a Framework for Reporting Trade Finance: This resource updates a previous policy paper that aimed to address the measurement of trade finance in macroeconomic statistics. Visit the IMF website.
- The Organisation for Economic Co-operation and Development’s (OECD) Trade Finance for SMEs in the Digital Era: This resource explores policy approaches that can support the ability of small businesses to benefit from digital advancements to have greater access to trade finance. Visit the OECD website.
- The Wolfsberg Group, International Chamber of Commerce, and Bankers Association of Finance and Trade (BAFT) Trade Finance Principles: These consist of standards for designing trade finance products and operations that mitigate financial crime risks in the context of open account trade transactions. Access this resource.
- World Trade Organization – International Finance Corporation (WTO-IFC) Trade Finance and the Compliance Challenge: This describes the global business and regulatory environment of trade finance and showcases capacity building programs where countries can participate. Access this resource.
Where can policymakers access good practices and national examples?
- The Asian Development Bank’s (ADB) Effective Practices in Trade Finance Examinations: This resource presents experiences from bank regulators and commercial banks to provide guidance for examiners of commercial banks’ trade finance businesses. Visit the ADB website.
- The African Development Bank’s (AfDB) Trade Finance in Africa – Overcoming Challenges: This resource assesses trade finance developments in Africa and provides policy recommendations for reducing barriers that prevent small business access to trade finance. Visit the AfDB website.
- The Inter-American Development Bank’s (IDB) Trade Finance Facilitation Program (TFFP): This program promotes access of financial intermediaries to trade finance in Latin America, with the aim of expanding and diversifying funding sources available to importers and exporters. Visit the IDB website.
- The IFC’s Priorities in Financial Institutions: This resource is about the IFC’s work with local intermediaries to support MSME access to finance. Visit the IFC website.
- Informal Working Group on MSMEs: Drawing from recommendations submitted by business associations, the Informal Working Group has prepared a consolidated document that includes the of topic trade finance.