What is trade finance and why may I need it?
There are many definitions of trade finance, varying by organization and purpose. Trade Finance Explained, a joint publication by several international and private agencies, has straightforward definitions geared for MSMEs. These are summarized in the below guide.
Trade finance represents the financial instruments and products that are used by companies to finance international trade and commerce. 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.
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.
For more information on 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. The latter 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).
What are the different types of trade finance arrangements between buyer and seller?
- Trade Credit: This is the least expensive arrangement for the buyer (importer). Normally, the buyer is tasked with paying 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. (See our guide on trade insurance.)
- 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 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 different types of trade finance payment terms?
- Letter of credit (LC): These are described 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.
- 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 bank payment obligation “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, where the seller/exporter “will request payment by presenting its shipping and collection documents to their remitting bank,“ according to Trade Finance Global. 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.
- 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.
- Incoterms: Incoterms are very important for defining the risks between buyers and sellers. For more information, see guide on Incoterms.
- Financing and risk mitigation: By using different types of financing, like letters of credit and supply chain finance, including receivables finance (see guide on supply chain 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.
- 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 weigh the costs and benefits of using trade finance to determine if it would be a good option for your firm. Even if you have the cash to enable a transaction without additional finance, it may be worth considering trade finance given its additional assurances, guarantees, and the possibilities for your business to free up working capital for expansion.
More information on the considerations a business should make are available in the International Trade Centre’s (ITC) How to Access Trade Finance guide, written for small exporters to understand how to access trade finance.
Where can I learn more?