Master the basics of international trade finance by learning these four pillars

11/03/2016

Basics of International Trade Finance

Basics of International Trade FinanceThe value propositions related to trade finance—its primary contributions to facilitating international trade—are perhaps well illustrated as four “pillars” supporting the overall financing proposition.

Trade finance is about some combination of:

  • enabling and facilitating payment across the globe;
  • providing risk-mitigation options through trade finance mechanisms, structures and techniques;
  • offering a range of financing options to importers and exporters (as well as banks, when needed); and finally
  • ensuring access to timely information about any element of a given transaction, from the status of a payment to the location of a shipment.

1. Payment

Trade finance offers several mechanisms to facilitate and assure timely, authorized and secure payment in the course of a transaction.

For example, banks and financial institutions around the world are members of SWIFT, the Brussels-based organization that facilitates electronic communication and payments between banks, financial institutions and soon, corporate clients across the globe.

SWIFT is a member-based organization that has a global standardized messaging system that allows banks to authenticate and transmit various types of messages, including text messages and payment instructions, in a standard format across the globe.

From simple electronic funds transfers (EFTs) to complex trade finance instruments, SWIFT is an invaluable enabler of fast, secure and dependable communication between member organizations.

In addition to the basics of transmitting payment, trade finance instruments define prearranged conditions (agreed between importer and exporter, and regulated by a set of internationally recognized rules) against which payment will be triggered. Those conditions are meant to protect importers and exporters from risk.

2. Risk mitigation

Trade finance instruments are very effective options for reducing or eliminating a broad range of risks across the globe, in almost any market condition imaginable.

Individuals or firms venturing into international trade or global commerce will, by nature, have a certain tolerance for risk.

Provided that this tolerance is based on an adequate assessment of the risk involved through research, knowledge and due diligence, measures can be taken to ensure that the risk is calculated and is in proportion to the expected return. In most cases involving international trade, some risks will remain.

Trade finance instruments and practices are designed to assist importers and exporters with effective risk-mitigation techniques.

The risks, which can be mitigated through appropriately structured trade finance instruments or services, include:

  • civil unrest and revolution or other financial crises in either the importer’s or the exporter’s country, generally referred to as country risk;
  • commercial risks of insolvency or non-performance by either the importer or the exporter, or potentially, a bank involved in the transaction (the latter is also referred to as bank risk); and
  • foreign currency risk, resulting from fluctuations in exchange rates, for either importers or exporters. This risk arises because transactions are most commonly denominated in U.S. dollars or, increasingly, Euros, with the importer and/or the exporter operating in an entirely different currency, and therefore being exposed to foreign exchange risk.

One of the key contributions of trade finance to facilitating international commerce is referred to as credit enhancement.

This occurs when the payment promise of one party (for example, the importer) is replaced by an independent payment promise from another, financially stronger party, such as a bank.

This type of risk-mitigation option can also apply between banks, when a payment promise is shifted from a small financial institution located in a high-risk market to a larger, stronger bank in a stable financial centre.

To illustrate, an exporter in France may be selling materials to a client in Ivory Coast, with the importer agreeing to pay within 30 days of receipt of an invoice and related shipping documents.

If the transaction is structured—as it can be using trade finance instruments—so that a bank in Ivory Coast takes on the payment obligation of the buyer, this shifts the payment promise or undertaking from the importer to the local bank.

Further, at the importer’s request, the exporter can, quite legitimately, arrange to have the payment promise shifted from the Ivory Coast bank to a bank in France—again, using trade finance techniques.

Ultimately, the payment undertaking or payment obligation has now shifted from a commercial party in Abidjan—a party with potentially questionable financial strength—to a French bank that is well known to the exporter.

In this way, trade finance has enabled the credit quality of the transaction, from the exporter’s viewpoint, to be enhanced.

In addition to mitigating risk, credit enhancement also has the effect of lowering the overall cost of a trade-financing transaction.

This occurs organically, given that the improved credit quality can drive down the cost of funds associated with the deal, as a result of the lower risk of the transaction.

Risk-mitigation solutions can also be provided by financial institutions working in partnership with government entities called export credit agencies, or ECAs.

These agencies offer a range of guarantee, insurance and financing products and services, which are often indispensable in the consummation of international transactions, especially in higher-risk markets.

3. Financing

Trade finance provides for numerous forms of financing across the lifespan of a trade transaction.

At its most basic level, financing involves the lending of funds to one party by another, whether in the common situation where monies are actually transferred or in a variation (with the same final outcome) where payments are delayed by agreement, which has the effect of making funds available to the debtor for the period of the delay in payment.

Whether a buyer borrows €10,000 for three months to finance the purchase of new inventory, or whether the supplier agrees to deliver the inventory today, but accept payment at a future date—perhaps 90 days hence—the outcome for the buyer is that they have been financed: €10,000 for three months.

An exporter may need funds to produce goods for shipment but may not have the necessary cash flow.

Once a sales contract is concluded between importer and exporter and a trade finance instrument is issued, usually by a bank or other financial institution, financing may be arranged to assist the exporter in producing the agreed goods for sale. This is often referred to as pre-shipment financing.

Similarly, when the importer receives goods and payment is due, the importer may not have immediate access to the funds necessary to effect payment.

Trade finance instruments provide a mechanism to facilitate immediate payment to the exporter, as originally agreed, while permitting the importer to delay payment to the bank for an agreed period.

Such arrangements allow importers to sell their goods, generate a profit and reimburse the bank from the proceeds of the sale.

Overall, the instruments that support the conduct of international trade are very versatile: they provide significant flexibility, offer a variety of options and are quite readily adaptable to a wide range of legal, political and geographic jurisdictions, business practices and financing requirements.

Trade finance instruments and processes have sometimes evolved in very specific ways to meet the business needs of a country or region.

The option of using certain trade finance instruments as collateral for straight loans, for example, is fairly common in parts of Asia (though less common in the Americas and Europe), and matches the financing needs as well as the banking relationships of the regions where this option is exercised.

A party providing financing, whether this is a bank or either trading partner, may choose to take on the risk of financing, or may reserve the right to claim monies back from the borrower in the event of default, delay or other unacceptable event.

These options are referred to as financing without recourse, or with recourse. With recourse indicates that the lender may, in the event of difficulty in recovering the funds advanced, claim the monies back from the borrower, and the terms of the financing provide that the borrower must return the funds borrowed.

Financing without recourse protects the borrower from any future claim by the lender, who must instead pursue recovery of funds from the original source— generally one of the other parties in the trade transaction.

Non-recourse financing tends to be more expensive for the borrower due to the higher risk to the lender.

4. Information

The latest pillar to be added to the value proposition of trade finance is the provision of timely, accurate and detailed information about every aspect of a trade transaction, from the status of the shipment to the precise reporting of financial flows, at any given moment in that transaction.

Access to timely information related to both the physical movement of goods and the financial flow of a deal is no longer just a matter of interest or preference but, rather, a critical dimension of business efficiency and competitiveness.

Trade finance and logistics providers are investing significantly in the enhancement of technology and related reporting capabilities, working to turn the provision of timely information and high transactional visibility into a significant element of their value proposition to importers and exporters on a global basis.

Technology—from processing systems to web-accessed software and sophisticated reporting systems—is enabling the delivery of trade finance solutions across the life of a transaction, and doing so at an ever-faster pace, to keep up with the evolving needs and increasing expectations of importers and exporters.

The latest developments in trade finance include significant forays by leading global banks into areas that traditionally have not been the purview of trade bankers but are increasingly so today.

Logistics, customs brokerage, supply chain finance and management are all areas where the informational pillar is of critical value to importers and exporters.

In the past decade, we have also seen the entry of non-bank players into the trade finance arena. Companies that have traditionally managed the physical aspects of the global supply chain are moving towards providing financing solutions as a complement to their traditional products and services.

This content is an excerpt from the FITTskills International Trade Finance textbook. Enhance your knowledge and credibility with the leading international trade training and certification experts.

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About the author

Ewan Roy

Author: Ewan Roy

I'm a Digital Marketing Specialist for the Forum for International Trade Training (FITT). My background is in writing and research, and I am passionate about communicating new ideas and telling stories that matter to you.

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