What is Trade Finance?

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Trade finance is advantageous to both importers and exporters as it keeps the trade lifecycle moving forward. Additionally, given that some 80 to 90% of world trade relies on trade finance, it holds immense influence on economic growth at both the local and international levels. But what exactly is trade finance? In short, trade finance offers a variety of financing options that enable commercial trade while mitigating risk. 

What is trade finance? 

Trade finance facilitates trade between buyers (importers) and sellers (exporters) by providing the necessary financing for and reducing the risks associated with commercial transactions. This type of finance can benefit businesses ranging in size, from large enterprises looking to mitigate international trade risks, to small e-commerce businesses who’ve had difficulty securing a traditional loan. 

How does trade financing work?

Intermediaries finance transactions between importers and exporters by leveraging different types of financing instruments, including lines and letters of credit. Intermediaries come in many forms, typically banks and other financial institutions. With trade finance, loans are secured by the underlying goods or receivables that are the subject of the transaction and are inherently self-liquidating.

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What are the financial instruments used in trade finance?

As we mentioned, trade finance covers a variety of financing methods. The term “trade finance” is an umbrella term encompassing several financial instruments, including both real and virtual monetary contracts, that banks and lenders use to make these transactions possible. These instruments help provide financing to buyers and sellers while also protecting funds and parties from risks including fraud and nonpayment. Below is a sampling of financial instruments commonly used in trade finance:

Lines of credit (LOC): A fixed sum, borrowed by both importers and exporters, and repaid according to predetermined timelines. 

Letters of credit (LC): Written guarantees that the importer will pay the exporter an agreed-upon sum within a certain timeframe, provided the exporter adheres to specified guidelines. Written by the importer’s bank, letters of credit provide importers with an advance of goods before payment.

Cash Advances: Funds provided to the exporter before the shipment of goods. This is advantageous to the exporter in that they can avoid disturbing their manufacturing/production cadence due to a lack of funding.

Factoring: The discounted sale of exporters’ medium and long-term accounts receivable on a “without recourse” basis.

What are the risks associated with trade finance?

Thanks to the traditionally low-risk implications of trade finance, such as short-dated transactions and self-liquidated funds, it tends to be considered a lower risk option for investors. That said, it is not without risk. The below outlines three primary risk factors and options for mitigating their impact.

Credit Risk

Credit risk is the risk associated with an exporter failing to receive an account payable. To protect themselves, businesses can use letters of credit to secure payments. Additionally, exporters can accept payment in full before the shipment of goods, to reduce or eliminate the risk of non-payment.

Country and Political Risk

A country’s political and economic stability can prove risky to international trade finance transactions. In addition to their stability, a country can introduce non-tariff trade barriers and bans on the sale of specific goods. To mitigate these risks, it is beneficial to understand the exchange control regulations associated with countries at each end of the trade transactions. 

Foreign Exchange Risk

Exchange rates are in constant flux. Foreign exchange risk encompasses the losses that an international trade transaction may suffer due to a sudden drop in currency value. Without an effective exchange policy in place, exchange rate volatility can impact businesses of all sizes. This is particularly true when the transactions are denominated in a different currency than the company’s primary one. Identifying foreign exchange risks and instituting an appropriate policy is imperative to protect against international currency risks. 

Recent Trends that Affect Trade Finance

A Decline in Correspondent Banking Relationships (CBRs) 

A correspondent bank is a bank that provides services on behalf of another that are, equal or unequal, financial institution. This includes activities such as facilitating wire transfers, conducting business transactions, accepting deposits, and gathering documents on behalf of another financial institution. 

According to a survey published by the IFC in September 2017, 27% of participating banks indicated that they saw reductions in CBRs in the previous year. With 78% of these banks anticipating that their compliance costs would drastically increase, there could be a continued strain on the relationship between CBRs and banks. 

De-risking Across the Global Banking System

The survey also noted that, while the recent actions taken to increase financial security and stability at the international level have positive intentions, they are reported to hurt emerging markets. Increased compliance requirements, for instance, have proven too costly for some banks. Such de-risking efforts, in addition to the decrease in CBRs we mentioned, are noted to be hindrances to emerging markets. 

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What is the trade finance gap?

Recently estimated at US$1.5 trillion, the trade finance gap is the deficit in financing between emerging and developed markets. A variety of factors contribute to the growth of the trade finance gap, including tight regulations and low credit ratings. Banks in these markets often have less access to reliable correspondents than developed markets. This, in turn, inhibits small business’ access to traditional financing methods and widens the already large deficit.

How it affects developed markets

As access to trade financing continues to favor large firms, these developed markets can continue to develop and further expand the global trade finance gap. The majority of banks anticipate that the gap will continue to grow without a shift or conscious effort to hinder its growth. Some large companies and global banks are noted to be working together, leveraging technology to improve some of the primary contributors to the growing global trade gap. 

How it affects emerging markets

Emerging markets that have a large trade finance gap may have limited access to funds, prohibiting them from making substantial imports. Their growth is often stunted without financial support. This is exemplified in a recent study that revealed 45% of micro, small and medium enterprises (MSME) financing applications were rejected, compared to just 17% of multinational firms. According to the study, the majority of these proposals were rejected because they failed to establish additional collateral. 

That said, emerging markets account for 360-440 million of the world’s 420-520 million MSMEs, and therefore provide a great opportunity for growth. With the necessary due diligence, emerging market banks can make significant returns on equity (ROE) by financing these MSMEs.

Trade finance can be an appealing option for investors looking to expand their portfolios with self-liquidating funds and fairly typical short-term transactions. Keeping the trends we mentioned in mind, you can decide how trade finance might benefit your portfolio and business ventures. 

This communication and the information contained in this article are provided for general informational purposes only and should neither be construed nor intended to be a recommendation to purchase, sell or hold any security or otherwise to be investment, tax, financial, accounting, legal, regulatory or compliance advice. Any link to a third-party website (or article contained therein) is not an endorsement, authorization or representation of our affiliation with that third party (or article). We do not exercise control over third-party websites, and we are not responsible or liable for the accuracy, legality, appropriateness or any other aspect of such website (or article contained therein).
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