WHAT IS TRADE FINANCE?
Trade finance is the financing of international trade flows. It exists to mitigate, or reduce, the risks involved in an international trade transaction.
There are two players in a trade transaction:
- an exporter, who requires payment for their goods or services, and
- an importer who wants to make sure they are paying for the correct quality and quantity of goods.
WHAT ARE THE RISKS?
As international trade takes place across borders, with companies that are unlikely to be familiar with one another, there are various risks to deal with. These include:
Payment risk: Will the exporter be paid in full and on time? Will the importer get the goods they wanted?
Country risk: A collection of risks associated with doing business with a foreign country, such as exchange rate risk, political risk and sovereign risk. For example, a company may not like exporting goods to certain countries because of the political situation, a deteriorating economy, the lack of legal structures, etc.
Corporate risk: The risks associated with the company (exporter/importer): what is their credit rating? Do they have a history of non-payment?
To reduce these risks, banks – and other financiers – have stepped in to provide trade finance products.
TYPES OF TRADE FINANCE PRODUCTS
The market distinguishes between short-term (with a maturity of normally less than a year) and medium to long-term trade finance products (with tenors of typically five to 20 years):
LETTERS OF CREDIT
The oldest and most common form of short-term trade finance is the letter of credit.
A letter of credit (LC) is essentially a pledge to make a payment – issued by a bank on behalf of its importing client. It is a written undertaking that a bank gives on behalf of its customer to pay the exporter an amount of money within a specified time frame – as long as the exporter complies with certain terms and conditions.
The importer bank provides the LC to the exporter (or exporter’s bank). The document essentially says: “I’ll pay you XX amount – if you ship the right goods to me.”
In this way the exporter is not taking the payment risk on the importing corporate, but on the bank. (Key to the use of LCs is the concept that bank risk is usually considered lower than corporate risk.)
If the exporter presents the bank with the correct documents – proof of shipping the correct goods, such as bills of lading – they can expect to get paid.
Quite often, this transaction will involve one further party – a confirming bank.
A confirming bank will usually be in the country of the exporter (reducing the political risks of waiting on the payment from an overseas bank). This bank will ‘confirm’ the LC provided by the importer’s bank.
The confirming bank will check the documents (proof of export against the LC requirements) and then pay the exporter the due amount (at a fee – paid usually by exporter).
There are many different kinds of LCs and LC structures that might stand behind a straightforward credit line to a client: standby LCs, back-to-back LCs, revolving LCs.
- Reduces risk of non-payment
- Could be the only way a customer/importer can obtain foreign currency to pay exporter
- Some countries require involvement of a local bank in payment for a significant import contract
- Does not wholly guarantee payment
- Bank in importer’s country could go bankrupt
- Political situation could impose freeze on payments
LETTERS OF CREDIT IN CONTEXT:
The general long-term market trend is moving away from letters of credit as, up until the recent financial crisis, importers and exporters were becoming more confident in trading with each other on an open account basis. Companies became more than happy to take on certain risks and deal with certain countries.
What’s more, the trade credit insurance market has been growing. Some trade transactions are conducted with just insurance providing a way of mitigating non-payment risks.
But, in the immediate aftermath of the crisis there was a resurgence in LC use and other trade finance instruments due to a drop in confidence and overall trust.
SUPPLY CHAIN FINANCE
Supply chain finance (SCF) is a concept that has been developing since roughly the 1990s, although it is becoming increasingly more relevant in today’s market
The term supply chain finance can be applied to many different activities within a bank or in the market as a whole. There isn’t an exact definition.
Banks market this product as a way of better managing a corporate’s working capital. Working capital – the money the company has in its accounts to pay general day-to-day expenses – is a key concern in today’s market.
It also means that banks are financing more than just one transaction/one export contract (as is the case with LCs). Instead, they are looking to support the continuing flow of goods.
Many banks have introduced supply chain finance programmes, based broadly around these concepts:
Supplier finance programmes: These leverage on the high rating of the buyer: the small suppliers to the larger, more credit-worthy, corporate can opt to get their 30-day/60-day/90-day invoices paid earlier (at a cost payable to the bank), or wait to the due date for payment.
These programmes aim to help the larger buyer and the suppliers manage their working capital efficiently.
Large buyers can take advantage of extra time to pay their suppliers, while the smaller suppliers access money quicker, rather than having it tied up in unpaid invoices.
Buyer finance programmes: These work in reverse: the bank extends banking facilities to buyers to finance imports from the exporter. It is then repaid on the due date by the buyers.
The benefits of this scheme is that it helps ensure the supplier gets paid, and helps manage its balance sheet by reducing its days sales outstanding (DSO). It can also help win importing clients who want to import a certain product, but lack access to enough liquidity.
STRUCTURED TRADE & COMMODITY FINANCE
This is a specialised activity dedicated to the financing of high-value supply chains. Every loan is tailor-made to client, transaction and region. They tend to be more long-term – sometimes up to five years.
Structured trade finance usually refers to the financing of cross-border commodity flows (and as such is most commonly known as structured commodity finance).
Structured commodity finance encompasses several different methods of finance for producers and traders of goods and commodities, including:
Pre-export finance (PXF): offering a company a means of raising money by using its export contracts as collateral
Borrowing base facilities: working capital credit facilities that are secured by current assets
Revolving credit facilities (RCF): A type of borrowing base facility which the borrower (usually a big commodity trading house) can draw from and pay back as needed, benefiting from extra flexibility
Warehouse financing: A loan made to a producer or processor with goods or commodities held in a warehouse as collateral (security). The goods can be held in a public warehouse approved by the lender or in the borrower’s warehouse, but managed by a third party (a collateral manager).
EXPORT & AGENCY FINANCE
Export credit agencies, commonly known as ECAs, are public government-owned agencies and entities that provide government-backed loans, guarantees and insurance to corporates from their home country that seek to do business overseas in developing countries and emerging markets.
ECAs aim to help promote the exports of their home country by allowing exporters to provide buyer’s credit to importers and by insuring transactions that take place in risky markets.
An ECA’s role is usually limited to guaranteeing transactions, and it is not uncommon to have several ECAs guaranteeing different parts of a deal involving exporters from various countries (particularly in big-ticket project financing). However, more and more ECAs are providing direct loans.
Export finance refers to credit facilities and techniques of payment at the pre-shipment or post-shipment stages.
TRADE CREDIT & POLITICAL RISK INSURANCE
There are a number of private insurance companies that offer specialist insurance protection against credit and wider political risks to a range of clients including banks and other financial institutions, exporters and importers, commodity traders and foreign investors.
Trade credit insurance protects against non-payment brought about by credit risks such as default, insolvency or bankruptcy.
Political risk insurance protects against non-payment due to exposure to political force majeure events, including acts of terrorism and war and other political violence. It also covers the risk that payment cannot be made due to actions by a foreign government.