What Is Trade Finance?
Trade finance refers to short-term financing required to facilitate the exchange of goods and services. This could be for both domestic as well as international transactions. It works to ensure that trade takes place in a smooth, efficient and hassle-free manner.
It encompasses all the financial instruments, products and services that help businesses undertake trade. These include Letters of Credit (LC), Supply Chain Finance, Factoring and Insurance, among others. The main parties involved in trade finance include exporters/sellers, importers/buyers, banks, financial institutions, insurers and trade finance companies.
According to the World Trade Organization, trade finance facilitates around 80 to 90% of international trade.
Why Is Trade Finance Used Internationally?
Trade finance is especially significant to facilitate international transactions. There are a lot of risks associated with International Trading, such as payment risks, performance risks, political risks and risks associated with the exchange rate, to name a few.
When it comes to international trade, on the one hand, the exporter would want upfront payment so that they are not taken advantage of and can fulfil the importer’s order. While on the other hand, the importer would only be willing to pay after getting some assurance of delivery and quality. The importer would also require credit facilities for such transactions. These are genuine concerns of both parties in such transactions.
Trade finance helps balance these two conflicting interests by ensuring that the exporter receives payment, thus mitigating the payment risk, and the importer has access to certain credit facilities.
One of the ways in which trade finance can help resolve this conflict is through an instrument known as a Letter of Credit (LC). The Importers’ bank may issue a Letter of Credit, on application by the importer, to the exporter’s bank. The exporter’s bank will confirm and present this document to the exporter, who can receive an immediate upfront payment for the goods/services from the bank by selling the Letter of Credit. The bank will recover this amount from the importer through the importer’s bank.
The exporter then ships the goods and also submits proof of shipment to their bank, which will be further sent to the importer’s bank. When the LC matures and the amount payable to the exporter falls due, the importer will make this payment to their bank, which will then further transfer this payment to the exporter’s bank.
Therefore, in a transaction that typically involves two parties, i.e., the buyer and the seller, one more party is introduced to help mitigate the risk involved in such transactions through trade finance. In this way, trust is built between the buyer and seller, thus promoting further trade.
Advantages Of Trade Finance
Better Cash Flow Management
Many businesses that import and export frequently choose to have financing agreements in place even if they don’t need the money or assistance. This is because trade financing is an excellent way to manage cash flow. Cash flow problems have a tendency to escalate, and all businesses should ensure that their cash flow situation is secure and well-managed.
With trade financing, one never needs to pay for funds not in need because it is set up only when there is an order to fund. Each trade financing transaction is limited to a single import or export order. One can simply use it when needed. It’s not a long-term deal, but more funding can always be pursued.
Trade financing provides a credit facility that can help one pay for the goods purchased from suppliers from all over the world. Its flexibility provides a period to source funds before settling the balance. It also aids the company’s cash flow allowing it to purchase goods in larger quantities.
Another benefit it has in terms of flexibility is that upfront payment can also be made in the seller’s local currency, which saves hassles of currency exchange risks.
Trade financing provides a payment guarantee to the sellers on behalf of the financial provider. Risk assessment before signing a contract offers suppliers the confidence to proceed with the transaction, knowing that maximum security is assured.
Never Miss A Deal
Trade financing makes things easier when one has a viable purchase order or is making a purchase for the supplies in need but has no cash in the account. It is not based on the businesses’ credit history or a certain level of credit score, and it is not mandatory to offer assets as security.
The focus for trade finance is on the next deal and ensures that if the business is in place, it can be funded. Unlike debt financing, chances of funding further deals aren’t decreased if trade finance is already in place. Finance providers are generally happy to fund if there are other providers as well.
No Requirement Of Onerous Collateral Obligation
One of the main advantages of trade financing is that there is no need to put up collateral. It’s a positive development and therefore won’t need any personal guarantee.
Choosing trade financing gives several competitive benefits as a result of a simple transaction. It is vital to remember that once the credit line is established, no ownership of items is taken. Instead, assistance in achieving the pace at which the business wishes to import and sell things is provided. This has a significant impact on the business’s growth and makes foreign purchases more convenient.
Enables Companies Negotiate Better Terms With Their Suppliers
There is a higher chance of better negotiation with the suppliers if trade financing is used in domestic and international businesses. This is beneficial as there are more opportunities to expand the business and earn more profit.
As a result of trade financing, buyers and sellers don’t have to worry about being paid on time or receiving high-quality items. Their financial providers will play a significant role which is why it is one of the most effective strategies for international business owners.
Challenges And Gaps In Trade Finance
Despite the undeniable benefits that access to trade finance provides for international trade, there is still a huge gap in its demand and supply. Trade finance is a very reliable and low-risk mechanism to facilitate trade, but there is still an insufficient and inadequate supply to keep up with the growing demand.
SMEs And Female Entrepreneurs Left Behind
According to data collected by the Asian Development Bank (ADB) for its 2019 report titled Trade Finance Gap, Growth, and Job Survey (6th edition), the global trade finance gap is around 1.5 trillion dollars. It is particularly acute among Small and Medium-Sized Enterprises (SMEs), as well as businesses run by women.
This trade finance gap also acts as a hindrance to achieving the Sustainable Development Goals adopted by the United Nations in 2015.
According to this report, 74% of the surveyed banks believe that there is insufficiency when it comes to fulfilling the trade financing needs for the growth of international trade, while the remaining 26% of banks don’t.
As per the report, 45% of the trade finance applications filed by SMEs are rejected. This compares to 39% in the case of mid and large-sized firms and 17% in the case of MNCs.
44% of trade finance applications filed by women entrepreneurs are rejected, compared to 38% in the case of male-run enterprises.
Lack Of Accessibility
Many factors act as barriers to the growth, development and accessibility of international trade finance. The ADB analysed these factors in its report through a survey conducted among banks. 76% of the surveyed banks felt that Anti-Money Laundering (AML) and KYC requirements are a major barrier to trade finance growth.
Other factors include high transaction costs/low fee income, low credit ratings, global economic uncertainty, and a lack of knowledge about trade finance.
As far as SME borrowers of trade finance are concerned, banks and trade finance providers usually demand more collateral from them to mitigate the risk of default. This also hinders the growth of trade finance, especially among SMEs.
Along with the barriers to trade finance, the report also studies the main reasons for the rejection of trade finance applications, including lack of additional collateral, KYC issues, and inadequate information.
Requirements And Legislation
The International Chamber of Commerce (ICC) Banking Commission’s Global Survey Report is also an in-depth study into the condition of international trade finance. In the survey for the 2020 report, there were participating banks from 85 countries. The report studies the potential barriers to the growth of trade finance.
It was found that a lot of the participating banks expressed their concerns about Anti-Money Laundering and KYC requirements, international compliances and regulations, high transaction costs, and trade restrictions as barriers to trade finance.
Future Of Trade Finance
With these challenges in mind, many are looking to what the future of trade finance may bring. Advancements in technology such as natural language processing, blockchain and optical character recognition are set to improve trade finance and do away with traditional bureaucracy. So much so that McKinsey predicts that digitising and enhancing the trade finance landscape could add up to 600 million new jobs. However, with trade finance being seen as a ‘traditional’ way to finance, it may take years for this sector to scale in the digital age.
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