We all now live in a truly global world market. As a result, doing business internationally has become increasingly important for many industries to ensure continued growth and expansion. Of course, international trade is nothing new – it has been in existence for a very long time.
Trade finance developed over time as a means of facilitating trade even further. It has been a significant contributor to the enormous growth of international trade in recent decades.
What is trade finance?
Trade finance is a finance facility specifically for trade purposes. It can be used for both domestic and international trade transactions between a seller and a buyer. Various financial institutions can assist these transactions by financing the trade. It is estimated 80%-90% of world trade is reliant on this method of financing1.
Some of the financial instruments2 used in trade finance are:
- Lending lines of credit
Can be issued by lenders to help both importers and exporters.
- Letters of credit
Reduce the risk associated with global trade since the buyer’s bank guarantees payment to the seller for the goods shipped.
However, the buyer is also protected since payment will not be made unless the terms in the letters of credit are met by the seller.
Both parties have to honour the agreement for the transaction to be settled.
Is when companies are paid based on a percentage of their accounts receivables.
- Export credit
Or working capital can be supplied to exporters.
Can be used for shipping and the delivery of goods and can also protect the exporter from non payment by the buyer.
Companies involved with trade finance may include importers and exporters, banks and other financiers, insurers, export credit agencies and various other service providers.
How trade finance works
The function of trade finance is to introduce a third party to transactions to remove the payment risk and the supply risk. Trade finance provides the exporter with receivables or payment according to the agreement while the importer might be extended credit to fulfill the trade order.
What are the benefits?
Sellers and buyers frequently do not know each other and are operating in different countries. The seller can be exposed to various credit and legal risks caused by distance, differing laws and a lack of personal knowledge of the other party.
Trade finance works by reconciling the different needs of both an exporter (seller) and importer (buyer). An exporter would naturally prefer to be paid upfront by the importer for a shipment. For the importer, there is a risk the exporter could keep the payment and refuse shipment.
On the other hand, if an exporter extends credit to an importer the importer could then refuse or delay payment.
Trade finance acts as a third party to remove both the payment risk and the supply risk
Letter of credit
Probably the most common solution to this problem is through a letter of credit. The letter of credit is opened by the buyer (in the seller’s name) through a bank or financial institution in their home country.
This provides the seller with a guarantee they will be paid – as long as certain delivery conditions have been met. This includes documentary proof the goods have been shipped. For this reason the use of letters of credit has become a very important aspect of international trade.
The development of trade finance has played an integral part in the growth of the international supply chain.
Australian businesses need to be ready to take advantage of ever expanding international trade opportunities with our current biggest export market. Trade finance options are varied and can be structured to your particular situation.
As your finance specialist we work closely with you to understand your needs to provide a suitable finance solution.
Reach out for more information or a chat about your business finance needs.