What is trade finance?

The following is a guide for those of you new to the market, those looking for clarification, and those of you who have bluffed your way through up to this point.

What is trade finance?

There are various definitions to be found online as to what trade finance is, and the choice of words used is interesting. It is described both as a ‘science’ and as ‘an imprecise term covering a number of different activities’. As is the nature of these things, both are accurate. In one form it is quite a precise science managing the capital required for international trade to flow. Yet within this science there are a wide range of tools at the financiers’ disposal, all of which determine how cash, credit, investments and other assets can be utilised for trade.

In its simplest form, an exporter requires an importer to prepay for goods shipped. The importer naturally wants to reduce risk by asking the exporter to document that the goods have been shipped. The importer’s bank assists by providing a letter of credit to the exporter (or the exporter’s bank) providing for payment upon presentation of certain documents, such as a bill of lading. The exporter’s bank may make a loan to the exporter on the basis of the export contract.

Below I have outlined the various ways in which trade is financed by banks beyond the basic financial transaction described above – which I would refer to as traditional trade finance. I have divided this extended definition into the sectors which Trade Finance as a channel for the latest news and analysis for this market strives to cover.

Trade services and supply chain

Building on what I have termed traditional trade finance, there are a number of ways in which banks can help corporate clients trade (both domestically and cross-border) for a fee.

A typical service offering from a bank will include:

Letters of credit (LC), import bills for collection, shipping guarantees, import financing, performance bonds, export LC advising, LC safekeeping, LC confirmation, LC checking and negotiation, pre-shipment export finance, export bills for collections, invoice financing, and all the relevant document preparation.

Despite this focus on the LC, over the years the term trade finance has been shifting away from this sometimes cumbersome method of conducting business. It is now estimated that over 80% of global trade is conducted on an open account basis.

Led by large corporates, this form of trade saves costs and time and so has been adopted by smaller corporates as they become more comfortable with their buyer and supplier relationships. Open account transactions can be described as ‘buy now, pay later’ and are more like regular payments for a continuing flow of goods rather than specific transactions. This is much cheaper for corporates.

In response to this development, the organisation SWIFT launched the TSU (trade services utility), a collaborative centralised data matching utility, which allows banks to build products around its core functionality to improve the speed and flow of open account trade. This is helping banks re-intermediate themselves into these trade flows.

While volumes of LCs have remained flat in recent years, their value actually increased and they remain an essential part of emerging market trade and trade in countries where exchange controls are in force. This increase in value is also a reflection of the commodity price boom of 2007/08.

Factoring & Forfaiting

Factoring, or invoice discounting, receivables factoring or debtor financing, is where a company buys a debt or invoice from another company. In this purchase, accounts receivable are discounted in order to allow the buyer to make a profit upon the settlement of the debt. Essentially factoring transfers the ownership of accounts to another party that then chases up the debt.

Factoring therefore relieves the first party of a debt for less than the total amount providing them with working capital to continue trading, while the buyer, or factor, chases up the debt for the full amount and profits when it is paid. The factor is required to pay additional fees, typically a small percentage, once the debt has been settled. The factor may also offer a discount to the indebted party.

Forfaiting (note the spelling) is the purchase of an exporter’s receivables – the amount importers owe the exporter – at a discount by paying cash. The purchaser of the receivables, or forfaiter, must now be paid by the importer to settle the debt.

As the receivables are usually guaranteed by the importer’s bank, the forfaiter frees the exporter from the risk of non-payment by the importer. The receivables have then become a form of debt instrument that can be sold on the secondary market as bills of exchange or promissory notes.

Structured Commodity Finance

Structured commodity finance (SCF) as covered by Trade Finance is split into three main commodity groups: metals & mining, energy, and soft commodities (agricultural crops). It is a financing technique utilised by commodity producers and trading companies conducting business in the emerging markets.

SCF provides liquidity management and risk mitigation for the production, purchase and sale of commodities and materials. This is done by isolating assets, which have relatively predictable cash flow attached to them through pricing prediction, from the corporate borrower and using them to mitigate risk and secure credit from a lender. A corporate therefore borrows against a commodity’s expected worth.

If all proceeds to plan then the lender is reimbursed through the sale of the assets. If not then the lender has recourse to some or all of the assets. Volatility in commodity prices can make SCF a tricky business. Lenders charge interest any funds disbursed as well as fees for arranging the transaction.

SCF funding techniques include pre-export finance, countertrade, barter, and inventory finance. These solutions can be applied across part or all of the commodity trade value chain: from producer to distributor to processor, and the physical traders who buy and deliver commodities.

As a financing technique based on performance risk, it is particularly well-suited for emerging markets considered as higher risk environments.

Export & Agency Finance

This part of Trade Finance’s remit covers the roles of the export credit agencies, the development banks, and the multilateral agencies. Their traditional role is complement lending by commercial banks at interest by guaranteeing payment.

These agencies have once again become of vital importance to the trade finance market due to the role that they play in facilitating trade, insuring transactions, promoting exports, creating jobs, and increasingly through direct lending. All are important in the current global downturn.

ECA are private or governmental institutions that provide export finance, or credit insurance and guarantees, or both. ECAs can have very different mandates which we will not delve into here (please refer to Trade Finance’s annual World Official Agency Guide). As the global economic crisis continues we are seeing a trend towards a liberalisation of these agencies’ remits.

The development banks, sometimes referred to as DFIs (development finance institutions), and the multilaterals similarly have different mandates depending on their ownership or regional remit. Most will have a form of trade facilitation programme that promotes trade through the provision of guarantees.

ECAs and multilaterals are becoming a crucial part of the financing of large infrastructure projects around the world as credit from commercial banks remains scarce.

And the rest…

It doesn’t stop there, Trade Finance also follows: the trade credit insurance and political risk insurance markets – an important part of doing business in developing economies; the syndications market as banks and agencies lend funds to enable the trade finance activities of other institutions; Islamic trade finance through its increasing popularity and expansion beyond its historic markets; and finally Trade Finance follows the changes in global regulations and tracks the law firms and in-house legal teams that contribute to making deals happen.

Make sure you stay abreast of the latest news and analysis across the spectrum of global trade with Trade Finance – the information source on the trade, supply chain, commodity and export finance markets.