Unknown to many, trade finance is one of the most historic types of finance; originating since 3000 BC, where the first Babylonian clay tablets were discovered, inscribed with what is now termed a Letter of Credit, or Promissory Note.
Fast forwarding to today, over US $3tn of trade is done per year (and this is growing, Chart 1) and much of this is financed through ‘Open Accounts’. Open accounts are built on the premise that a seller or distributor will pay for the goods 30-60 days on receipt of them, but offers little skin in the game for their buyers, who might not pay. Trade finance is the umbrella term for the financing of trade both domestically and internationally, helping both buyers and sellers finance the sale of goods and services.
Chart 1: Volume of merchandise exports and imports by level of development, 2012Q1-2016Q4
Seasonally adjusted indices, 2012Q1=100
For exporters, trade finance is an opportunity to grow trusted relationships with buyers around the world, and opens opportunities to do business in new markets without worrying about risks around non-payment. Financial institutions, banks and alternative funders offer instruments to facilitate trade.
For most businesses, cash is king, and paying suppliers up front for raw materials, contractors and intermediaries in order to export the finished goods can mean it’s impossible to complete larger deals, due to lack of working capital. Furthermore, end customers often take 60-90 days to make payment, which could delay the next big deal or next customer, due to cash constraints.
What can trade finance be used for?
Trade finance can be used for both exporters and importers, in conjunction with confirming and advising banks, and has a number of use cases, including:
- Guaranteeing payment to a seller through a bank
- Getting unpaid invoices advanced
- Payment to a seller once the buyer receives the goods
- Protecting FX volatility when paying in different currencies
The most common form of trade finance is Open Accounts (80-90% of trade is done on these terms) and Letters of Credit, or Documentary Credits. Financial institutions will guarantee payment to a seller through a credit facility once the seller ships the goods via a Letter of Credit.
A Letter of Credit is issued by a bank and guarantees payment to the seller / exporter if the terms and conditions specified in that LC are met.
Many companies might use some form of trade finance as part of their overall supply chain and finance / cash flow management strategy. If your company imports or exports overseas and is looking to grow or reassess it’s cash management situation, it’s definitely worth utilising trade finance services to help the business.