Trade finance is one of the broadest and most crucial aspects of financial services in the world. The space occupied by trade finance is indeed so huge that seldom can people understand it fully. Every monetary activity which plays a role in commerce and international trade comes under the ambit of trade finance.
Since 1983, several aspects of global trade and export trade markets have been funded via trade financing. The term has developed a long way from being a primary letter-of-credit product to a fully grown combined bond and debt ECA financing solution.
It could be difficult to grasp the full scope of trade financing owning to the massive scale of this term. However, we will try to understand the basics of this sector in brief.
In simple terms, trade financing includes the issuance of letters of credit, lending, factoring, export credit, and insurance. Organizations that are involved in these operations include bankers and financiers, importers and exporters, insurers and export credit agencies, and service providers.
Each participant plays a small but crucial role in the bigger picture. Essentially all the factors work together to remove payment risk and supply risk by introducing a third party to transactions. They are also used to provide receivables to the exporter as per the agreement and extend credit to the importer. These operations are carried out by suppliers, trade finance houses, banks, syndicates, and buyers.
Hence, trade finance is used to finance the trade cycle funding gap when buyers and sellers are short of money. Again, both buyers and sellers look at it as a tool for reducing their risk. To adopt a better approach towards the situation, the financier demands control over fund usage, goods, and source repayment. It will also require visibility and monitoring over the trade cycle through the transaction and security over the goods and receivables.
Even a small conflict between the exporter and the importer is handled by trade finance. Evidently, every exporter reduces the payment risk from the importer while accelerating the receivables. On the other hand, the importer minimizes supply risk from the exporter and ensures that he receives extend credit to maintain his cash flow. Essentially, in this arrangement, the risk of a possible hazard in payment and supply gets diminished by a third party.
It is important to understand that trade financing is not primarily focused on a buyer’s lack of funds or liquidity, unlike general financing which is used to manage solvency or liquidity. It is simply used to mitigate the risks that are present in the international trade and banking systems. By reducing uncertainty and handling working capital issues for both parties involved in a trade, this type of financing allows for smooth operations of international trade. Be it political instability or currency fluctuations, the financier absorbs the risks for their clients.
Letters of credit also come handy in a case when both the participants are not sure about each other’s creditworthiness. In such a situation this letter ensures that after successfully receiving proof of the exported item the issuing bank will release payment to the exporter.
By mitigating risks, trade exchange has become an integral part of international business.