Introduction

to
Trade Finance
 INTRODUCTION
THE TRADE FINANCE
A common dilemma faced when engaging in the sale and purchase of goods and
services, especially where international trade is concerned, is the seller wanting
to get paid before shipping the goods and the buyer wanting to receive the goods
before paying the seller. In simple terms, this can be called the trade dilemma,
where certainty around the inherent risks associated with trade, and the need to
bridge working capital cash flow gaps through access to external sources of
funding, become key in the facilitation of trade transactions. In order to provide
a solution for buyers and sellers, the financial sector intervenes by providing
them with trade finance products and services, increasing certainty for both
parties involved in a trade as well as funding where necessary.
 The Trade Finance
Trade finance is a set of techniques aimed at mitigating and transferring trade risks to the financial
sector, and/or using bank funding to enable domestic and cross border/ international trade flows. Trade
finance focuses on supporting the physical flow of goods across borders while primarily using the goods,
receivables and cash generated from the trade as the principal security.

“Trade finance focuses on supporting the physical

flow of goods across borders while primarily using
the goods, receivables and cash generated from the
trade as the principal security.”

Trade Finance exists to finance the trade cycle at various points of the transaction, also allowing
participants to manage the capital required for trade, while mitigating or reducing the risks involved in an
international trade deal.
Trade Finance deals typically involve at least three parties: the exporter (seller), the importer (buyer) and the financier, and
differ from other types of credit products as transactions should have the following features:

❑An underlying supply of a product or service ❑Other required documentation (certificates of origin, etc)

❑A purchase and sales contract ❑Insurance cover

❑Shipping and delivery details ❑Terms and instruments of payment, e.g. letter of credit, advance
payment, deferred payment, etc.

Eco System of Trade Finance

Why Is Trade Finance Necessary?
Trade Finance (also known as Supply Chain Finance and Import & Export Finance) is a massive driver of
economic development and helps maintain the flow of credit in supply chains. It is estimated that 80-90%
of global trade, worth $10 trillion per year, is reliant on trade and supply chain finance.

Who Benefits From Trade Finance?

❑ Trade Finance has many beneficiaries, from Corporates to Small & Medium Enterprises (SMEs), and
countries/ governments
❑ Companies use Trade Finance to increase the volumes of goods and services which they trade, fulfil
large contracts, and scale operations internationally
❑ Governments also assist with guaranteeing trade finance, as they aim to increase the trade of goods and
services.
Examples of Trade Finance
Banks
Funds
Alternative Financiers such as forfaiting houses

Insurance Underwriters
Trading Companies

Users of Trade Finance

Importers
Exporters
Trading Companies
 Risks of Trade Finance
International Trade has particular characteristics that give rise to different types of risks. Trade financiers thus
spend most of their time understanding and mitigating these risks. The following is a selection of some of the
key risks in international trade finance:
Country Risk
A collection of risks associated with doing business with counterparties based in a foreign country, including
exchange rate risk, political risk and ultimately, sovereign risk. Factors to bear in mind when considering country
risks involve the current political climate in the country, the state of the local economy, the existence of reliable
legal structures and the availability of hard currency liquidity, among other factors.
Corporate Risk
These are risks associated with the exporting/importing entities, primarily focusing on their credit rating and any
history of defaults, either through non-payment or through non- delivery/deficient delivery.
Commercial Risk
This refers to potential losses arising from weaknesses stemming from, or defects in, the underlying trade
(quality/adequacy of the goods being traded, robustness/adequacy of the contracts, pricing matters, etc).
Fraud Risk
These are risks typically associated with either unknowingly engaging with a fraudulent counterparty, receiving
forged documents and insurance scams.
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Documentary Risk
Documents play a vital role in international trade. Missing or incorrectly prepared documents pose risk for both
buyers and sellers as this can cause delays in shipments and ultimately delays in payments.

Foreign Exchange/Currency Risk

This is the risk posed by fluctuations in the exchange rates, relating to payments and receipts in foreign
currency. Unless it is hedged, the exporter or importer has no control over this movement in the rate of
exchange and on occasion such changes can wipe out the profit or even more attributed to the transaction.

Transport Risk
About 80% of the world’s major transportation of goods is carried out by sea, which gives rise to a number of
risk factors associated with transportation of goods. Storms, collisions, theft, leakage, spoilage, cargo theft,
scuttling, piracy, fire and robbery are just some of those risks.
 Products of Trade Finance
Trade finance products are generally categorized under two
areas: Unfunded Trade Finance and Funded Trade Finance.
❑ Unfunded Trade Finance products are focused on credit
enhancement/support, such that the provider involved
does not offer liquidity to the trade counterparts, but
rather supports the transaction by guaranteeing the
performance of the parties in their different roles
❑ Funded Trade Finance Products are focused on the
provision of funding/liquidity by a financial institution to
the parties participating in the trade transaction.
 TYPES OF TRADE FINANCE
‘Trade Finance’ is a catch-all term for the financing of international trade. Below,
we have briefly summarized the main trade finance products which are available to
businesses
❑ Trade Credit
❑ Cash Advances
❑ Purchase Order (PO) Finance
❑ Receivables Discounting
❑ Term Loans

Other Types of Business Finance

There are other types of trade finance which we think would be useful for SMEs
to know about, which aren’t strictly ‘trade finance’ as we define it, but they’re
worth considering.
❑ Equity finance
❑ Leasing and asset-backed finance
❑ Asset finance
 Trade Credit
Usually, the seller of goods or services requires payment by the buyer within 30, 60 or 90 days after the product is shipped (post-
shipment). Trade credit is the easiest and cheapest arrangement for the buyer. It is based mostly on trust directly between the buyer
and the seller. Insurance cover is usually taken by the seller on the buyer, due to the risk of non-payment.

Cash Advances
A cash advance is a payment of funds (unsecured) to the exporting business prior to the shipment of goods. It is often based on
trust; a cash advance is usually favorable and sought by the exporters so that they can manufacture or produce goods following an
order. However, it is a high-risk financing structure for the buyer, as there may be delays on sending product or non-delivery.

Term Loans
Longer-term debt (including term loans and overdraft facilities) can be more sustainable sources of funding. They are often backed
by security or guarantees. Often in the world of international trade and finance, securing against assets owned by business owners
in differing countries is difficult.
 Purchase Order (PO) Finance
Purchase Order (PO) finance is commonly used for trading businesses – who buy and sell; having suppliers and end
buyers. Financing is on the basis of purchase orders that allow a shot of finance into a growing company – this type of
facility is sometimes used or not known about by many companies and is at many times an alternative to investment. It also
provides huge advantages when negotiating with suppliers and end buyers – gaining credibility within the transaction
chain. PO finance usually goes hand in hand with invoice finance, as purchase order financier is paid back by an invoice
finance lender when goods are received by the customer.

Receivables Discounting
Invoices, post-dated checks or bills of exchange can be immediately sold on the market at a reduced rate, to the invoice
value. Receivables are mainly commercial and financial documents, and banks, finance houses and marketplaces allow
such documents to be sold at discounted prices in return for immediate payment. The discount rate, which may be
relatively high and can be costly for SMEs is calculated based on the risk of default, the creditworthiness of the seller or
buyer and whether the transaction is international or domestic.
 Other Types of Business Finance
There are other types of trade finance which we think would be useful for SMEs to know about, which
aren’t strictly ‘trade finance’ as we define it, but they’re worth considering.

Equity finance includes seed funding, angel investment, crowd funding, venture capital (VC)
funding and flotation. The principles however are the same. Generally, a business owner will give a
proportion of his or her shares to an investor and if the company grows and shares become more
valuable, they will sell their shares in the business (exit) and make a return on their initial investment.

Leasing and asset-backed finance involves the borrowing of funds against assets such as machinery,
vehicles and equipment. There are several finance mechanisms which allow SMEs to have access to
assets which are repaid in smaller contractual, tax-deductible repayments.
 Asset finance allows SMEs to purchase equipment or assets over a period
of time, and this method of machinery use is favorable for tax treatment in many
markets. There are different types of leasing/ asset finance, including finance
leases, hire purchase and operating leases