Trade finance tends to be a catch-all definition that is broad enough to encompass all the means and ways in which monetary support can be given to assist cross-border and international trade. As time passes, new methods and technologies emerge, and some peel away, and it is for this reason that this article revisits the different types of trade finance that are out in the world today…
There are various ways through which a business can receive financial support when either selling merchandise or services to another business, whether or not that other business is in another country or not. For the most part, trade finance deals with international and cross-border trade because this type of business – for the companies involved – tends to be much riskier.
The reasons why the risks increase are fairly obvious: laws, cultures, and currency systems change as borders are crossed, meaning exposure to bad agents, necessary and unnecessary costs, and transport and logistical obstacles increase too. Notwithstanding, governments in more vulnerable parts of the world can topple and change quickly meaning foreign policy geopolitics can also change, which also adds to the risks of a company expanding onto the international stage.
Stanchions of Finance
As set out by Trade Ready (a blog for international trading experts), there are four pillars of trade finance. These are payment (a variety of ways in which payment can be made in a timely way, is authorized properly, and is secure), risk mitigation (effective options for limiting broader risk internationally), financing (numerous options and opportunities for receiving financial support across the entirety of a trade deal and beyond), and information (the most recent pillar to be added where the flow of accurate, timely, and secure data has become essential).
Concerning payment, financial entities all over the world use the SWIFT network to standardize financial communications. This enables authentication measures and the deployment of instructions without misunderstanding or misinterpretation The system is fast, dependable, and secure.
The key to risk mitigation is to make calculated assessments rather than take rash or blind chances. Instruments of trade finance assess acceptable risk versus financial return and are thus a much more intelligent way to conduct business.
Liabilities that can be verified and analyzed are things such as civil unrest and revolution, commercial insolvencies and poor performance, and peaks and troughs in foreign currency exchange. In terms of the actual financing itself, despite the perceived complexity of some deals, the basic and unchanging concept is the lending of money from one entity to another and is variously outlined below.
And, regarding information; the technological revolution in communication technology means that each phase of a deal can be monitored with data being recorded and then fed to all pertinent parties, a shipment status, financial flow reports, and any other conceivable data point.
Even more than this, new technologies are emerging that greatly increase data security while facilitating the growth of business networks so that boundaries are becoming less relevant and participation by everyone is possible.
Species of Financing
Depending on where one is to look, the definitions or names given to the different varieties of finance can differ, but the means and methods used are broad commonalities (and can be seen in figure 1). Those depicted here are especially useful to Small and Medium-size Enterprises (SMEs) and may not encompass every type of trade financing that is constantly emerging:
Receivables Discounting (RD). Documents that act as proof of exchange in trading can be sold or even auctioned on the market at a reduced rate (such as an invoice). The seller might do this to replenish their financial coffers faster albeit at a lower return. SMEs can greatly benefit from this since they may not have the financial resources to pursue other business transactions until they have a return on the current one.
Purchasers of the document – and now the holders – have provided finance to the seller (typically the SME) and recoup their own outlay by receiving the balance of the deal at a later time, from the original buyers of the goods/services. This practice is also known as accounts receivable. Perhaps a similar method is factoring, where the sale of actual receivables occurs compared to borrowing.
Cash Advances. An advance of cash to an exporting business or entity before the shipping of merchandise has occurred. This type of finance is often based on an understanding, or trust, and can be an unsecured transaction. Exporters find this type of finance attractive because it gives them the freedom to produce the merchandise immediately after an order has been received. There are potential drawbacks for the buyer though since risks are higher around delays to the merchandise being sent or even the wholesale failure of the delivery of the product.
Term Loan. This is a type of financing deemed to be much more sustainable than others. Tending to be a longer-term agreement, the financier will have established security against their loan through an asset of some kind from the borrowing entity. Where this type of financing encounters difficulties is when a financier attempts to secure their loan against the asset/s of a business in a country where laws and regulations governing ownership can be inhibiting. Another name for this is the generic business loan.
Trade Credit. The standard operating procedure is that the seller sets a provision to be paid by the buyer within 30, 60, or 90 days after merchandise and/or services have been shipped. The nature of the finance is one of trust: the seller essentially extends credit to the buyer by shipping merchandise and then waiting to be paid.
To mitigate the potential liability though, the seller can take out insurance against the buyer’s failure to pay or can use other means of financing themselves (which are listed here). Sometimes, in this dynamic, multiple financing might occur across the deal wholesale, involving numerous financial entities and multiple agreements.
Purchase Order Finance. On receipt of a purchase order from an end customer, a finance provider can pay the supplier directly and then take payment from the end customer in turn. The point of this type of finance allows the financier to be able to support the whole of the supply chain from the beginning of the trade from the supplier to repayment at the end.