What is Trade Finance?
Trade finance deals with both domestic and international trade transactions, including all the financing needed for the trade. Finance trade also makes trade transactions easy for both importers and exporters.
The Four Pillars Of Trade Finance
The pillars will help you understand finance basics of trade finance.
Financing
Trade finance provides various financing instruments for trade transactions which make it flexible and versatile. Financing entails lending funds to someone through another which can be transferring of actual money or the delay in payment based on agreement. As a result, funds can be made available to debtors pending the time of delay in payment.
For instance, an importer can decide to borrow a certain amount for about two months just to finance buying new products. Or an exporter can agree to accept payment of the products delivered today in two months. This is referred to as financing because during the two months the importer has been financed.
The trade finance instrument is usually issued by banks and other financial institutions when an agreement has been concluded between the importer and exporter. In a situation whereby an exporter doesn’t have enough funds to produce the number of products needed in the agreement. Then financing can be arranged to help the exporter.
Likewise, an importer can receive products without having the funds needed to make payment. Trade finance instruments help the exporter receive payment based on agreement and allow the importer to delay making payment to the bank at an agreed time. With this kind of agreement, importers can sell their products, make profits and then pay back the bank on the agreed time.
Payment
Trade finance provides various mechanisms that ensure secure, timely and authorized payment during the period of the transaction. As we all know, financial institutions and banks globally are members of the Society for Worldwide Interbank Financial Telecommunication(SWIFT).
SWIFT is a Brussels-based organization that facilitates electronic communication and payments to financial institutions and banks globally. The members of SWIFT worldwide can share financial transaction information in a trusted, secure and reliable environment globally.
This organization is accountable for any information based on transactions using a standard format and they transmit instructions for payments and messages. SWIFT can be used to carry out simple electronic funds transfers to more complex trade finance instruments. Trade finance instruments deal with transmitting payment and also help with agreement conditions between importer and exporter to avoid possible future risks.
Risk Mitigation
There are some risks involved in international trade or global commerce. But trade finance instruments have been very successful at eliminating a variety of risks in any imaginable market condition. Trade financial instruments and processes are designed to help both importers and exporters with risk mitigation. The risks that can be mitigated with trade finance instruments can be categorized into three.
Currency risk: this risk is a result of fluctuation in exchange rates for the exporters or the importers. The reason is that transactions are commonly made with the U.S dollar and the importer or exporter can be using currency that is quite different.
Commercial risk: is either a result of the importer or exporter not keeping to the terms of an agreement or the bank.
Country risk: it can be as a result of a revolution, financial crisis, civil unrest faced either in the importer or exporter country.
Information
This is one of the important pillars of trade finance as there is a need for accurate, timely, and detailed information. All information from shipment status to reporting of financial flows at every step of the transactions. Having access to precise and accurate information on the financial flow and movement of products is very important.
Logistic providers, as well as trade finance, have been investing in technology that will help both importers and exporters have access to detailed, precise, accurate and timely information. This pillar is very important to both importers and exporters when it comes to the areas of management, logistics, supply chain finance and customs brokerage. The financial ratio of a company can help you gain meaningful information.
How Trade Finance Works
Trade finance helps to eliminate payment risk and supply risk by introducing a third party or an intermediary to financial transactions. Trade finance helps exporters to receive payment based on the agreement while there might be a need to increase credit for importers to perform the trade order.
Intermediaries like banks and other financial institutions intervene to finance business transactions between importer and exporter. These business transactions can be domestic or international. Trade finance has contributed greatly to the growth of international trade. There are lots of parties involved in trade finance, some of which are insurers, banks, importers and exporters, export credit agencies and service providers and trade finance companies.