Trade finance entails facilitating international trade flows using financial instruments and products, such as bank guarantees and letters of credit from banks and other financial institutions. Trade finance makes it easier for importers and exporters to transact business.

International trade finance exists to mitigate or reduce the risks associated with international trade transactions. This is achieved by reconciling the divergent needs of an exporter and an importer by introducing a third party that eliminates payment risk for exporters and supply risk for importers.

According to the World Trade Organization, about 80 to 90 percent of world trade relies on trade finance. This article looks at how this works and the different types of global trade finance.

Risk Management and Payment in International Trade

There are inherent risks when a trade occurs between foreign companies in different countries. The exporter is concerned about receiving their payment on time, while the importer is concerned with receiving their product in the correct quantity and quality. Also, importers often place new orders for high-value bulk shipments that require substantial upfront costs to manufacture and supply, which come with significant risks.

The role of third-party trade financing is to pay the exporter in accordance with the trade agreement, while giving the importer credit to fulfill the trade order. This enables exporters to obtain quick access to financing in order to manufacture and ship products. This also allows exporters and importers to keep their working capital positive and concentrate on optimizing their operations for growth. At the same time, shipments are transported and paid for within a reasonable period. Receiving finance upfront generally helps to reduce the risk of defaults.

Exporters may never know whether or not an importer will pay them for goods shipped if trade financing is not available. At the same time, importers are hesitant to purchase a product because there is no guarantee that the seller will ship the goods to them.

Types of International Trade Finance

Trade finance can be provided by traditional banks and other financial institutions. Multiple parties are usually involved, including importers/exporters, trade finance companies, banks, export credit agencies, and insurers. The following are some of the primary services offered by trade finance companies:

- Letter of Credit

This is a promise made by the importer’s financial institution to the exporter that once the exporter shows all documents to confirm shipment, as stated in their sales contract, the financial institution will pay the exporter.

- Factoring

This is when an exporter sells a discounted invoice to a trade financier. Exporters use this to accelerate their cash flow. In this case, the trade financier, or factor, gives the exporter cash up front and collects payment from the importer at invoice maturity. This assists the exporter in reducing the risk of potential bad debts.

- Bank Guarantee

A bank acts as a guarantor for an exporter or importer in this case. With a condition, the bank guarantees a sum of money to the beneficiary. Suppose the exporter or importer is unable to meet the terms of their agreement. This provides comfort to both the buyer and the seller.

- Insurance

When shipping goods, insurance can be used to protect the exporter from nonpayment by the buyer. Loans, forfeiture, overdraft facilities, and export invoice financing are among the other services available.

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