Trade finance is a type of international business payment method used by companies to execute international trade. It’s like an ‘IOU’, if you will, that bridges trust and credibility between different trading entities across international borders. Trade finance is generally used in situations where there might be reservations about cash flow.
For example, if a new company based in the UK was purchasing wholesale goods from a new manufacturer based in the Netherlands, there may be reservations about whether the goods would be shipped and whether the payment would be received – due to lack of a proven track record. That’s where trade finance comes in.
How does trade finance work?
So, let’s use our UK and Netherlands-based companies once more. Here’s how the trade finance process would work:
- The UK company wish to place a large order with the Netherlands-based company.
- The Netherlands company then demands assurance of payment – prior to the shipment.
- The UK company then procures a ‘Letter of Credit’ (LC) from its bank, which vouches that payment will be made upon shipping.
- The Netherlands company presents this LC to their bank once they’re ready to dispatch the goods.
- The banks communicate with one another, to verify and fulfil the payment.
- The goods are dispatched.
What type of business is most likely to use trade finance?
Trade finance is mostly used by businesses conducting international trade, such as importers and exporters. Importers are companies that bring goods or services into a country, whereas exporters send goods and services to another country. Some examples of those goods and services include:
- Cars and other vehicles
- Heavy machinery
- Software and banking services
- Fossil fuels (oil and natural gas)
- Other consumer goods
International trade: what are the four pillars?
There’s a lot that must be considered when a company is providing trade finance, namely the four pillars of international trade. Let’s delve into what they are.
With international trade comes a wide range of payment options. 3S Money for example, offers International Business Accounts with access to 65+ currencies in over 190 countries. They also offer local IBANs, allowing businesses to send and receive international payments in the countries they do business in. Check your eligibility for an International Business Account today, and be pre-approved within minutes.
2. Risk Mitigation
The world of international trade is rife with risk. From geopolitical events and recession to natural disasters, FX fluctuations and much more, so special procedures must be in place to limit those risks. We cover those instruments and procedures further down.
Many companies face financial issues from time to time, which can impact global business operations. That’s where the different trade finance solutions come in, such as export-oriented financing.
Clear and detailed paperwork is key when it comes to trade. It not only ensures each party understands the deal, but it also prevents mishaps and cultivates trust.
Key instruments of trade finance
We briefly touched on letters of credit, but there are other important instruments used to facilitate trade finance. Let’s take a deep dive into what they are:
- Letters of credit (LCs): a contractual commitment issued by the foreign buyer’s bank guaranteeing payment (on time and in full).
- Bank guarantees: offered by a financial institution, promising to cover a financial obligation if one party in a transaction fails to.
- Export and import financing: bespoke financial solutions tailored to either exporters or importers.
- Factoring and forfaiting: factoring is the sale of receivables at a discounted rate, ensuring liquidity. On the other hand, fortaiting involves the sale of an exporter's receivables at a discount, transferring the associated risk to the forfaiter.
- Insurance: covers the likes of credit insurance to marine-centric policies. It is devised to shield commercial entities from potential risks.
The role of financial institutions
As well as the legal documents and credentials, financial institutions also play a large role in facilitating trade finance. Some of those institutions and their roles include:
- Traditional Banks: risk assessment, instrument provisioning.
- Export Credit Agencies: payment guarantees.
- Multilateral Financial Institutions: facilitating global commerce.
Is trade finance worth it?
There are both risks and benefits associated with trade finance. We covered the risks earlier on, so let's look at some of the benefits. Trade finance can help importers and exporters with:
- Ensuring payment security
- Reducing risk for both buyer and seller
- Promoting international trade growth
- Portfolio diversity
- Accessing new global markets
Enter global markets with confidence
At 3S Money, we understand that reaching global markets can help businesses excel to the next level, but it can also be risky. Thankfully, we’re FCA, DFSA and CSSF regulated to ensure our clients’ funds are protected. We also offer International Business Accounts with local IBANs, which can help you confidently access new global markets.
Ready to expand your business’ global reach? Get started with a 3S Money International Business Account today.
Trade finance can be high risk or low risk, depending on the specific circumstances of each trade transaction.
The four pillars of trade finance is a concept often used to describe the key principles that underpin many trade finance transactions. They are payment, risk mitigation, financing and information.
There are several trade finance options available to businesses. Three of those include:
- Letters of Credit
- Trade Credit Insurance
- Export Financing