The Crucial Importance of Trade Finance

What Is TradeFinance?

 

Trade finance depicts financial instruments, services and products which are used by companies for facilitating international trade. Trade finance can make it possible as well as easier for buyers and sellers to transact their business through trade. 

The crucial importance of trade finance is it exists to mitigate or we can say to reduce the risks involved within the trade transactions. These risks can be payment risks or corporate risks. 

There exist two players in a trade transaction: (1) the supplier, who requires payment for the goods being sold, and (2) the buyer/importer who wants to make sure that he pays for the correct quality and quantity of goods.

 

Understanding Trade Finance

The key function of trade finance is introducing third-party towards the trade transactions in order to remove the risk of payment along with supply risk. It provides supplier with receivables and payment as per the agreement whereas the buyer may get extended credit for fulfilling the trade order. 

Basically, following parties are involved in trade finance:

●        Banks

●        Trade finance companies

●        Importers and exporters

●        Insurers

●        Export credit agencies and service providers

Trade finance is commonly used when traders require some kind of financing to carry out various trade related tasks and to facilitate the trade cycle funding gap. In order to provide effective trade finance, the financier or trade finance provider requires:

-          Controlling the usage of funds, controlling the products along with the source of repayment

-          Monitor the trade cycle via trade transaction

-          Security over the commodities and receivables

TYPES OF TRADE FINANCE PRODUCTS

The market of trade finance consists of certain short-term (with a maturity of normally less than a year) medium term as well as long-term trade finance products. These can be distinguished on the basis of their tenors. Short term trade finance has tenor of less than a year whereas long term can have tenor of 5 to 20 years.

Commonly used trade finance products are:

●      Letter of credit

●      Supply chain finance

●      Structured trade and commodity finance

●      Export and agency finance

●      Trade credit and political risk insurance

To bring down the payment risk and the supply risks during international trade, trade finance introduces third party to business transactions. Through trade finance, exporters get receivables or payments, as per the agreement and the importers receive credits to fulfil the trade order.

The key parties involved in trade finance are the banks, companies, exporters, importers, insurers, credit agencies and service providers.

While general financing usually indicates financial necessity in cases where buyers lack funds or liquidity, trade finance is mostly used to provide protection against the unique inherent international trade risks – like currency fluctuation, political instability, non-payment issues, credit-worthiness of any party involved in the trade and others.

WHAT ARE THE RISKS?

As global trade takes place across borders and usually the buyers and supplier are not familiar with each other and as a result there exists various risks to deal with. These risks include:

Payment risk: Will the seller get paid on full or partial basis on time? Will the buyer get the commodities he expected?

Country risk: This kind of risk can be seen in a number of situations such as exchange rate risk, political risk and sovereign risk.

Corporate risk: The risks which are associated with the company or importer and exporter. For instance, what credit rating is provided by them? Do they have any history of non-payment?

In order to reduce such risks, banks along with other finance providers have stepped in to facilitate traders with trade finance products.