If you’re in the business of selling products, then you’ve probably considered expanding your market abroad. Going global, however, isn’t without risk. If you’re selling to an overseas buyer, then shipping products before you’ve been paid runs the risk of the buyer defaulting on payment. And if you’re the buyer, paying before you’ve received the goods is also risky for similar reasons – your shipment may never arrive.
Trade finance arose to offset this risk in cross-border transactions, particularly where the parties are based in different countries. In a trade finance transaction, a bank will act as an intermediary between the parties to ensure that the seller receives payment for its goods and that the buyer receives the products it’s expecting.
Here, we'll be covering:
- What is trade finance?
- How does trade finance reduce risk?
- What types of trade finance are there?
- What is a letter of credit in trade finance?
- What are bonds and guarantees in trade finance?
- Bonds versus letters of credit
- What are structured trade finance transactions?
- What is the Uniform Customs and Practice for Documentary Credits?
- What do I need to look out for in a trade finance transaction?
- What type of security will I need to offer in trade finance?
- What role does insurance play in trade finance?
- What’s pre-export trade finance?
- What are the advantages of pre-export finance?
- What’s export credit agency finance?
- What are the benefits of export credit agencies?
What is trade finance?
Trade finance is a term used to describe instruments issued by banks that reduce the risks of buyers and sellers of goods in international trade. Because there’s often a substantial time lag between goods being shipped and their arrival and because different countries are involved, there are inherent risks involved in global transactions. Trade finance steps in to enable the parties to reduce the risks of being out-of-pocket. Trade finance also helps buyers and sellers reduce their costs, streamline their supply chain, and deal confidently with each other.
For a seller, having effective trade finance in place ensures that their sales terms are attractive and increases their competitiveness as a result. It can also lead to bigger orders and improved economies of scale.
How does trade finance reduce risk?
An exporter of goods runs the risk that they are never paid for goods that are shipped. To eliminate that risk they can require pre-payment, but that shifts the risk onto the importer.
Overseas trade also comes with inherent risks, for example, exchange rate fluctuations, legal issues, language differences and the potential for political instability. Furthermore, it’s trickier for parties to evaluate the credit risk of their counterparts when they’re based overseas.
Trade finance steps in to guarantee payment and shipment, provided certain conditions are met.
What types of trade finance are there?
There three main types of trade finance:
- Letters of credit
- Bonds, guarantees and standby credits
- Structured trade finance transactions
What is a letter of credit in trade finance?
A letter of credit is a contract under which a bank agrees to make payment to an exporter provided they produce specified documents that prove that they have shipped the goods. Letters of credit are the most frequent method of payment in international trade, although they are used less often in domestic trade.
Letters of credit are organised by the buyer, who opens the letter of credit with its bank (the issuing bank). Once the goods have been delivered to the carrier, the seller presents the required documents (normally a bill of lading) proving the shipment to the issuing bank. The bank then checks those documents, and if they meet their requirements, they’ll pay the seller and deliver proof of payment documents to the buyer. Once they have these documents, the buyer will be able to claim the goods from the carrier.
What are bonds and guarantees in trade finance?
Bonds and guarantees are another way to protect against an exporter failing to ship, or an importer failing to pay. The bond issuer guarantees to fulfil the obligations of the exporter or importer if that party defaults.
The key difference between letters of credit and bonds is that a letter of credit is a payment mechanism, where the bank fulfils the obligations of the buyer to pay for the goods. A bond doesn’t trigger payment to the exporter unless the importer defaults on their duty to pay. In either instance, though, a bank will make payment to the seller in place of the buyer.
In trade finance, a bond or guarantee will often involve two banks – one bank in the country of the buyer and one in the country of the seller. This is so the seller does not have to pursue a foreign bank to enforce its demand for payment.
Bonds versus letters of credit
The key difference between letters of credit and bonds is that a letter of credit is a payment mechanism, where the bank fulfils the obligations of the buyer to pay for the goods. A bond doesn’t trigger payment to the exporter unless the importer defaults on their duty to pay. In either instance, though, a bank will make payment to the seller in place of the buyer.
In trade finance, a bond or guarantee will often involve two banks – one bank in the country of the buyer and one in the country of the seller. This is so the seller does not have to pursue a foreign bank to enforce its demand for payment.
What are structured trade finance transactions?
Structured trade finance transactions are where a bank loans funds to an exporter that they use to finance the production of goods. Typically, the loan is secured by the seller’s collateral, and once they’ve been paid by the buyer, these proceeds are used to repay the loan.
Trade finance can be structured in different ways. These include:
- Pre-export and prepayment finance – where a seller borrows money that’s repaid directly from the proceeds of the sale of goods
- Warehouse financing – where a seller borrows money that’s secured on the goods stored in a warehouse
- Borrowing base facilities – a working capital loan made to exporter that’s based on the value of certain of the exporter’s assets
- Export credit agency finance - where trade agencies of individual countries lend support to exporters of goods from their country
- Trade receivables securitisation – where an exporter sells its unpaid invoices to a financing vehicle at a discount from their face value
- Islamic finance transactions – transactions structured to be in line with Islamic finance principles
What is the Uniform Customs and Practice for Documentary Credits?
The Uniform Customs and Practice for Documentary Credits (UCP) is a set of international standards for international trade finance. The UCP presents a single uniform set of rules and practice for issuing letters of credit. If the USP applies to your transaction, it can significantly speed up the process of negotiating trade finance documents.
The UCP is made applicable to a letter of credit by an express term in that letter of credit.
What do I need to look out for in a trade finance transaction?
The key things to look out for if you’re considering trade finance include:
- Understanding the precise obligations of each party
- Understanding which country’s legal jurisdiction will govern the transaction
- Hedging against currency risks
The parties’ obligations
What the issuing bank will require from each party will depend on which trade finance option you choose. Letters of credit are the most common method of payment in international trade, and they require the issuing bank to pay the seller once they present certain documents. In more complex deals, you may need more than one bank to get involved.
Legal jurisdiction
If more than one bank is involved, they’ll enter into bilateral agreements that determine the role of each party. You’ll need to make sure that these bilateral contracts are consistent with the governing law of the letter of credit. This issue can be complex where the parties are in different jurisdictions.
In general, the law that will govern a transaction is that of the country in which the documents are presented by the seller for payment.
Currency risks
Export transactions involve payment across country borders and can introduce material currency risks, particularly where one party doesn’t operate in the currency of the other party. A buyer may seek to hedge its foreign exchange rate risk, but the costs can be prohibitive. Alternatively, a lender may offer hedging services in return for a fee.
What type of security will I need to offer in trade finance?
If you enter into a structured trade finance transaction, the bank may require some kind of collateral to secure their advance. In asset-based lending, the bank will take security over your property as security for its loan.
In pre-export finance facilities, loans are normally secured by the sale and purchase contract. A lender may also take security over bank accounts, including collection accounts.
In borrowing base facilities, security is taken over the assets forming the borrowing base. These are usually goods in storage or transit, and security normally extends to the right to payment for goods and sale proceeds.
What role does insurance play in trade finance?
Insurance plays an important role in trade finance transactions. It provides an additional layer of protection for a lender. Insurance can help protect against the risk of damage or destruction of goods underlying an international contract.
Common types of insurance in trade finance include:
Asset protection insurance – insurance covering the risk of damage or destruction of goods
Non-payment insurance – insurance covering the risk of non-payment under a contract
Political risk insurance – insurance against the risks of a change of law, civil war, revolution or expropriation of assets
What’s pre-export trade finance?
Pre-export finance (PXF) is where a loan is extended to a borrower that’s to be repaid directly from the cash flow generated by the sale of goods.
Security is typically taken over your rights under the export contract and the collection account into which the buyer will make payment.
PXF loans are typically used to meet a borrower’s working capital requirements.
What are the advantages of pre-export finance?
Pre-export loans are based on existing orders from buyers. As the loans are secured, their terms can be more favourable than unsecured lending, as the lender is exposed to less risk.
In addition, there are a greater number of lenders operating in the market, so you’ll have a wider choice
Pre-export finance is often negotiated, and lenders may be able to accommodate a borrower’s needs under the particular transaction.
One of the principal advantages of pre-export finance is that it provides liquidity to a borrower. They can use the loans to maximise production and enjoy economies of scale, as the loans are used to produce the goods underpinning the orders.
What’s export credit agency finance?
Export credit agency (ECA) finance is where the representatives of a country lend money to support the export of capital goods and services from that country.
ECAs have the financial backing of the home state and the obligations it assumes are considered sovereign obligations. Their purpose is to support the trade policy of their domestic government.
What are the benefits of export credit agencies?
Most ECAs have very strong credit ratings and they can help counter a gap in commercial lending. If an ECA’s capital and reserves are insufficient, they may be able to call upon the home state to provide additional support. ECAs may also be willing to provide credit directly by lending to buyers and at highly competitive rates.
For more answers to commonly asked questions about trade finance, consult our Trade Finance solicitors. Get in touch on 0800 689 1700 email us at enquiries@harperjames.co.uk, or fill out the short form below with your enquiry.
