Trade finance is the provision of finance for trade. It exists to mitigate, or reduce, the risks involved in cross border transactions, particularly where the parties reside in different countries. In a trade finance transaction, a bank will act as intermediary between the parties to ensure that the seller receives payment for its goods.
Here, we'll be covering:
- What is trade finance?
- What types of trade finance are there?
- What is a letter of credit in trade finance?
- What are bonds and guarantees in trade finance?
- What are structured trade finance transactions?
- What is the Uniform Customs and Practice for Documentary Credits?
- What are the legal considerations in a trade finance transaction?
- What is a typical type of security?
- What role does insurance play in trade finance?
- What is pre-export finance?
- What are the advantages of pre-export finance?
- What is export credit agency finance?
- What are the benefits of export credit agencies?
What is trade finance?
Trade finance covers a broad range of financing arrangements that exist to help the production, export and sale of goods. In short, it is the provision of finance for trade. Trade finance arose because of the delay between a seller shipping its goods and a buyer receiving them. If a buyer pays for goods before they are shipped then it runs the risk of paying for goods it never receives. Conversely, if a seller ships its goods before payment is received then it runs the risk of never receiving payment. Trade finance mitigates these risks by introducing intermediaries who promise to pay upon satisfying certain conditions.
In a trade transaction, various intermediaries, such as banks and financial institutions, will help a buyer purchase goods from a seller. These intermediaries help to ensure that the buyer receives the goods and the seller receives payment.
What types of trade finance are there?
There three main types of trade finance. They are:
- 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 pay a seller, if the seller produces specified documents evidencing the shipment of goods. Letters of credit are the most frequent method of payment in international trade, although they are used less frequently in domestic trade.
Letters of credit ensure that a seller can be paid for goods as soon as they have shipped them on-board a vessel. A buyer will open a letter of credit with its bank (the issuing bank). Once the goods are shipped, the seller will present the documents required by the letter of credit to the issuing bank. The bank will then check the documents evidencing the shipment. If the documents meet the requirements of the credit, the issuing bank will pay the seller and deliver the documents to the buyer. Once in possession of the 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 a means of protection against the non-performance or financial default of another party. The bond issuer guarantees to undertake the fulfilment of a contractual obligation owed by one party to another if that party defaults. In the case of trade finance, a bank will normally undertake to pay a seller if a buyer fails to pay.
Bonds vs letters of credit
The key difference between letters of credit and bonds is that a letter of credit provides a means of payment, while a bond does not trigger payment unless there is a default. 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 that 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 secured loan is extended to a seller of goods to finance the production of those goods. Typically, the transaction is structured so that the proceeds of sale are applied to repay the loan.
There are a number of different types of structured finance transactions. These include:
- Pre-export and prepayment finance – a loan that is repaid directly from the sale of goods
- Warehouse financing – a loan secured on the quantity of goods stored in a warehouse
- Borrowing base facilities – a working capital loan based on a borrowing base of assets
- Export credit agency finance - where trade agencies of individual countries lend support to exports of goods from their country
- Trade receivables securitisation – where assets are sold to a financing vehicle that issues debt on a capital market.
- Islamic finance transactions – transactions structured to be in line with Islamic finance principles.
- Receivables financing - forfaiting, invoice discounting and factoring.
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 brings together the different domestics laws covering letters of credit into a single set of rules, standardised by the International Chamber of Commerce (ICC). The UCP presents a single uniform set of rules and practice and can significantly speed up the process of negotiating trade finance documents.
The UCP is currently in its sixth edition (UCP 600) and is made applicable to a letter of credit by an express term in the letter of credit.
What are the legal considerations in a trade finance transaction?
The key legal considerations in a trade finance transaction include:
- The precise obligations of each finance party
- Legal jurisdiction
- Currency risks
The precise obligation of the issuing bank will depend on the financing arrangement chosen. Letters of credit are the most frequent method of payment in international trade and they impose an obligation on the issuing bank to pay the seller on presentation of the relevant documents. In more complex deals, a number of banks may be required.
In many letter of credit transactions there are two banks involved, the issuing bank in the buyer’s home country and the correspondent bank in the seller’s home country. These banks will enter into bilateral agreements which determine the role of each party. Care should be taken to ensure that these contracts are consistent with the governing law of the letter of credit and other related credits. Determining the governing law of contracts can be complex where the parties are in different jurisdictions and have different rules on the conflicts of laws. In the event that no governing law is specified then the general rule is that the governing law will be that in which the documents are presented by the seller for payment.
Export transactions involve payment across country borders and can introduce material currency risks, particularly where one party does not operate in the currency of the other country. 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 is a typical type of security?
A typical type of security in trade finance will depend on the type of trade finance transaction involved. In asset-based lending, a receivables financier will often take security over a company’s debts as security for its loan.
In pre-export finance facilities, loans are normally secured by taking security over the sale and purchase contract. A lender may also take security over banks accounts, including collection accounts.
In borrowing base facilities, security is taken over the assets forming the borrowing base. These are the 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 financier. Insurance can help protect against the risk of damage or destruction of the goods.
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 is pre-export finance?
Pre-export finance (PXF) is where a loan is extended to a borrower that is to be repaid directly from the cashflow generated through the sale of goods or commodities.
Security is typically taken over the borrower’s rights under the export contract and the collection account where amounts under the export contract must be paid.
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 a form of secured lending and as such can attract more favourable terms than unsecured lending. The secured nature of the loan means that a lender has to take less risk and may therefore offer more favourable terms. Secured loans often have a greater access to lenders than higher-risk, unsecured, financing, and so a borrower may be able to choose from a range of lenders.
Pre-export finance is heavily documented and lenders may be able to anticipate a borrower’s needs regarding grace periods, indebtedness or permitted disposals based on prior transactions.
What is 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 its home state and the obligations it assumes are considered sovereign obligations of its home state. 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 supply from the commercial markets. If an ECA’s own capital and reserves are insufficient then they may be able to call upon its home state to provide additional support. ECAs may also be willing to provide credit directly by lending to buyers and at highly competitive rates.