What is trade finance?
Trade finance provides financing to firms conducting domestic and international trade in goods, services or commodities. If a firm trades across international borders, the “financing gap” between purchasing receivables from suppliers and realising profit from sale of those receivables can be extremely lengthy. Known as a trade cycle, these gaps create large risks for suppliers requiring repayment for the material and labour costs they have expended, and for importers requiring both proof of dispatch and finance before paying their suppliers. Trade finance provides these firms with bespoke financial products to manage these cycles and undertake new or expanded international trade ventures.
In doing so, trade finance offers three key benefits to firms. First, trade finance enables firms with cashflow restrictions caused by trade cycles to invest in profitable ventures without requiring the sale of equity or provision of extensive capital securities. Second, trade finance products are tailored to these firms’ requirements, offering flexible lines of credit with long repayment terms to help importers manage their lengthy finance gaps. Third, trade financiers offer specific tools (such as letters of credit) to facilitate international trade transactions, which enhance trust and security for all parties in the venture.
For more information, see TFG’s Introduction to Trade Finance.
Types of trade finance
Broadly, trade finance offers two key product groups to support firms. Firstly, trade finance structures enable lenders to provide finance secured against the borrowing firm’s operations. This often takes the form of accounts receivable finance, whereby trade financiers provide loans to firms on the basis of owed future income streams. For example, suppliers can use purchase order financing to access funds which enable them to meet purchase orders raised by buyers, to be repaid when their invoice for that receivable is paid by the buyer. Alternatively, buyers can advance funds against unpaid invoices. This can take the form of invoice factoring, where importers use finance secured against an unpaid invoice to repay suppliers before profits are generated from selling their receivables to their customers, or invoice discounting, whereby firms sell unpaid invoices to institutions in exchange for loans.
Secondly, trade financiers use trade finance tools to facilitate payments between buyers and sellers at different points in the trade cycle to ensure trustworthy, secure transactions. Most commonly, letters of credit are issued by trade financiers to pay suppliers on behalf of buyers once key export documentation (such as a bill of lading) are provided. Alternatively, financiers can guarantee payment when key contractual obligations (such as the dispatching of goods) are met, either through providing bank guarantees for specific payments or operating performance bonds which mature as terms are gradually met.
How is trade finance structured?
Simple trade finance ventures can usually be catered for using a combination of the structures and tools described above. However, more significant ventures can require complex financing structures, which trade financiers can create. For example, if the proposed transaction is simple but the capital requirements to fund it are high, trade financiers can operate as arrangers, bringing together groups of lenders to offer syndicated loans to borrowers with returns and risk apportioned appropriately.
Moreover, when one or more discretionary transactions are required within a venture, structured trade finance is usually necessary. Broadly, structured trade finance involves the creation of financial products through pooling individual ventures. These securities can interest larger investors looking for greater returns from products which correlate to their appetite for risk. In particular, structured trade finance can help larger firms who operate in different jurisdictions and trade globally, or who are engaged in high-volume, high-capital ventures (such as international commodities trading).
Who provides trade finance?
A variety of institutions provide trade finance to firms, with each offering a unique product. However, the size, cost and terms of finance are broadly dictated by the nature of the funders’ source of capital, their ability to assess the borrower’s operational risk, and their appetite for investment risk. From this perspective, trade financiers divide into three groups.
First, traditional commercial banks do offer trade finance products. Larger multinational banks often have specialised trade finance divisions, whose extensive capital reserves, reputational credibility, and global footprint can appeal to major international firms. In contrast, smaller domestic banks can offer more specialist products to SMEs with niche needs. However, both ultimately engage in other lending activity beyond trade, so generally have a low tolerance for investment risk and require property or equity as securities against their loans.
Second, non-bank lenders focused exclusively on trade financing can also provide these products by connecting firms with more diverse funding sources (such as direct private investment). These financiers usually have greater appetite for trade finance investments, and consequently offer more flexible terms and require less tangible securities (such as purchase orders or goods receivable) when lending.
Finally, government-backed export creditors and development banks also offer certain trade finance products. Whilst sometimes appropriate in specific circumstances, their limited product range usually targets longer-term trade financing for firms engaged with particular territories (usually, emerging markets).
How to access trade finance
Accessing trade finance starts with a credit application process. Firms provide detailed overviews of their business operations and future plans; their product or service, and its context within the market; and of the specific investment and its anticipated outcome, including detailed financial forecasts. As with conventional loans, trade financiers evaluate this information to consider the firm’s health and the investment’s viability before lending. However, trade financiers’ experience of international trade helps them gauge the operational risk posed much more accurately than conventional lenders, who may be deterred by the longer financing gap inherent in international trade ventures.
Following this assessment, trade financiers locate finance and structure appropriate product offerings. Commercial banks draw on their internal credit facilities, which can create regulatory hurdles, higher risk thresholds, and more aggressive repayment schedules. In contrast, trade financiers will identify a variety of potential financiers and present firms with a range of funding options, enabling them to secure finance on the most favourable terms and price.
Once negotiated, the terms and conditions of any product will be confirmed by the lenders’ finance, credit assessment and legal facilities. Generally, bespoke products agreed with private investors are confirmed quicker than commercial banking offerings. Finance is then released to the lender, in the form of a lump sum, a line of credit, or through specific trade finance tools (such as letters of credit).
For TFG’s latest Trade Finance Guide and contact details, please see here.
Written by James Dinsdale, writer at Trade Finance Global