What Is Trade Finance?

Trade Finance is offered to exporters and importers and is used to manage risk as well as cash flow.

Most large banks offer a range of products in this category and it is important that you are familiar with all of them to avoid obtaining a facility that costs you too much or doesn’t meet your needs.

The biggest mistakes exporters and importers make involve underestimating the amount of money required and also the cost of borrowing that money.

The most common facilities include:

Trade Finance Loan (for open account trading)

Open account trading is an agreement between an exporter and an importer which allows the importer to pay for goods once they have been received – usually within 30 – 90 days.

It requires a lot of trust between both parties and is usually reserved for relationships which have withstood the test of time and operate in stable economies.

In this situation, a bank will provide funds so the importer can pay for the goods. The bank will require its funds be repaid when the goods are sold and in some cases will collect the funds directly from the importer’s customer.

It is a high risk strategy for exporters who always face the possibility that the importer won’t pay.   It’s likely the lender will require that the debt be insured which will add to the cost.

Letter of Credit.

In this situation the exporter requires absolute certainty of payment, so the importer’s bank provides a Letter of Credit promising that payment will be made once all the terms and conditions are met and verified.

This is a very secure instrument which spreads the risk evenly between the seller and buyer, but the process is complex and relatively expensive in terms of transactions costs.

It is best used by companies in the early stages of their relationship.

Documentary Collections

When an exporter and importer have a good relationship they may agree to a Documentary Collection.

It means the importer doesn’t have to pay for the goods upfront.

What normally happens is that the exporter provides documentary evidence to its bank that the goods have been shipped. That bank forwards the documents to the importers bank. If the importer is satisfied the goods are en route, its bank will send a draft to the exporter’s bank and the exporter will be paid.

This facility is much cheaper and more convenient to set up than a Letter of Credit, but the banks play a limited role. They do not guarantee payment and do not verify the accuracy of the documents.  The exporter also carries most of the risk.