Most companies rely on external capital to finance costs for various business aspects, like advertising. They may also use this capital to finance intermediate input purchases, payments to workers, inventories, and other recurrent costs before sales and payments of their output happen.
Export activities involve extra upfront expenditures, forcing companies to count on external finance. Also, additional variable trade costs may arise because of duties and freight insurance, as well as shipping. Furthermore, cross-border delivery might take longer to complete as opposed to domestic orders. And this will increase the need for working capital requirements.
Therefore, governments and financial institutions have created different instruments to provide trade finance. These instruments are used and tailored to satisfy the needs of exporters. Most of these require some form of collateral. The role of trade finance in international trade is significantly important. In fact, up to 90% of world trade relies on trade finance instruments.
2 Purposes of Trade Finance
- It serves as a source of working capital for traders and international companies that need liquid assets.
- It provides credit insurance against political risks and the international trade risks, such as currency fluctuations.
These functions are fulfilled by a set of credit instruments, provided by government or financial institutions.
5 Types of Trade Finance Instruments
1. Documentary Credit
This relies on commercial letters of credit. The issuing bank will state its commitment to pay the beneficiary or exporter a certain amount of money on behalf of the buyer or importer. In turn, the seller must follow all the terms and conditions stated in the sale contract. This trade finance instrument allows the importer to use his cash flow for more important purposes.
The letter of credit makes sure that the exporter will be paid in a timely manner. This instrument is ideal for international contracts that are not easy to enforce and involve more risks than domestic contracts.
This is a trade practice wherein the supplier commits contractually to undertake specified initiatives that will benefit and compensate the other party. Both parties will agree that products will be traded at a fixed value without the use of credit terms. Instead, buyback promises or barter-exchange will be used.
This instrument is suitable for situations and countries wherein a shortage of liquid assets or foreign exchange reserves might prevent the exchange of goods for cash. But this involves greater risks and higher transaction costs than simple export transactions.
With this instrument, the exporter will remit guaranteed debt from a sale on credit to a third party, usually a financial firm, that pays the seller in cash upfront the value of debt less the discount. The discount is the price the exporter willingly pays to transfer the risk of default to the financial institution. So when the debt comes to maturity, the seller won’t be liable for default of the importer.
4. Open Account
This is a convenient method of payment in a foreign transaction. This may be satisfactory when the buyer is well-established, has been checked for creditworthiness, or has demonstrated a favorable payment record.
With this instrument, the exporter bills the customer, who will pay under agreed terms at a certain date. Some huge corporations make a purchase only on an open account. However, this poses higher risks. For instance, the absence of banking channels and documents might make legal enforcement of claims too difficult to pursue.
So before issuing a pro forma invoice to a buyer, exporters expecting a sale on open account terms must examine the economic, political and commercial risks thoroughly.
5. Bill Avalisation
This is the bank’s undertaking on behalf of the importer. The buyer’s bank will guarantee payment to the seller if the buyer won’t pay. This is quite similar to a letter of credit – it provides similar comfort to the supplier. However, this instrument has an easier structure for the importer.
The avalised bill substitutes the risk of the bank for the importer’s risk. Therefore, the exporter is provided with assurance that payment will be met. This can also be used to negotiate better credit terms to boost the trading relationship with the importer.
Today, the utmost concern of exporters is getting paid on time and in full. Thus, risk is a huge consideration in international trade. But there are methods to reduce such risks; to know what risks exist is one. Therefore, exporters must consult the best business bank to decide on the ideal method of payment for every specific transaction.