Cash & Liquidity Management

Understanding trade finance

Published: Feb 2012

The tools and methods of trade finance form the basis of every domestic and international trade transaction. Raising capital, mitigating risk exposure and executing payments all fall under its domain. With Basel III regulations on the horizon, trade finance is back in the headlines.

It can involve raising finance, reducing risk exposure, or completing payments between the buyer and seller. Often third parties, such as banks, are involved in facilitating the exchange, however there is also a growing number of non-bank entrants in the trade finance space.

Trade finance has been around for a number of years; but recently, in particular since the eruption of the financial crisis, it has undergone substantial stresses and strains.

Major developed economies, such as those in the Eurozone, are in trouble, damaging trade volumes; counterparty risk remains high; and Basel III regulations are set to boost capital reserve ratios and further restrict trade services, if passed in their current form. These factors (if an exemption is not granted for trade finance) will likely reduce banks’ capabilities – or appetite – for facilitating trade, pointing to an uncertain future for trade finance.

Furthermore, exporters are reducing their risk exposure, with some eschewing open account and returning to more traditional, secure forms of trade finance – even for countries within Europe that were once deemed ‘safe’.

In this article we will explore the various means of raising finance, explain risk mitigation, and delve into the different methods of executing payments relating to trade.

Methods and tools

Broadly speaking, there are two main types of trade finance: pre-export and post-export. This distinction is important given that the time of payment determines the viability of the supplier’s cash flow and the amount of working capital required by the business.

Pre-export financing

Suppliers must first finance the production of their goods and services in order to export. They have several options available to them:

Payment-in-advance

Payment-in-advance involves the buyer sending full payment (or at least a significant part of it) prior to the delivery of goods. This method allows the supplier to mitigate credit risk and non-payment risk, and eases cash flow constraints considerably. On the flip side, however, the risk of the transaction is shifted entirely to the buyer who, until the goods are received, must treat the exchange as a donation. Wire transfers constitute the most popular method of payment-in-advance.

The advantages of using an overdraft facility are its flexibility and ease of use, but these pros should be weighed against the often heavy interest rate charged.

Overdraft

An overdraft is a common and popular tool to fund trade. It allows the business’s account be overdrawn up to a certain limit. In other words, it is an extension of a business’s credit line. The advantages of using an overdraft facility are its flexibility and ease of use, but these pros should be weighed against the often heavy interest rate charged.

Working capital loans

Working capital loans can be raised to fund operating costs such as labour and raw materials. The loans are short-term, usually up to a year, and can be secured against a company’s assets. In certain cases, such as large, low-risk companies, the loans can be raised on an unsecured basis.

Post-export financing

Factoring

Factoring is a form of receivables-based finance, often used by suppliers in need of cash in the short term. It involves a factor – a financial institution, usually a bank – that provides finance through the purchase of the supplier’s accounts receivables or invoices. Receivables involved are short-term and the amount paid upfront by the factor is usually 80%. The factor then chases down payment from the buyer. Once payment is secured, the factor forwards the remainder to the supplier minus a discount for its services. In contrast to forfaiting, factoring can be done with or without recourse.

Invoice discounting is a similar tool to factoring – only this time the onus of chasing down payment remains with the supplier.

Invoice discounting

Invoice discounting is a similar tool to factoring – only this time the onus of chasing down payment remains with the supplier. As before, a discounter provides finance to the supplier for anything as much as 100% of the invoice’s face value. This again helps to alleviate any cash flow problems for the supplier. The buyer then pays into a dedicated bank account, also known as a trust fund. In this scenario, the buyer may or may not know the invoice is being discounted. After the bank trust receives the payment, the sum is collected by either the discounter or supplier. If the former does so, then it forwards the remaining amount of the payment to the supplier minus a fee for its services. The discounter usually makes a thorough assessment of risk exposure before committing itself to the transaction.

Forfaiting

Forfaiting is another tool for receivables-based trade finance. It differs from factoring in that the accounts receivable involved are medium-term and there is no recourse to the exporter. Forfaiting allows the supplier to virtually eliminate risk as long as the goods have been delivered to the buyer according to the terms and conditions outlined. Receivables are usually guaranteed by the buyer’s bank, allowing the supplier to remove the transaction from its balance sheet and in turn improving its financial ratios.

Supplier finance

Also known as ‘reverse factoring’ supplier finance is a relatively new solution, sometimes referred to as ‘supply chain finance’ or SCF. It adopts a more collaborative approach between buyer and supplier. The former, through its bank, initiates the transaction (which is unusual as it is usually the supplier initiating these kind of arrangements), and continues to support the latter’s finances to complete the trade. Reverse factoring is useful as it allows large buyers, with solid credit ratings, to sustain smaller, but potentially vital, suppliers in times of economic difficulty. Another advantage is that the buyer can extend the payment terms it wants from its suppliers.

Every trade is characterised by exposure to risk – a fact that has become more pronounced since the advent of the Great Recession.

Managing risk

Every trade is characterised by exposure to risk – a fact that has become more pronounced since the advent of the Great Recession. In the table below we examine four varieties of risk. They range from economic to exchange rate, from transportation to political risk. The buyer and seller have several means at their disposal to mitigate exposure, such as letters of credit or export credit agencies.

Risks in international trade and mitigation methods

Risk category Economic risks Exchange rate risks Transportation risk Political risks
Foreign policy Domestic policy Economic policy
Example
  • Importer is not willing or unable to pay
  • Importer does not accept merchandise
  • Exporter does not deliver on time or products agreed
Floating exchange rates: variation in exchange rates

Fixed exchange rates: risk of deviation

Damaged or loss of goods
  • War
  • Embargo
  • Restrictions
  • Revolt
  • Civil war
  • Prohibition to transfer foreign exchange
  • Currency declared non-convertible
Methods to mitigate risks
  • Private insurance or public export credit agencies
  • Letter of credit
  • Bank guarantees
Bank provide hedging facilities: public exchange risk insurance Private insurance Export credit agencies or private insurance

Sources: The United Nations Economic and Social Commission for Asia and the Pacific; World Trade Organisation, “Trade, Finance and Financial Crises”, Special Studies 3.

Methods of payment

The most common methods of settling a trade deal include: payment-in-advance; letters of credit; documentary collection; and open account trading. We have already touched on the former – see above – so in this section we will examine the latter three. Each payment method has its own advantages and disadvantages, some favouring the buyer over the suppler (and vice versa). Their relative appeal often depends on the circumstances of individual companies and industries.

Given recent economic troubles, importers and exporters across the globe now place a heavy emphasis on cutting risk exposure through the use of trade finance instruments. Although open account trading still accounts for a significant volume of global trade – believed to be close to 80%, safer, more costly, forms of trade finance, such as letters of credit, have made a comeback due to counterparty risk concerns.

Letters of credit

Letters of credit (LCs) are among the safest ways of securing payment for a trade transaction. They are particularly attractive in the current climate of international trade. Nevertheless, letters of credit still make up less than 10% of international trading.

Banks are used as intermediaries, facilitating the transaction between buyer and seller. After the commercial contract is agreed, the buyer’s bank sends a letter of credit outlining payment conditions to the supplier’s bank. Payment is guaranteed to the supplier as long as it meets the terms outlined in the letter of credit.

E-letters of credit – where scanned, secure documents are sent instantly online – offer the best of both worlds: security and speed in the transaction.

The evolution of letters of credit points to a more promising future. E-letters of credit – where scanned, secure documents are sent instantly online – offer the best of both worlds: security and speed in the transaction. Initially popular in Germany, e-LCs are now spreading throughout Europe and the United States. Yet the term ‘letters of credit’ itself encompasses a variety of forms. The following are just some examples:

Confirmed letter of credit

A confirmed letter of credit involves the guarantee of not one, but two banks supporting the payment of a transaction. This further benefits the supplier who must contend with the risk of non-payment. These are useful for when the supplier has concerns about the credibility of the buyer’s bank.

Transferable letter of credit

The exchange between buyer and seller is facilitated by a third party. There are two stages: first, the third party provides payment to the supplier under the conditions outlined in the transferrable letter of credit (issued by the buyer’s bank); secondly, having received the goods, the third party completes the transaction with the buyer. Since the intermediary buys from the supplier at a small discount, it earns a profit when it sells to the buyer at full-price.

Revolving letter of credit

A letter of credit with a ‘revolving clause’ attached. This clause means that the cumulative cost of the supplier’s shipments can be drawn against the document. Little to no amendments need be made by the buyer. As a result, this arrangement is ideal for regular trading partners.

Documentary collection

Documentary collection, like letters of credit, is a payment method that involves intermediary banks facilitating the transaction. The supplier ships the goods prior to payment, but sends the delivery to a third party, such as a shipping line. At the same time, the supplier also sends specific documents and details to its (remitting) bank requesting payment from the buyer. The remitting bank forwards this material to the buyer’s (collection) bank. In certain cases, goods can be inspected by the buyer prior to payment.

At this point, documentary collection can involve the buyer either paying the face value of the payment on the spot (‘document against payment’ – D/P) or at an agreed future date (‘document against acceptance’ – D/A). The former option favouring the suppler; with the latter offering a distinct advantage to the purchaser. But while the two banks act as conduits for the transaction, the method itself offers no verification process. And there is limited recourse available to the supplier in the event of non-payment, given that the delivered goods might now be located in a foreign jurisdiction. Nevertheless, documentary collection remains an attractive option. It is often cheaper and quicker than letters of credit, and safer than open account.

Open account

Open account is by far the most widespread payment method where trade is concerned. Its popularity is correlated with the fortunes of the global economy: in times of plenty, open account trading flourishes; but when recession hits, traders turn towards more secure forms of payment for trade.

In stark contrast to payment-in-advance, open account heavily favours the buyer: goods are shipped and delivered prior to any payment. Usually, the buyer then has between 30 and 90 days to meet payment conditions. During this interval, exposure to risk of non-payment lies solely with the supplier who, in effect, finances the buyer until cash is received. In order to mitigate this risk, the supplier can choose to use trade finance techniques, such as export credit insurance.

Open account is best suited to long-term trading partners and often works around a reliable, trusted relationship. Suppliers that trade on open account often offer buyers more competitive trade terms than sellers who do not. But they are more susceptible to economic and political risks as a result.

For more information on trade finance and supply chain finance techniques, please see Treasury Today’s Best Practice Handbook on Managing The Financial Supply Chain. Copies can be ordered at treasurytoday.com or by emailing subscriberservices@treasurytoday.com.

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