Markets across the globe are becoming more accessible and cross-border transactions are now part of everyday life for many SMEs. This has led to trade finance becoming an increasingly important business tool, but it is often widely misunderstood and thought of as over-complicated.
The jargon and acronyms associated with cross border transactions may be to blame for this misconception. Confusing terms such as LC, FOB, CIF, 'bill of lading', 'airway bill' and 'tenor' are often thrown around.
So what is Trade Finance?
Although it can be used for domestic transactions, Trade Finance usually refers to the financing of cross border or import / export transactions. Trade Finance is a form of working capital. For an importer it means receiving funding in order to pay a supplier and allow time for the goods (or services) to be received, sold and turned into cash. For an exporter it provides working capital up until the customer (the importer) pays for the goods or services.
Exporters would typically utilise export factoring or bill facilities as the primary means of supporting Trade Finance requirements. Additionally they may insist upon a letter of credit to secure the transaction (refer below).
For importers there are two main components to the Trade Finance (Import Finance) transaction. Firstly there is the manner in which the supplier will be paid and secondly the type of facility that will provide the actual working capital. The working capital is provided by a short term loan typically called a Trade Bill, Import Bill or a Trade Loan. These are normally supported by a bill of exchange.
There are typically three mechanisms which a buyer can utilise to pay an overseas supplier:
1. Letter of Credit
A Letter of Credit (LC) or a documentary credit is an undertaking by a bank to pay (either immediately or at a future time) upon the presentation of specified documents by the Beneficiary (Exporter) on terms that the bank will be reimbursed by the Applicant (Importer).
Letters of Credit are powerful tools that mitigate the risks involved for both Importers and Exporters. The Exporter is guaranteed (by the issuing bank) to get paid for the goods or services; the Importer can be confident that unless the exporter delivers on time, and in compliance with specifications, payment will not be released. The guarantee provided by the issuing bank is subject to the Exporter presenting documents that provide evidence that the conditions of sale have been met and shipped or delivered on time.
2. Documentary Collection
A Documentary Collection is so-called because the seller receives payment from the buyer in exchange for the shipping documents, with the funds and documents channelled through their respective banks. While Documentary Collections are less complicated and cheaper than Letters of Credit, they are riskier for sellers because they do not have a verification process and offer limited recourse if the buyer does not pay.
3. Telegraphic Transfer
Telegraphic transfers are now a commonly used method of payment in Trade Finance and Import Finance scenarios. It is effectively an electronic payment of cleared funds by the buyer that are credited directly to the sellers' nominated bank account. They are a fast and easy, however do not have the protections of either Letters of Credit or Documentary Collections. As such, we recommend Telegraphic Transfers only be made 'against documentation' i.e. against a proof of delivery (Bill of Lading or Airway Bill) and ideally where there is a long-standing trade relationship between the buyer and seller.
Check out our Glossary of 'Incoterms' for further explanations of the different technical terms associated with international trade.
Tradeline - A smarter Trade Finance and Import Finance solution
Tradeline is a smarter way for businesses to access trade finance and import finance to help them buy more stock for resale. Read more about Tradeline here.