Trade Finance – Knowledge Hub
Why 2017 will be a great year for trade finance
It would be remiss of us to say that 2016 didn’t go without challenges and unexpected outcomes. However, we believe that 2017 will see strong momentum in trade and supply chain finance. The increase in the digitalisation of trade finance (be that through blockchain or electronic processes), as well as the step change of approach around AML, KYC and anti-terrorism will certainly flow into 2017.
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10 Trade Finance Questions and our Answers
Given that the TFG trade finance team speaks to funders, banks, people looking to trade and open Letters of Credit, we’ve put together a list of 10 questions that are commonly asked or raised during the process of trading goods and/ or services overseas.
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Structured Trade Finance
Structured trade finance products are used primarily in the commodity sector by traders, producers and processors. Banking corporations tailor these financing arrangements based on the needs of the client. Structured trade products are mainly warehouse financing, working capital financing and pre-export financing. Also, some institutions extend reserve based lending and finance the conversion of raw materials into products amongst other bespoke finance products. Structured trade finance products are extended across the supply chain to facilitate trading activities.
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How is trade finance governed and what is the UCP 600?
The UCP 600 (“Uniform Customs & Practice for Documentary Credits”) is the official publication which is issued by the ICC (International Chamber of Commerce). It is a body of rules on the issuance and use of a letter of credit and applies to 175 countries. The aim has been to standardise a set of rules aimed to benefit all parties during a trade finance transaction – for that reason, it is designed by industry experts rather than through legislation. The UCP was created in 1933 and has been revised by the ICC up to the point of the UCP600. The UCP600 came into force on 1 July 2007.
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What is the difference between trade and export finance?
Trade and export finance are sometimes used interchangeably. However, it is important to explain the distinction and how the terms are used.
Trade finance is a term universally used for financing both imports and exports. In many mediums this will encapsulate invoice finance, purchase order finance, off balance sheet lending, letters of credit and similar funding instruments. Trade finance is usually spoken about in reference to cross border trade. However, it may also be domestic trade. It is commented on by many as being seen as a financing mechanism which is not well known in the market, but by having purchase orders and suppliers – there is a way of financing a trade through the use of a lender’s funds.
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Frequently Asked Questions
Why is trade financing important?
Trade financing (also known as supply chain and export finance) is a huge driver of economic development and helps maintain the flow of credit in supply chains. It is predicted that 80-90% of global trade is reliant on trade and supply chain finance, and is estimated to be worth around USD $10 trillion a year.
What does trade finance include?
Trade finance includes the following:
- Lending facilities
- Issuing Letters of Credit (LCs)
- Export factoring (companies receive funds against invoices or accounts receivable)
- Forfaiting (purchasing the receivables or traded goods from an exporter)
- Export credits (to reduce risks to funders when providing trade or supply chain finance)
- Insurance (during delivery and shipping, also covers currency risk and exposure)
What are the methods of payment for trade finance
As the least risky product for the seller, a cash advance requires payment to the exporter or seller before the goods or services have been shipped. Cash advances are very common with lower value orders, and helps provide exporters / sellers with up front cash to ship the goods, and no risk of late or no payment.
Letters of Credit (LCs)
Letters of credit (LCs), also known as documentary credits are financial, legally binding instruments, issued by banks or specialist trade finance institutions, which pay the exporter on behalf of the buyer, if the terms specified in the LC are fulfilled.
An LC requires an importer and an exporter, with an issuing bank and a confirming (or advising) bank respectively. The financiers and their creditworthiness are crucial for this type of trade finance: it is called credit enhancement – the issuing and confirming bank replace the guarantee of payment from the importer and exporter. In this section, and in most cases, we may consider the importer as the buyer and the exporter as the seller.
Documentary collections differ from a Letter of Credit (read our blog post on the differences between DCs and LCs).
In the case of DC, the exporter will request payment by presenting its shipping and collection documents to their remitting bank. The remitting bank then forwards these documents on to the bank of the importer. The importers bank will then pay the exporters bank, which will credit those funds to the exporter.
An open account is a transaction where the importer pays the exporter 30 – 90 days after the goods have arrived from the exporter. This is obviously advantageous to the importer and carries substantial risk for the exporter – it often occurs if the relationship and trust between the two parties is strong.
Open accounts help increase competitiveness in export markets, and buyers often push for exporters and sellers to trade on open account terms. As a result, exporters may seek export finance to fund working capital whilst waiting for the payment.
Who are the providers of trade and export finance?
Retail and commercial banks
Some commercial banks have specialised trade finance divisions, which offer facilities to businesses. Commercial banks represent the majority share of financial institutions globally, although they range in size from small and niche banks to large multinational banks.
The banking services offered by trade finance commercial banks include: issuing letters of credit, accepting drafts and negotiating notes, bills of exchange and documentary collections. The advantage of larger commercial banks over smaller niche banks is twofold: their global presence (they may have foreign subsidiaries which makes L/C confirmation cost effective), and their credibility.
Alternative Finance and Non-Bank Funders
There are many types of financial institutions that do not use public deposits as a funding resource. Funding sources include crowd-funded (pooled) investment, private investment and public market sourced capital.
Traditional ‘receivables-backed finance’ has been disrupted by smaller finance platforms since the economic crisis. This has been driven by a decrease in appetite for risk by larger banks, which has opened the doors to agile smaller finance lenders, who can fill the gap. Private investment funds and larger banks provide capital to alternative trade financiers. Crowd-lending (peer to peer) finance has also entered the trade finance sector. In addition to this, new technologies to disrupt the somewhat lengthy application process for certain types of trade finance make it easier to assess risk, supply credit and documentation to importers and exporters.
What is the process for applying for trade finance?
The initial ‘credit’ application drives the process when applying for credit. A trade finance application will require provision of the following:
- Thorough introduction to the business, including a future vision (business plan), goals of the business and any significant accomplishments to date
- Information on the key stakeholders/ directors including past experience and equity make up of the company
- Introduction and an analysis of the product or service offered
- Overview of the sector/ competitor landscape
- Summary of anticipated results, including financial forecasts
Lenders will often ask for information on current assets or collateral that the business owns, including debt and overdrafts, assets that the company or directors own (property, equipment, invoices).
2. Evaluating the Application
The lender will undertake a full credit risk assessment of the documents that have been received. The credit analysis will usually involve inputting figures from the applicant’s income statement, balance sheet and cash flow documents. It will also take into consideration the collateral the SME can provide, and the quality of this.
The evaluation process will normally involve some kind of credit scoring process, taking into account any vulnerabilities such as the market the business is entering, probability of default and even the integrity and quality of management.
Eligible SMEs applying for trade finance can negotiate terms with lenders. An SME’s aim with a lender is to secure finance on the most favourable terms and price. Some of the terms that can be negotiated can include fees and fixed charges, as well as interest rates.
If you’re prepared and understand the structure of fees and charges, it can help you negotiate terms that are in your favour. Sometimes it may be a good idea to seek advice from your local trade body to avoid any risks, understand the charges and the structure of the loan and insurance.
4. The Approval Process and Documentation of a Loan
Typically, the account officer who initially deals with the applicant and collects all of the documentation will do an initial credit and risk analysis. This then goes to a specific committee or the next level of credit authority for approval. If the loan is agreed (on a preliminary basis) it goes to the legal team to ensure that collateral can be secured/ protected and to mitigate any risks in the case of default.
The loan document is a legally signed contract from both parties that consists of definitions, a full description of the finance facility that has been agreed (amount, duration, interest rates, currency and payment terms – both interest and non-interest charges). The conditions of a loan will also be included, which will state any obligations of the buyer and the lender, as well as what would happen in the case of any disputes or a default.
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