Back to basics: The foundations of trade finance

The plethora of terms and technicalities in trade finance is likely to trip up seasoned industry professionals and new entrants alike. Trade finance is filled with seemingly impenetrable processes and rigid procedures that often require decades to get your head around. 

Silvia Andreoletti, Senior Reporter at Trade Finance Global (TFG), spoke with Ravi Sivasubramanian following his recent move to Mizuho as Head of Trade Finance – EMEA, to refresh our understanding of the basics behind trade finance’s complexities, as the instruments and mechanisms continue to power global trade.

Silvia Andreoletti (SA): The trade finance industry goes by many names: trade finance, export finance, supply chain finance, documentary finance. What are the differences between them? What are the key characteristics of trade finance?

Ravi Sivasubramanian (RS): It’s often a major source of confusion for practitioners, sometimes regulators, and definitely clients. But if you look at the business that we are in, fundamentally, it is to support trade between two parties. Trade is the buying and selling of goods and services. Trade finance, in my view, refers to the universe of products and solutions supporting that trade activity. 

In major organisations, trade finance products and solutions are aimed at supporting three broad categories of client requirements:

1. Risk mitigation,
2. Providing liquidity and working capital funding, and 
3. Optimisation or balance sheet management. 

These three categories broadly divide the types of trade finance products out there. Each product supports a specific type of client requirement.

Letters of credit, guarantees, and standby letters of credit are risk mitigation products offering protection either to the seller (to ensure prompt payment from a buyer) or to the buyer (to ensure prompt delivery of goods and services). In projects and contracts, a guarantee or standby letter of credit can also be used to ensure prompt performance in accordance with the contract by either party.

Liquidity and working capital solutions can be offered on their own or combined with some of the risk mitigation instruments above. These include products like import finance, export finance, pre-export finance, trade loans, receivables finance, and payables finance. The name of the product describes the activity that’s being financed.

It is confusing when people look at it cold, but primarily, these products and solutions support trade between two parties. 

SA: Could you go through the most common trade finance instruments and explain how they work?

RS: At a broader level, we can categorise these into two buckets: negotiable instruments, comprising letters of credit, bills of exchange, and promissory notes, and non-negotiable instruments comprising bonds, guarantees, indemnities, and standby letters of credit. 

Negotiable instruments

Negotiable means that an instrument can be endorsed, transferred, or assigned, and the holder of that instrument will have the right to receive payment on the due date. Negotiability effectively means that the instrument can be transferred to cash value. 

The simplest way to understand a negotiable instrument is a check. When we write a check, the holder of the check has the value, and they can go to a bank to cash that check. In the same way, the holder of a negotiable instrument can simply present the instrument to the issuer and demand payment.

Letters of credit

A letter of credit represents a promise by a bank to pay the seller if the seller submits documents in conformance with the terms of the letter of credit.

Letters of credit are a core offering in the trade finance industry in which banks intermediate to eliminate counterparty risk between buyers and sellers.

There are several parties involved in a letter of credit transaction.  The buyer (or the importer), the seller (or the exporter), the issuing bank (buyer’s bank), and the confirming/negotiating bank (seller’s bank).  By taking risk on each other, the two banks are effectively saying: (to the seller) “don’t worry, we will pay on behalf of the buyer” and (to the buyer) “don’t worry we will pay only if the seller provides the right set of documents called for”, thus eliminating the risk between the buyers and sellers. 

Bill of exchange

Bills of exchange are bills or invoices issued by the seller that are accepted by the buyer, who commits to paying the seller on the due date. Bills of exchange are commonly used in English law jurisdictions and can be presented to the bank to get early payment. 

This lets the seller get funds before the invoice is due by presenting the bill of exchange to its bank. Banks will offer early payment to sellers by discounting the bill of exchange, meaning they give the holder of the bill a discounted value in exchange for providing the funds early. 

The bill of exchange can be endorsed – or avalised – by a bank, which effectively adds a guarantee to that bill that says the bank will pay on behalf of the buyer. 

On the maturity date, the negotiating bank will seek payment from the buyer or the avalising/endorsing bank. 

Promissory note

Promissory notes are similar to bills of exchange, but mirrored: a promissory note is a promise to pay that is issued by a buyer to a seller. 

In a bill of exchange, the seller issues the bill, the buyer accepts it and agrees to pay;  in a promissory note, the buyer is the one promising to pay on a future date. That promissory note is typically held by a seller, like a bill of exchange, so that the seller can go to the bank and ask for early payment based on that promissory note. 

Non-negotiable instruments

Non-negotiable instruments, on the other hand, are essentially risk mitigation tools. Unlike a normal letter of credit, you can’t use a standby letter of credit to ask a bank for early payment. A standby letter of credit or a guarantee is only actually used when one party fails to meet its obligations. Only then can a demand be made. 

Because these instruments are not normally used to make payments, they are called non-negotiable. Negotiable instruments, on the other hand, are used as payment mechanisms. So if you are issuing a letter of credit, the seller can get payment only through that letter of credit; if there is a bill of exchange, the payment can be made only when that bill of exchange is presented to the issuer. 

SA: What is the importance of documents in documentary trade finance? What is the difference between documentary finance and open accounts trade?

RS:  Documentary credit refers to transactions that rely upon the presentation of documents to get payment. Take a letter of credit, for example, which is a promise to pay if the seller provides documents in conformance with the terms of the letter of credit. Here, the documents serve as evidence that the seller, who is requesting payment, has in fact shipped the goods. 

These documents are agreed between the buyer and the seller, typically comprising shipping documents (bills of lading) and commercial invoices. Banks will check those documents, make sure that they’re in order and comply with the terms of the letter of credit, and then they will make the payment. 

This reduces risk between the seller and the buyer. The buyer will be assured that the seller has held up his side of the deal and that the goods are on their way, and the bank can make the payment on the buyer’s behalf. 

In a documentary credit, banks intermediate and deal in documents. Banks check those documents before making a payment. This provides some assurance to the buyer that the payment is for goods that are being shipped by the seller, and the seller is assured of a payment because the bank makes the payment, not the buyer. 

If the underlying trade between the parties does not require a letter of credit, it is called an open account transaction. 

In an open account trade, banks do not intermediate, and there are no documents presented.  There is no assurance to the buyer that goods are being shipped: the seller has no assurance of payment from the buyer. Hence, the counterparty risk between buyers and sellers is not eliminated.  

Banks can still support an open account trade by providing early payment. Products like receivable finance or payables finance support open account trades. 

SA: What are the types of risks faced by banks in trade finance?

RS: There are two major categories of risk that banks are exposed to in a trade finance transaction. 

The first is documentary risk. In a letter of credit, for example, if documents submitted by sellers aren’t checked correctly by the confirming bank’s operational team, that puts the bank at risk. Incorrectly checked documents – which may contain mistakes or not conform to the terms of the letter of credit – could lead to the issuing bank refusing payment. 

The next is credit risk – the ability and the willingness of a counterparty to meet its obligations. When a bank issues a letter of credit, the bank makes payment on behalf of the buyer and is thereby exposed to the risk that the buyer may not pay it back. Before issuing a letter of credit, a bank evaluates the ability and willingness of its client – the buyer – to reimburse the bank for payments it made under that letter of credit. 

At its core, this is no different from lending to that counterparty, and the credit risk is very similar. However, banks tend to have a bigger risk appetite for trade finance compared to, say, a five-year loan to the same buyer. This is because trade facilities are uncommitted, typically short-term – three to six months – and there is a clear underlying purpose that can be evidenced by invoices and shipping documents. 

Ultimately, banks get repaid from their clients selling the goods; they don’t need to wait for the company to generate profits to pay them back. This is why trade is considered lower-risk within the gamut of credit exposure that banks take on, especially compared to, say, a loan or a complex derivative transaction.

SA: How is insurance used to counter these risks?

RS: Banks use insurance to mitigate credit risk. Let’s say that a bank has a credit risk appetite for a client of £100 million, but the transaction entails risk exposure of £150 million. The bank can’t accept the transaction as it is, but it can go to an insurance provider and ask them to cover the excess £50 million.

Insurance companies effectively enhance the amount of lending that banks can provide to their clients because the insurance company is covering part of the risk. If the bank doesn’t get repaid by its client, then it can claim that amount under the insurance policy.

Insurance companies provide risk mitigation to banks to protect them against non-payment risk. However, this is the only risk they can mitigate through insurance: banks must manage other risks – like documentary risk, legal risk, financial crime and fraud risk, or reputational risk – on their own.

If the bank doesn’t get payment because there was a fraud, a sanctions hit, or a financial crime issue, then the insurance company will say, “Don’t come to us – this wasn’t a credit risk.” An insurer will only pay if the bank’s client is unable to pay or has gone insolvent.

SA: But they usually don’t claim the full amount, right? If I’m lending out £500 million, I can’t be covered for all £500 million?

RS: Typical insurance companies won’t provide 100% cover, but instead cover up to around 90% of a transaction, because they want the banks to have some skin in the game. The insurer isn’t the one running the transaction; the bank is. The bank knows its client in and out and has a track record with them, so the insurance companies always rely on banks to do that due diligence. 

Insurance companies are comfortable providing such protection as they have the means to assess default risk on a wide portfolio of credit risks. The amount of premium charged by insurance companies has a close link to the default expectations in their portfolio.  For example, when insurers underwrite, say, £5 billion of credit risk with say an expected default rate of 1%, they expect only £50 million of claims, and the premiums they charge would more than cover this claim rate, hence resulting in profits.

SA: We often hear about self-liquidating instruments in trade finance, which are often seen as safer than other products. What does it actually mean for something to be a self-liquidating instrument?

RS: That’s a very interesting question, and you’re going to get multiple answers depending on who you’re talking to.

In the strictest sense, ‘self-liquidating’ means that repayment of a transaction is not contingent upon the creditworthiness of the client.  For instance, the transaction can be structured such that funding is provided to purchase goods that have been pre-sold to a third party, and the sale proceeds can be ring-fenced to be applied towards repayment.  Hence, the repayment is not contingent upon the client’s credit quality. 

This structure means that repayment of that funding doesn’t rely on how the company is going to perform in the future: the structure itself is self-liquidating.

However, the term is often used loosely, even in regulation. Sometimes ‘self-liquidating’ just refers to any transaction which is short-term and is repaid through the sale of goods without necessarily having control over the goods or funds through the end-to-end process. 

If a bank controls all the steps in a watertight structure, then it makes sense to call it self-liquidating. The industry often calls even unstructured funding self-liquidating because banks get paid back from sales instead of waiting for profits to be generated – it’s a frequently misused term.

SA: What role do multilateral agencies or export credit agencies play in a trade finance transaction? How does it differ from insurance’s role?

RS: The role of multilateral agencies is very similar to that of insurers, except that the risk profile of an insurance company compared to a multilateral agency (MLA) or export credit agency (ECA) is entirely different. 

MLAs and ECAs are almost always government-backed, either by one jurisdiction or multiple collaborating ones, as in MLAs. These agencies provide guarantees and insurance policies, performing the same role as insurance companies.

The first difference, then, is credit quality. While an insurance company may be single A-rated or double A-rated, ECAs and MLAs are considered effectively risk-free due to Government backing. Banks benefit from the protection and the much lower capital requirements for exposures that are covered or guaranteed by MLAs and ECAs. 

Another difference between insurance companies and MLAs and ECAs is that MLAs and ECAs have a charter and a purpose to fulfil. An ECA, for example, is effectively mandated by their government to promote exports from that country. 

MLAs typically support emerging market borrowers who may not be able to access funding on their own. Some MLAs only cover government or state-owned entities, others only cover the private sector, but they all have the goal of providing development funding to emerging markets, such as Africa or emerging Europe. 

This allows banks to support their clients who are trading in high-risk jurisdictions without taking on excessive risk.