What is trade finance in banking?
This is the term used for the department in a commercial or investment bank where trade transactions (cross border and domestic) are financed. Financing is usually between a supplier and end buyer; with the occasional involvement of a trader.
The idea of trade finance is to mitigate risk throughout the life cycle of a transaction. An exporter will do this by covering the non-payment risk of the buyer with a documentary credit issued by a bank. Funds are only advanced to the exporter when he presents the documents that fulfill the terms of such credit.
Within trade finance we also see many other risk mitigants, such as standby documentary credits which acts as a guarantee and are activated when a payment does not take place. Guarantees are also used by banks to stand behind a contract. Documentary credits such as letters of credit are used to facilitate cross border trades.
There are many types of bonds that are also used to ensure trust in cross border relationships; which can include bid bonds. They are usually used to support up to 5% a customer’s tender and if such tender is successful and the supplier accepts, then a performance bond may have to be created. This is to ensure the contract entered into can be performed and the bond may be up to 20% of the contract value.
Some contracts will stipulate that there must be an advance payment made prior to delivery of goods; so an advance payment bond ensures repayment of any advance if the agreement is not fulfilled.
In relation to plant or machinery purchases, the purchaser may hold back up to 10% for a year. However, if the seller requires 100% of the value; then a retention bond can be provided to cover this shortfall. Therefore a retention bond will be provided by the exporter’s bank in favour of the buyer.
Payment guarantees are also used to make sure that there is payment to the exporter if there is non fulfillment of payment obligations.
Trade Finance and Documentary Collections
Trade finance bankers also refer to documentary collections; which is a payment service where an exporter and importer transact through banking channels. By using documentary collection, the bank will control the goods and title documents; when their correspondent bank is satisfied (with the trade) in another jurisdiction; they may release such documents. Documents will only be released by the seller’s financier against payment or the acceptance of a bill of exchange. This means that title documents stay in the banking channel until there is an acceptance of collection or payment.
The benefit of having collection type payment is that the commitment to pay is made upon the receipt of relevant documents; which is managed through the banking system.
Does payment always need to be made for release?
It is usual for payment to be made by the importer prior to release of documentation, but there may be instructions for a term bill of exchange is satisfactory. Thus, there will be a release of documents if there is acceptance of a bill of exchange, and payment will then be made in the future.