What are the Risks and Challenges of Trade Finance?
Understanding the dynamics and complexities of international trade is important for buyers, sellers and lenders. Managing risks is key to growing a successful trading business, either internationally or domestically. This can be done by using specific types and structures of trade finance products. International trade carries substantially more risks than domestic transactions, due to differences in language, culture, politics, legislation and currency. We have summarized the main types of risk under the headings below: product, manufacturing, transport and currency.
Product-related risks are those which the seller automatically has to accept. As an integral part of their commitment, for example, they usually have to provide specified performance warranties, agreed maintenance or service obligations.
The buyer must consider how external factors such as how negligence during production, or extreme weather during shipping could affect their product.
These matters could well lead to disputes between the parties, even after contracts are signed.
It is important for the seller that the contract is worded correctly, so that any changes which could affect the product are covered, with clear outcomes provided.
Manufacturing risks are particularly common for products which are tailor-made or have unique specifications. Often the seller would be required to cover costs of any readjustments of the product until the buyer sees fit, because the product can’t be resold to other buyers. Such risks can be addressed as early as the product planning phase, which often means the buyer has to enter payment obligations at a much earlier stage of the transaction.
To mitigate the risks for both the buyer and the seller (especially for bespoke products), the terms of payment may be part-payments and separate guarantees throughout the design, production and delivery of the product.
These are the risks associated with the movement of the goods from the seller to the buyer.
Cargo and transport risks can be reduced through cargo insurance, which is usually defined by standard international policy wordings (issued by the Institute of London Underwriters or the American Institute of Marine Underwriters).
The agreed terms of delivery will usually state who is responsible for arranging insurance (the buyer or seller).
If the buyer fails to insure (where it is his responsibility) the cargo shipment in a proper way, the insurance could be invalid if, for example, the port or transport route changes and the items arrive in damaged condition.
Currency risk management is often misunderstood or neglected by businesses. Any business which purchases and sells products (or services) in multiple currencies should consider options to mitigate foreign exchange (FX) rate volatility.
Changes in exchange rates will impact the profit margin on international contracts, as well as the value of any assets, liabilities and cash flows which are denominated in a foreign currency.
There are a range of financial instruments available to manage FX risk. Due to the increasing volatility seen in the market and the need to operate in various currencies, policies need to be flexible and cater accordingly.
Prior to developing a strategy, a company should look at what proportion of their business relates to imports or exports, the currencies that are being used, when payments are to be made, and what currency is used for supplier payments and invoices.
Trade Finance Hub
1 | Introduction and the benefits
2 | Types of trade financing
3 | Methods of payment
4 | Pre and post-shipment finance
5 | Risks and challenges
6 | Trade and export finance providers
7 | The credit process and securing finance
8 | SME Trade Finance Guide