What Is Trade Finance?

Trade finance is a set of processes which have developed over centuries to facilitate international trade. Importing and exporting are economic activities at the heart of the market system which has heightened the quality of life in countries and cultures around the world. However, businessmen engaged in importing and exporting have always been naturally nervous about the security of their work. Exporters worry that they will not be paid for the goods that they are exporting and prefer an advanced payment. Importers are concerned about sending out payment before the goods arrive.

The Function of  Trade Finance

Exporters do not want to send goods around the world without receiving payment first. When they require this from an importer in another country, the importer may want to reduce the risks involved by asking for documentation of the shipped goods as a form of security. As in any situation between two parties which do not completely trust each other, the assistance of a third party is often helpful.

The importer’s bank can step in at this juncture to provide the assistance at the heart of trade finance. There are many ways that banks may provide support with a trade finance account. One frequently used form of security for the transaction is a letter of credit. The bank issues this letter on behalf of its client, the importer. This letter is either sent to the exporter directly or to the exporter’s bank. The letter assures payment upon presentation of certain other documents, such as a bill of lading. This latter bill demonstrates that certain items have been designated for shipping by the appropriate authorities.

When everyone on the exporter’s end is satisfied with the appearances of these documents, the exporter’s bank will customarily advance funds to the exporter. The exporter can then feel secure about sending off the goods that required labor and investment because they have been exchanged for money. When the goods arrive at the importer’s location, the transaction terminates with a payment to the exporter’s bank. In essence, the banks step in and handle the payments. The importer does not even necessarily pay the exporter directly because payments can go through the banks.

Roles in Trade Finance

There are four key roles played in this transaction.

  • The importer desires certain goods but is naturally hesitant about sending off payment to an exporter which may be a relatively unknown entity.
  • The exporter receives an order from an importer but is apprehensive about shipping valuable goods without some assurance that there will be payment. Often, the exporter requires payment first.
  • The importer’s bank sends a letter of credit to the exporter which guarantees payment.
  • The exporter’s bank may also be a party to this transaction. Upon verifying the validity of the letter of credit, this bank will advance a loan to the exporter so that the transaction can proceed.

Other Activities in Trade Finance

There are other ways in which financial entities can facilitate international trade. Examples include documentary collection, export factoring and trade credit assurance. Each of these involves regulating the transfer of money so that exporters are more willing to ship goods and importers are more willing to release payments.

The Evolution of Trade Finance

This is a cumbersome process that has begun to transform in a world made much smaller by the Internet and rapid transportation. It was naturally advantageous in the days when someone sent their goods off on a months-long voyage overseas with little idea of when payment would be received. Much of today’s global trade is done using an open account system in which buyers and sellers have become more comfortable with their financial relationship.

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