Trade finance includes lending, the issuance of letters of credit, factoring, export credit and insurance. Companies involved with such finance include importers and exporters, banks and financiers, insurers and export credit agencies, and service providers.
A trade transaction requires a seller of goods and services as well as a buyer. Various intermediaries such as banks and financial institutions can facilitate these transactions by financing the trade. Trade finance includes such activities as lending, issuing letters of credit, factoring, export credit and insurance. Companies involved with trade finance include importers and exporters, banks and financiers, insurers and export credit agencies, and other service providers.
While a seller (or exporter) can require the purchaser (an importer) to prepay for goods shipped, the purchaser (importer) may wish to reduce risk by requiring the seller to document the goods that have been shipped. Banks may assist by providing various forms of support. For example, the importer’s bank may provide a letter of credit to the exporter (or the exporter’s bank) providing for payment upon presentation of certain documents, such as a bill of lading. The exporter’s bank may make a loan (by advancing funds) to the exporter on the basis of the export contract.
Other forms of trade finance can include documentary collection, trade credit insurance, finetrading, factoring, and forfaiting. Some of which are specifically designed to supplement traditional financing.
Secure trade finance depends on verifiable and secure tracking of physical risks and events in the chain between exporter and importer. The advent of new information and communication technologies allows the development of risk mitigation models which have developed into advance finance models. This allows very low risk of advance payment given to the Exporter, while preserving the Importer’s normal payment credit terms and without burdening the importer’s balance sheet. As trade transactions become more flexible and increase in volume, demand for these technologies has grown.
Repayment terms relating to trade finance activities are generally short-term with the majority being used solely for the completion of a particular financial transaction. This financing forms a safety net, helping to protect the interests of buyers and sellers in an international marketplace and assisting in the completion of transactions that may involve multiple currencies.
Although international trade has been in existence for centuries, trade finance developed as a means of facilitating it further. The widespread use of trade finance is one of the factors that has contributed to the enormous growth of international trade. Trade finance is of vital importance to the global economy, with the World Trade Organization (WTO) estimating that 80 to 90% of global trade relies on this method of financing.
General financing may be used to cover an issue of solvency or liquidity, but trade financing may not necessarily indicate a lack of funds or liquidity on the buyer’s part. Instead, it may be used to protect against the unique risks present in international trade, such as currency fluctuations, political instability, issues of non-payment or questions regarding the creditworthiness of one of the involved parties.
In its simplest form, trade finance works by reconciling the divergent needs of an exporter and importer. While an exporter would prefer to be paid upfront by the importer for an export shipment, the risk to the importer is that the exporter may simply pocket the payment and refuse shipment. Conversely, if the exporter extends credit to the importer, the latter may refuse to make payment or delay it inordinately.
A common solution to this problem in the area of trade finance is through the issuing of a letter of credit, which is opened in the exporter’s name by the importer through a bank in his home country. The letter of credit essentially guarantees payment to the exporter by the bank issuing the letter of credit upon receipt of documentary proof that the goods have been shipped. Although this is a somewhat cumbersome process, the letter of credit system is one of the most popular trade finance mechanisms.
Trade finance is going through a revolution. New technologies and development are energizing traditional players, transforming their offerings and pulling trade into the 21st century. One of the main developments is the introduction of blockchain technology into the trade finance ecosystem. The promise of blockchain is that it has the ability to streamline the trade finance process. In the past, trade finance has been provided primarily by financial institutions, unchanged for years, with many manual processes on old-legacy systems that are expensive and costly to update.
Such structures are mostly managed manually or through antiquated systems, which are not scalable and result in higher operational costs for financial institutions. Blockchain technology can provide enormous benefits to solve these technological challenges in trade finance. It can be used to provide the basic services that are essential in trade finance. At its core, blockchain relies on a decentralized, digitalized ledger model, which by its nature is more robust and secure than the proprietary, centralized models which are currently used in trade finance.
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