By Jamie Johnson
What is trade finance?
Trade finance provides finance to exporters and importers in order to facilitate trade. According to the World Trade Organization (WTO), between 80% and 90% of trade involves trade finance.
Trade finance is so prevalent because of the risks and costs involved in international trade. Importers may not be able to afford to pay exporters upfront for the goods. Even if they did, they would run the risk of the exporter taking the payment and rescinding on its contractual obligations.
The products involved in trade finance
There are two main products offered for trade finance: letters of credit and bank guarantees.
Letters of credit
A letter of credit is a contract whereby a bank agrees to pay the exporter if there is proof from the exporter that these goods will be sold. The bank may request financial documents, shipping documents, legal documents and insurance documents from the exporter.
Letters of credit are governed by the Uniform Customs and Practice for Documentary Credits (UCP). The current version of the UCP is the UCP 600. The International Standard Banking Practice (ISBP) sets out how banks should implement this legislation.
Banks play four prominent roles in letters of credit: as issuing banks, as advising banks, as nominated banks and as confirming banks.
An issuing bank will be based in the country that the importer is based in. This will issue the actual letter of credit and the required capital once any required documentation has been given.
An advising bank will usually be based in the country that the exporter is established in. The issuing bank will ask the advising bank to advise the exporter when the letter of credit has been opened. Under Article 9 of the UCP 600, the advising bank needs to satisfy itself that the credit is authentic.
The nominated bank is the bank where the exporter provides documents and gets the payment for the goods they are exporting. Typically, the advising bank will also become the nominated bank.
The confirming bank confirms the credit and has an equal liability to the exporter on any undertakings given by the issuing bank. Typically, the confirming bank will be the same as the nominated bank. In most cases, trade finance will involve two banks, but it could also involve more.
Alternatively, there could be an open account. This is where the exporter and importer’s banks are correspondent banks. This means that money can be deposited and withdrawn from the account at will. An open account requires a great deal of trust between the exporter and importer.
A bank guarantee is an undertaking from a bank where it guarantees that the liabilities of the importer will be met if the importer cannot do so. Or, it ensures that the liabilities of the exporter are met. This differs from a letter of credit because a letter of payment involves an actual payment from the bank. In contrast, guarantees only include payments in the case of a party defaulting on its obligations.
There are three main types of guarantees: tender guarantees, advance payment guarantees and performance guarantees.
Tender guarantees ensure that banks underwrite the risk of an exporter needing to open tender for bids again.
Advance payment guarantees may occur if there is an advanced payment required by a contract and the importer defaults on these obligations. In this case, the bank would again underwrite the risk.
Performance guarantees involve banks guaranteeing that the contract will be performed as stated. So, for example, if there is a requirement for the goods to be delivered within a specific time frame, this will be guaranteed by the bank.
Export credit agencies (ECAs)
In addition to banks, ECAs will help with the financing of trade. An ECA provides help for the exporting of goods and services from the country the ECA is based in. An ECA can be a private actor, a governmental actor or a mixture of both.
There are three forms of support an ECA can provide: loans, guarantees and insurance.
Firstly, ECA can provide loans to an importer to ensure that it has the capital required to purchase the goods or services from the exporter.
An ECA can also provide guarantees to banks who are providing finance for the transaction. This means that banks may finance deals that would otherwise be too risky for them to get involved in.
Finally, an ECA can provide insurance to an exporter in case the importer does not pay them for their goods. They can also provide credit risk insurance (see our guide on credit risk insurance for more information).
There are two main types of risk that banks and ECAs need to be mindful of when providing trade finance: financial risks and political risks.
Financial risks can occur if the importer or exporter has solvency issues. So, there may be issues with delivering the goods or services, which would mean that the bank would have to carry out any guarantees it has provided. Alternatively, there may be issues with importers repaying any outstanding debts to the bank, which would decrease the bank’s profit from the transaction.
Political risks can occur if a government changes its approach to trade. If sanctions are imposed on a country, then the transaction cannot go ahead at all. In addition, the imposition of tariffs would make trade significantly less profitable. Given the current threats to globalisation, political risks should be taken seriously.
Apollo Aviation Group pays a $210,600 settlement – (February 2020) Apollo was required to pay a settlement to the US Office of Foreign Assets Control (OFAC) because its exported engines ended up making 12 violations of US sanctions targeting Sudan. Despite the engines originally being shipped to the UAE, they were found in breach of the existing sanctions regime.
Hin Leong Trading collapses – (April 2020) Hin Leong collapsed because of its over-exposure to trade finance and commodity trading. The collapse is likely to discourage other traders from getting involved in trade finance.
Mobily receives SAR1.1 billion financing from ECA – (December 2018) Mobily signed a ten-year financing agreement with the Swedish Export Credit Agencies to expand its telecom network.