What is 'Trade Finance'?
Trade finance represents monetary activities related to commerce and international trade. Trade finance includes lending, the issuance of 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 service providers.
BREAKING DOWN 'Trade Finance'
Repayment terms for trade financing transactions are typically short term. This type of financing creates a safety net to protect the interests of buyers and sellers in the international marketplace and assist in the completion of transactions that may involve multiple currencies.
Although international trade has been in existence for centuries, trade finance facilitates its advancement. The widespread use of trade finance has contributed to the enormous growth in 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.
Trade Finance, Solvency and Liquidity
General financing is used to manage 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 inherent in international trade, such as currency fluctuations, political instability, issues of non-payment or the creditworthiness of one of the parties involved.
International Trade Financing
In its simplest form, trade finance works by reconciling the divergent needs of an exporter and importer. An exporter would prefer to be paid upfront by the importer for an export shipment to avoid the risk that the importer takes the payment but refuses to ship the goods. Conversely, if the exporter extends credit to the importer, the importer may refuse to make the payment or delay the payment.
A common solution to this problem is the issuing of a letter of credit, which is opened in the exporter's name by the importer through a bank in the home country. The letter of credit guarantees payment to the exporter, from the issuing bank, upon receipt of documentary proof that the goods have been shipped. The letter of a credit system is cumbersome, but it is one of the most popular trade finance mechanisms.