The function of trade finance is to introduce a third-party to transactions to remove the payment risk and the supply risk. Trade finance provides the exporter with receivables or payment according to the agreement while the importer might be extended credit to fulfill the trade order.
Trade financing is different than conventional financing or credit issuance. General financing is used to manage solvency or liquidity, but trade financing may not necessarily indicate a buyer’s lack of funds or liquidity. Instead, trade finance may be used to protect against international trade’s unique inherent risks, such as currency fluctuations, political instability, issues of non-payment, or the creditworthiness of one of the parties involved.
Below are a few of the financial instruments used in trade finance:
- Lending lines of credit can be issued by banks to help both importers and exporters.
- Letters of credit reduce the risk associated with global trade since the buyer’s bank guarantees payment to the seller for the goods shipped. However, the buyer is also protected since payment will not be made unless the terms in the LC are met by the seller. Both parties have to honor the agreement for the transaction to go through.
- Factoring is when companies are paid based on a percentage of their accounts receivables.
- Export credit or working capital can be supplied to exporters.
- Insurance can be used for shipping and the delivery of goods and can also protect the exporter from nonpayment by the buyer.
