Trade finance refers to the settlement arrangements used by importers and exporters to mitigate trade risks and ensure the terms and conditions of an underlying contract are met.
What Is Trade Finance?
In general, trade finance refers to the settlement arrangements used by buyers (importers) and sellers (exporters) to mitigate trade risks and ensure the terms and conditions of an underlying contract are met. As the value of global trade reached US$ 28.5 trillion in 2021, the demand for financing trade widened.
According to the World Trade Organization, 80% of global trade is financed by trade finance and credit insurance, the rest is conducted on open account terms. The ICC forecasted the need for US$ 5 trillion in trade credit market capacity for post-covid trade recovery, while the Asian Development Bank estimated the global trade finance gap at US$ 1.7 trillion. Various trade finance options are available for companies to finance international trade and commerce while mitigating trade risks arising from cross-border deals.
Trade Finance Risks
There are three most common types of trade finance risks that trade parties deal with when trading across borders.
1. Customer risk (commercial risk) is the risk of the trading partner not being able to deliver or pay as agreed, or the trading partner not willing to fulfill the agreement. The customer risks most often include the payment risk and the default risk.
2. Country risk (political risk) refers to the risk arising from the actions of government, authorities, or regulators that may affect the possibility of doing trade. Examples of country risk include war, riots, civil commotions, changes in trade regulations, changes in taxes and duties, changes to licensing requirements, shortage of currency, restrictions on foreign exchange outflows from the country, etc.
3. Financial risk refers to the risks arising from fluctuations in currency rates (currency risk), interest rates (interest risk), and commodities prices (price risk).
Other trade finance risks include operational, liquidity, legal, dilution, compliance, fraud, and settlement risks.
Trade Finance Risk Management
The standard approach in trade finance risk management is to follow the risk management process that results in the risk mitigation plan and execution.
The risk management process includes the following steps:
1. Establishing the management context
2. Risk assessment
3. Risk identification
4. Risk analysis
5. Risk evaluation
6. Risk treatment
7. Review and monitoring.
Trade Finance Risk Mitigation
Trade finance products are simple financial solutions structured to mitigate trade risks, including customer, country, and financial risks. The trade finance products are categorized according to the purpose as Unfunded Trade Finance and Funded Trade Finance. The Unfunded Trade Finance products are focused on supporting the trade transaction by guaranteeing the performance of the parties in their different roles. The Funded Trade Finance products provide funding and/or credit support by a financial institution to the trade parties.
Types of Trade Products
1. Unfunded Trade Finance Products:
- Letter of Credit (LCs)
- Standby Letters of Credit
- Guarantees
- Bonds
- Documentary collection
- Trade credit insurance
- Political risk insurance.
2. Funded Trade Finance Products:
- Factoring
- Invoice discounting
- Supply chain finance (SCF)
- Forfaiting
- LC refinancing
- Pre-export finance
- Pre-payment finance
- Tolling facility
- Inventory finance
- Borrowing base facility
- Export and Agency finance.
Except for trade finance products, other trade finance risk management tools are available to combat risks. The trade finance risk information products focus on assessing trade risks related either directly to the trade parties or the operating environment. The trade finance information products include economic reports, business environment reports, company reports, credit reports, credit reference reports, debtor risk assessments, credit opinions, credit monitoring services, and other credit risk information products.
Coface, the leading credit insurance provider, offers both financial and informational products to help exporters and importers trade safely across the borders. Coface trade credit insurance mitigates commercial, credit, payment, and default risks, and single risk insurance decreases political risk. Coface business information services help assess trade partners and mitigate trade finance risk at the initial stage.
