To understand what trade finance is and why it is important, we should first define trade. Simply put, trade is the transfer of goods or services from one business entity to another, in exchange for money. Trade can be domestic ⎯ carried out within one economy ⎯ or international. In this article, we will be focusing on the latter.
International trade is the exchange of goods and services between countries, which allows consumers around the world to find goods and services that they could not have otherwise.
Of course, this complex process has its rules and regulations, which is where trade finance comes into the picture. Trade finance refers to various financial tools and services that support international trade. It makes it easier for both the importer (buyer) and the exporter (seller) to do business abroad.
Any aspiring business owner that plans to take their services to a foreign market should know the basics of this concept. Here are some of the most essential facts that will introduce you to the world of trade finance.
1. The Instruments of Trade Finance
The services that are used to simplify the processes of international commerce are provided by third-party, independent institutions. Most commonly, these are banks, insurers, or export credit agencies.
These institutions use a variety of economic instruments to ensure that conducting business internationally is as secure as possible. Some of the main instruments include:
- Letters of Credit – A promise by the buyer’s bank that, once the seller provides the proof of shipping, the bank will pay for the purchased goods.
- Bank Guarantees – In case the buyer or the seller fails to meet the terms of the contract, the bank guarantees to cover the payment to the beneficiary.
2. Factoring and Forfaiting
Factoring is a process by which the seller sells all their open accounts to an independent institution at a lower price. The institution is called ‘the factor’ in such cases.
Selling the accounts to a third party allows the seller to get the money they need for further trade. The buyer then pays the full price to the factor at a later date, which is when the factor makes a profit.
Forfaiting, on the other hand, is a means of funding that allows the seller to receive immediate cash by selling their receivable accounts. They do so at a more affordable price through a third party, known as ‘the forfaiter’ in this case.
The difference between these two processes is in who makes the payment to the third party. With factoring, the buyer pays the factor directly. But with forfaiting, it is the buyer’s bank that guarantees the payment.
3. No-Risk International Trade
The main purpose of the trade instruments is to remove the risks related to making payments and shipping. That is achieved by third parties (e.g., banks) providing the funds for the transactions between the buyer and the seller.
For instance, a seller requires a buyer to pay for the goods in advance. The buyer, however, does not want to pay for those goods before they get a confirmation that the right products have been shipped. In such situations, the bank can issue a letter of credit in order to pay out the seller right away. Once the shipping confirmation arrives, the buyer pays the bank.
Before these services were made available, the sellers were never sure when they would be paid. Likewise, the buyers had no guarantee that the products would arrive on time.
Therefore, the introduction of institutions and services that deal with such agreements has removed many of these risks.
4. Increased Profits
The transactions are now happening at a greater speed, so more money is generated on both sides. Ideally, that means that both the exporters and the importers can do more business abroad.
However, international commerce is expensive, and many companies would not have the funds to produce the goods and ship them overseas on their own. But with trade credits and services such as factoring and forfaiting, this is not only possible but is becoming the norm in trade.
Why is This Important?
The bottom line is that, due to globalization, international trade has become the staple of the modern economy. Trade finance ensures that doing business with foreign companies runs smoothly and efficiently. Thus, knowing the inner workings of it is a must for any successful business owner.
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