Trade finance refers to the use of financial instruments and products to facilitate international trade and commerce. It involves the provision of various financial services and instruments to support the complex and often risky nature of cross-border transactions between buyers and sellers. The primary goal of trade finance is to provide working capital, mitigate risks and ensure the smooth flow of goods and services in the global marketplace.
Trade Finance is governed by international rules and guidelines, such as the Uniform Customs and Practice for Documentary Credits (UCP 600). While each financial institution (banking and non-banking) may have their own specific regulations, these rules should however align with the established international practices for the issuance and handling of trade finance instruments.
- Most used and known trade finance products for importation
- Why use an offshore company for trade finance
- Foreign Exchange Control
Reasons why trade finance products are important:
- Risk Mitigation
Credit Risk: Trade finance products help mitigate credit risk by ensuring that payment is made upon the fulfilment of specified conditions. This effectively minimises the risk for non-payment or delayed payment for international sellers (the exporters), while also assuring the buyers (the importers) of the quality and quantity of goods or services.
Currency Risk: Currency hedging instruments are also considered as trade finance products as they help manage the risk of currency fluctuations in international transactions. This is crucial when dealing with multiple currencies and volatile exchange rates. - Facilitation of International Trade
By providing financial support and risk mitigation, trade finance products contribute to the competitiveness of businesses in the global marketplace. Companies that can offer secure and flexible payment terms are often more attractive to international buyers. - Working Capital Support
Instruments such as pre-export financing and factoring are part of trade finance and provide working capital to businesses engaged in international trade. This ensures that companies have the necessary funds to fulfil orders, produce goods, and cover other operational costs. - Increased Competitiveness
By providing financial support and risk mitigation, trade finance products contribute to the competitiveness of businesses in the global marketplace. Companies can offer secure and flexible payment terms that are often more attractive to international buyers. - Encouragement of Trade Relationships
Trade finance fosters trust and confidence between trading partners. Letters of Credit (LCs), for example, create a mechanism that ensures payment upon the presentation of compliant documents. This encourages sellers (expporters) to enter into transactions with buyers (importers) in different geographical locations. - Compliance with Regulatory Requirements
Trade finance products help businesses comply with regulatory and legal requirements in different countries. They provide a structured framework for documentation and financial transactions that align with international standards. The trade finance transactions often follow internationally recognised rules and guidelines, thereby enhancing transparency and consistency in trade practices. - Support for Small and Medium Enterprises (SMEs)
Can be particularly beneficial for SMEs that may face challenges in accessing traditional financing. Trade finance instruments like factoring and export credit insurance allow small businesses to participate in global trade with reduced financial risks. - Optimisation of Cash Flow
Trade finance products such as Supply Chain Finance (SCF), help optimise cash flow along the entire supply chain. Importers can extend payment terms, while exporters have the option to receive early payment, thereby improving liquidity for all parties.
Most used and known trade finance product for importation:
One of the most widely used and known trade finance products for international trade is the Letter of Credit (LC). LCs are commonly used in international trade transactions to provide a secure method of payment and risk mitigation for both the importer and exporter. The two primary types of LCs used in international trade are:
(a) Commercial LC
A Commercial LC is issued by a bank on behalf of the importer to the exporter, ensuring that payment will be made upon the presentation of compliant shipping and other required documents. This type of LC is commonly used in trade transactions where the exporter requires assurance of payment before shipping the goods.
An LC is either issued as an irrevocable LC (ILOC) or revocable LC (RLOC). The ILOC is a commitment by the issuing bank to honour the credit as long as the exporter complies with the terms and conditions speicified in the LC. Once issued, it cannot be modified or cancelled without the consent of all involved parties. On the other hand, an RLOC is a revocable LC less commonly used and discouraged in international trade as it can be cancelled or modified by the issuing bank without prior notice to the importer.
(b) Standby LC – SBLC
Unlike a traditional LC that is used as a primary payment mechanism, an SBLC is considered as a standby instrument.
There are two types of SBLCs:
- Performance SBLCs: Guarantees the performance of a contract or delivery of goods/services.
- Financial SBLCs: Services as a financial guarantee, ensuring payment in case of default.
In the case of international trade, an SBLC serves as a backup payment method if the importer fails to fulfil their payment obligations. It acts as a secondary form of payment assurance where the issuing bank commits to make a payment to the exporter and payment is triggered by the failure of the importer to fulfil its obligations, such as non-payment for goods.
SBLCs have a specified validity period and if the conditions are not met within that period, the SBLC expires. However, the SBLC may be renewed if needed, provided both parties agree and the terms of the agreement allows for renewal.
Why use an offshore company for trade finance?
We cannot discuss trade finance without considering global business entities ( offshore entities). These entities are essential in facilitating international trade by providing the legal and organisational structures necessary for businesses to engage in cross-border transactions. These entities are specifically established to expedite the movement of goods and services across borders, enable easy access to trade finance and take advantage of trade facilitation areas that offer specific incentives to attract foreign businesses and promote international trade through tax breaks and streamlined customs procedures.
The Global Business Corporations (GBCs) are setup in International Financial Centres, also known as IFCs or common referred as Offshore Jurisdictions (although there is a distinction between the two). The IFCs are usually recognised for their business-friendly environments and efficient regulatory processes, facilitating a more streamlined and effective approach to conducting trade finance activities. Furthermore, they often possess well-established financial systems that support trade finance operations, along with specific legal safeguards for businesses, such as provisions for dispute resolution and contract enforcement, to bolster the security of trade transactions. However, the primary reasons many businesses engaged in international trade choose to establish companies in offshore jurisdictions are to have unhindered access to foreign currency and capitalise on favourable tax rates.
Furthermore, to entice importers and exporters to operate within their jurisdictions, IFCs actively engage in various initiatives as members of intergovernmental organisations and economic communities such as SADC, COMESA, IOC, AGOA, and EPA-EU. This participation aims to promote regional integration, economic development, and cooperation. Consequently, companies established in these IFCs as resident entities can access economic and trade advantages, including reduced trade barriers, elimination or reduction of custom tariffs, and duty-free treatment for specific product categories.
Foreign Exchange Control
Foreign exchange controls in certain countries can impact access to trade finance. The impact varies depending on the specific nature of a country’s implemented controls.
Foreign exchange control refers to government restrictions or regulations governing currency buying and selling in the foreign exchange market. These controls may involve currency conversion limitations, capital flow restrictions, and other measures aimed at managing a country’s currency. In most cases, these measures lead to delays in processing international payments and increased challenges for businesses in managing currency exposures, resulting in financial uncertainties.
Furthermore, companies operating in countries with rigorous foreign exchange controls encounter difficulties when making pre-payments, utilising LCs, or entering into other forms of trade finance arrangements.
As a result of impediments to accessing foreign currencies imposed by restrictions and constraints, businesses are likely to face additional costs associated with the need for specialised services to navigate such restrictions or for hedging against exchange rate volatility.
Author: Lorna Chuttoo
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