What is Trade Finance?
Trade finance refers to financing for the purpose of trade, which includes both international and domestic transactions. It helps in mitigating or minimizing the risks involved in a trade transaction. The two main individuals/organizations in a trade transaction are exporters and importers. An exporter (seller) can ask the importer (buyer) to pay for the goods shipped in advance, and the importer may ask the seller to document the goods in order to reduce the risk.
The risks of trade transactions:
- Payment Risk: In an international trade transaction, there is always a risk of payment. The exporter is in the constant fear of the default in payment by the importer.
- Corporate Risk: The risk associated with the history of the companies of both the importer and exporter, such as payment history, credit history, etc.
- Country Risk: With international trade transactions, there are a number of risks associated like political risk, exchange rate risk, and sovereign risk.
As there are a lot of trade transactions going across the globe, the commodities getting exported and imported from one place to another demand some financial aid as well. The money in return against the shipping of goods will take its own time, so there is an expense of purchasing the raw materials, manufacturing, and the shipment of the same. For this, the right support at the right time is a must. Various intermediaries such as banks and NBFCs help in facilitating these transactions by trade transactions in various ways.
- Letter of credit: This refers to a promise given by the importer’s financial institute to that of the exporter’s that if the exporter’s contact provides complying documents to the buyer’s contact as specified in the agreement, then buyer’s contact will make the payment on behalf of the buyer.
- Banking Guarantee: It is an undertaking promise given by exporter’s financial institute to that of importer’s that if the exporter failed to fulfil the obligations specified in the agreement, then the exporter’s financial guarantor will make the payment to the beneficiary upon the receipt of the claim.
- Finance for Equipment: A heavy amount of finance is needed in order to purchase the materials, manufacturing, and shipment of the same. Equipment Financing is one of the reasons why MSMEs tend to apply for trade finance to bear the much-needed expenses.
- Collection and Discounting of Bills: It is a significant trade service offered, whereby, the intermediaries collect bills from both sides as per the norms in the agreement.
- Factoring: The intermediaries help the companies by providing them with working capital solutions.
There are many providers where companies can apply for trade financing:
- Banks: There are a number of commercial banks which provide financial support and solution for trade financing. But the list of documentation required is long and the process is very stringent and lengthy. It will be even more difficult if the company has a bad credit history. So, if someone is looking for instant finance, this might not be a good option to apply for.
- Online Lenders: There are many online lenders available who are willing to provide trade financing solutions and can help one with instant loans. But as the source is online, there is always a risk of cyber threat associated with this.
- NBFCs: Although Non-Banking Financial Companies are not banks, these are allowed to provide facilities such as business loans and trade finance. The advantage of applying to NBFCs is that these require minimal document verifications, and the interest rate is also very competitive. NBFCs also don’t ask for any collateral asset in order to get a loan.
- Consultancy Firms: There are numbers of firms who can act as an intermediary and provide solutions for trade financing normally associated with transactional deals and revolving around lines of credit.
There are plenty of options to mitigate the risks in a trade transaction, but one needs to do the cost and benefit analysis before applying for trade finance. Identifying and selecting the appropriate provider of trade finance will require a bit of research but will best serve the interest and requirements of the company. Therefore, before going for any business loan, any business must understand its requirement and other criteria.