Trade finance: What is it & how does it work?

What is trade finance?

Trade finance is an umbrella term that covers many financial products and instruments used by businesses to reduce the risk of trading abroad. It includes importing, exporting and domestic trade. Trade finance is a broad term that encompasses a range of financial products utilised by banks and companies to make trade transactions possible.

Trade finance for importers

If you’re an importer you won’t want your own money tied up in shipments of goods that could take several weeks to arrive – assuming they have actually been shipped.

Trade finance for exporters

And if you’re an exporter, you probably don’t want to wait until your goods have arrived at their final destination before you get paid – assuming your importer doesn’t default on payments. You might also want a cash advance based on a purchase order or invoice.

Why use trade finance?

In theory, trade finance mitigates these potential risks (e.g. payment risk, supply risk, bankruptcy risk) to international and domestic trade.

International trade involves various risks, such as currency fluctuations, credit risks, and shipment risks, which can make it difficult for parties to secure financing for their trade deals. Trade finance helps to mitigate these risks by providing financial instruments such as letters of credit, trade guarantees, and documentary collections that ensure payment and delivery of goods.

Moreover, trade finance also offers other services like financing working capital, providing credit insurance, and managing currency exchange risk, which are essential for companies engaged in international trade to grow their business.

Overall, trade finance plays a vital role in facilitating global trade and ensuring that trade transactions are executed efficiently, safely, and securely.

What does trade finance involve?

The trade financing process can involve several different parties, including the buyer and seller, the trade finance provider, export credit agencies and insurers.

Trade finance for importers and exporters includes:

loans from trade finance lenders (i.e. trade finance loans – see below)
invoice finance e.g. factoring
supplier finance
purchase order finance
revolving credit
letters of credit – guarantees an exporter will receive payment on time and for the full amount)
guarantees and bonds
export credits – provide government financial support to exporters
export credit insurance (ETI) – protects an exporter of products and services against the risk of non-payment by a foreign buyer
export forfaiting – a longer-term form of factoring that enables an exporter to receive cash by selling long-term receivables, i.e. the amount the importers owes the exporter.

Some people have a much narrower definition of trade finance. They use the term to describe loans that help you pay suppliers. Let’s look at these trade finance loans (or trade loans) in more detail.

If you’re a wholesaler, distributor or importer, a loan can give you the cash you need to buy inventory or stock from a supplier, in order to fulfil and order. In this narrower definition, trade finance is a form of working capital finance along the same lines as purchase order finance and supplier finance.

Let’s say you have a confirmed purchase order from a customer and you want to either import stock or inventory, or export products for resale. This is the point at which you’d talk to a trade finance lender. They will look at you favourably if both your customer and supplier are established businesses. Their loan will pay your supplier (in this case the exporter) before you (the importer) receive the goods.

Goods can be shipped to you more quickly so that you can fulfil your order. Your trade finance lender in other words acts as a third party to mitigate payment risk and supply risk.

A trade finance loan (trade loan) works like this:

Your supplier invoices the trade finance lender for the shipped goods
Your customer then pays the trade finance lender
Finally the lender pays you the profits, minus fees.

The loan helps you close the payment gap at the beginning of your sales cycle. It can also work alongside any existing finance your business might have, like invoice factoring or asset finance.

Defining terms:

Some people refer to a trade finance loan as ‘trade finance’. For us, trade finance as a catch-all term for a much broader range of products and instruments designed for businesses who trade internationally. These include trade finance loans (as described here), invoice factoring, supplier finance and export finance.
Because trade finance loans (or ‘trade finance’ if you are using the narrow definition) are based on purchase orders, they are sometimes referred to as purchase order finance or import finance.
It’s easy to confuse a trade finance loan (or ‘trade finance’ if you are using the narrow definition) with supplier finance (or supply chain finance), because a trade finance loan helps you fund the beginning of your supply chain. However, supplier finance is actually a different type of business lending that buyers offer to their suppliers.