Trade Finance – a tool for inclusion but disparate for most?
Trade Finance – the fuel for trade flows and engine for businesses
Trade Finance is the process of financing certain activities involving commerce and international trade, covering both domestic and international trade transactions. It is provided via various instruments such as documentary credits, D/A and D/P, forfaiting, export factoring, invoice financing, supply chain financing, etc. “Providers” and “Users” in the trade finance value chain as depicted in the figures below include importers and exporters (buyers and suppliers), banks and financiers, trade credit insurers and export credit agencies, amongst other stakeholders.
Essentially, Trade Finance makes it possible and easier for buyers and suppliers to trade, which in turn is a key driver of international trade and economic growth. A significant amount of research has indicated that there is a direct correlation between trade finance and, export and import volumes. The development of trade finance has facilitated international trade further, with the World Trade Organization (WTO) estimating that almost a vast majority of global trade (80%-90%) is reliant on some versions of trade finance.
Trade finance is used with the aim of bridging the funding gap between paying suppliers and receiving customer payments. Such working capital cycle gaps are common across industries where a typical scenario finds a trader having to pay his supplier on cash terms in order to effect shipment, but has to grant 60-90 days credit terms to his buyer in order to stay competitive. Banks and financial institutions provide trade finance products and services as a means of supporting these trades by helping traders manage their payments and associated risks, and providing needed working capital. Many trade finance instruments are short-term in nature to bridge recurring working capital cycle gaps; though trade in capital goods may be supported by longer-term credits.
- Mitigating payment risk: It is clear that late payments from trade partners, bad debts, out-of-stock and excess stock situations will have adverse impacts on the business, especially on smaller enterprises. In some cases, trade finance can be used to mitigate these risks such as in non-recourse or limited recourse structures. For example, a receivables financing facility backed by trade credit insurance can potentially protect against insolvency and protracted default situations, and political/country risks of export receivables. Hedging instruments are also widely used to hedge against currency fluctuations and cross-border trades.
- Increasing trade and working capital flow: With access to trade finance, companies can purchase more to capitalize on larger order fulfilments, carry inventory to meet industry demands and extend credit terms to their buyers in order to stay competitive. Efficiency in the supply chains also help create stable, long-lasting relationships between suppliers and buyers, promote growth of SMEs and contribute to overall market efficiency.
Trade finance and access to SMEs
Trade finance is inextricably correlated with a healthy and well-functioning trade ecosystem, and especially the sustainable growth of SMEs which is the key economic driver for all countries. However, it is evident that SMEs in developed and developing countries do not have optimal access to trade finance tools and have challenge integrating their requirements in the larger global trade systems held by lenders. Specifically, even though SMEs make up the client segment with the highest number of trade finance proposals submitted, more than 55% of trade finance requests from SMEs are rejected globally, compared to 33% from large corporates and 9.5% from multinational companies – see Figure 3 below. While Figure 4 depicts the proposed and rejected trade finance proposals by region.
The Changing Landscape of Trade Finance
L/Cs can be seen as one of the most popular and standardized tools of trade finance with nearly 40% of commercial L/Cs making up the trade finance product mix. L/Cs are issued by banks or finance institutions on behalf of a buyer, to minimize payment risks by providing a framework under which the payment would be made once delivery of goods is confirmed, as long as the terms and documents required are fulfilled and governed under UCP 600 (and its latest revisions). According to Society for Worldwide Interbank Financial Telecommunication (SWIFT, whose statistics is deemed a good indication of the overall usage trends for trade finance), the average L/C value in 2015 was USD 350,000. With reference to Asia Pacific, the average value (for exports) was recorded at USD 304,000. The top exporting countries using SWIFT L/Cs are: China, Hong Kong, India, Japan, and Singapore. As illustrated in figure 5 below, there were declines in export messaging for China, Hong Kong and Singapore. It is explained that these reductions were caused by increased perception of risk in L/C confirmations, as well as challenges stemming from the broader export trade markets.
Where L/Cs account for 40% of global trade by value, open account terms represent 80% of global trade by volume and are served by common trade finance instruments such as factoring, receivables finance, approved payables and buyer financing; and more recently, the introduction of bank payment obligation (BPO) which its own set of challenges and criticisms as well. According to an Accenture report, corporates are shifting to meet their own financing needs to ensure health of entire supply chain, and getting more selective in trade finance instruments due to high fees, complexity and delays with heavy paper documentation. By 2020, traditional trade finance for banks will drop from 52% to 36% of the trade-related revenues for banks while supply chain finance will increase from 33% to 45%.
Understanding of all the above, what does this mean to traditional lenders and how can innovative trade finance solutions like JED make a commercial impact to trade and working capital flow for businesses? Or more interestingly, how can JED collaborate with lenders to make trade finance even more accessible and simplified for smaller enterprises? We shall explore these and more in our upcoming articles.
Bank for International Settlements. Trade finance: developments and issues. Committee on the Global Financial System. Retrieved 16 April 2017
ICC Global Trade and Finance Survey 2016. ICC Banking Commission. Retrieved 16 April 2017
‘’A Brief Story of Trade Finance’’ http://www.tim.org.tr/en/a-brief-story-of-trade-finance.html Retrieved 16 April 2017
Euromoney Institutional Investor PLC ‘’What is Trade Finance?’’ https://tradefinanceanalytics.com/what-is-trade-finance Retrieved 16 April 2017
Accenture https://www.accenture.com/sg-en/insight-trade-finance-capital-markets Retrieved 23 April 2017
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