Trade Finance - An overview

The essence of trade finance lies in facilitating trade between counterparties (importers and exporters) while mitigating its risks, including non-payments (defaults), non-deliveries, etc. To put it simply, exporters (sellers) want to sell goods to importers (buyers) who can pay. Importers, on the other hand, want to purchase goods from sellers that can produce the goods to the specifications as listed in the contract. These needs are resolved through various trade finance products: 

1) Letters of credit ("LCs") - among the most common and standardised forms of trade finance. A bank guarantees payment to the exporter on behalf of the importer if the exporter meets the contractual terms and presents the required shipping documents (e.g. bill of lading). This reduces payment risk to the exporter. 

• Commercial LC (documentary credit) is the most common type, used for direct payment against shipment of goods.
• Standby LC (SBLC) acts as a guarantee and drawn only if the applicant (importer) defaults on their contractual obligations.
• Confirmation LC is when an additional bank (confirming bank) adds its own guarantee to the issuing bank's undertaking as another layer of security.
• Transferable LC is one that allows the beneficiary to transfer all or part of the LC to another one/multiple beneficiaries (e.g. middleman to end suppliers). 
• Back-to-back LC involves 2 LCs where a master LC acts as security for the issuance of a second LC
• Red clause LC allows the exporter to receive advanee payment from the advising bank before shipment of goods.
• Sight LC is where payment is made upon presentation of compliant documents.
• Usance LC is where payment is made at a specified future date after presenting the documents.

2) Documentary collection - also a common form of trade finance. Banks act as intermediaries to facilitate the exchange of documents. 

• Documents against payment is where the importer receives the shipping documents only upon making payment to the exporter's bank.
• Documents against acceptance is where the importer receives the shipping documents upon accepting a bill of exchange and will pay at a future specified date.

3) Factoring - simply put, it is the sale of a company's receivables in exchange for cash on a discounted basis.

4) Bank guarantee is where a bank promises to pay a beneficiary a specified sum in the event of non-fulfillment of contractual obligations. 

• Performance guarantee is where the bank guarantees a counterparty will fulfil their contractual obligations.
• Advance payment guarantee is where if an advance payment is not utilised as per the contract, the advance will be returned.
• Bid bond guarantee ensures a bidder will sign the contract if their bid is accepted.
• Payment guarantee is for payment for goods and services.

Funded trade finance: Involving direct cash advance or loan to a counterparty in the transaction, e.g. in receivables financing (factoring) and red clause LC.

Unfunded trade finance: Do not involve immediate cash outlay, but provides a commitment / guarantee against risks to facilitate the trade.

Key considerations in pricing a trade finance product:

1) Applicant's credit worthiness and country risk

2) Type of instrument

3) Notional value

4) Tenor

5) Relationship with the client

6) Complexity

How banks make money from trade finance:

1) Fees from BGs and LCs

2) Interest income from loans, e.g. import/export loans to purchase or produce goods