Trade finance refers to the finances that bridge the payment gap between the supply of products and the consumer’s receipt of those things. It is the supply of financial services and goods to facilitate global trade transactions. By providing these funds, we ensure that the flow of products and services is seamless. It also ensures that the process is free from monetary hardships. Trade finance helps reduce the risks and expenses of cross-border trade. It mitigates challenges like exchange rate changes, payment delays, political unpredictability, and fraud.
In simpler terms, one can understand Trade Finance through the following scenario when two separate parties are conducting the trade. Then there can be trust issues. In such cases the transaction of business becomes difficult. Due to trust issues, the seller prefers receiving payment before delivering goods or services. When the trade involves a significant amount, the buyer may hesitate to make advance payments. The buyer may also express a preference for engaging in trade on credit.
In such a scenario, trade financiers play a crucial role. They pay on behalf of the buyer to the seller, facilitating the transaction. Several companies in the market, including financial institutions and banks, facilitate and handle trade finance. There are several instruments to conduct trade financing. Typical trade finance products include letters of credit, bills of exchange, export credit insurance, factoring, forfeiting, supply chain financing, and bank guarantees.
Types of Trade Finance
The phrase ‘trade finance’ refers to a broad range of financial tools and strategies used by importers and exporters to support global trade. Among the primary categories of trade finance solutions that companies can choose from are:
- Trade Credit: Trade credit is the term used to describe the extension of credit to finance the purchase of products or services. Sellers provide it to buyers, or banks provide it to sellers or buyers. With trade credit, vendors can fulfill their obligations for goods or services. They know that they will receive payment from clients 30, 60, or 90 days later.
- Purchase Order (PO) Financing: A financier may pay a supplier before goods or services are delivered if the client issues a purchase order (PO). The provider will either pay the financier back on its own at the prearranged later date. Alternatively, it will give the end user instructions to pay the financier directly. The facility’s structure will determine the precise strategy taken.
- Cash Advance: A cash advance is a payment made to the exporting company before the delivery of goods or services. It is an unsecured transaction. It is well-liked by exporters because it enables them to begin manufacturing their goods as soon as they receive an order.
- Term Loans: Longer-term debts like term loans and overdrafts are more dependable sources of funding. This is because they are frequently supported by securities or guarantees. Securing assets owned by companies located overseas may be more difficult. This is due to local laws and ownership requirements.
Impact of Global Trade Financing
Trade finance is used in some capacity for about 80%-90% of all commerce worldwide. With an estimated $3 trillion in annual value, it represents about 3% of all trade worldwide. Trade finance helps countries develop economically overall by facilitating smooth trade transactions. This promotes employment opportunities, technological advancement, and cross-border trade in goods and services. It raises living standards and increases global prosperity.
Trade finance supports the expansion of businesses by guaranteeing or lending money. This enables businesses to purchase inventory and goods. The need for this arises when they lack confidence in other supply chain participants. By utilizing trade finance, companies can place larger orders with suppliers. They can also request higher volumes of stock, resulting in economies of scale and bulk discounts. SMEs, big businesses, and even governments use trade finance to accomplish a variety of growth objectives. This can entail expanding the quantity and range of products and services they offer. It can involve growing their international business or supporting them in carrying out significant contracts.
According to McKinsey & Company– “It has long been known that the $5.2 trillion global trade finance ecosystem enables the flow of goods and services throughout the globe”. The disruptions in the ecosystem of trade finance had a significant impact. In 2020, a study by the Asian Development Bank analyzed the effects of COVID-19. The study estimated a loss of $1.7 trillion, equivalent to 10% of world trade.
Need for Digitalization of Trade Finance
The current advancement in the field of ICT has revolutionized trade finance. Digitization is essential for it, otherwise, it poses many hurdles and difficulties for every party. Regarding the difficulties in trade finance, banks and corporations hold similar opinions. The majority of transaction documentation is still manual and relies on paper, adding to the expense and complexity while detracting from the customer experience. Thus, there originates a need for change.
According to the OECD (Organization for Economic Cooperation and Development), the paperwork and documentation form 15% of the hidden cost behind the total value thus a loss of billions of dollars annually. Digital trade ecosystem will ease the whole process making it quick and efficient.
The automated digital trade processes that will minimize human labor while guaranteeing consistency and lowering error rates are what corporates are most anticipating. Additionally, they want the more connectedness that digital ecosystems can offer within the dispersed trade community of banks, shipping companies, importers, exporters, and customs authorities.
Trade technology has a limitless capacity to eradicate the inefficiencies pervasive in the trade finance industry today. The good news about COVID-19 is that it has made doing business the old-fashioned way more challenging. Corporations now recognize the urgency of digitizing trade finance as soon as possible.
Technologies for Digitalization of Trade Finance
Distributed Ledger Technology (DLT): The protocols and technical framework known as DLT enable concurrent record updating, validation, and access throughout a networked database. Blockchains are based on DLT, whose infrastructure makes it possible for users to see changes and who made them, minimizes the need for data audits, guarantees data integrity, and restricts access to only those who require it. DLT can be a game-changer in the digitization of trade finance as it tackles many difficulties that traditional method faces.
Smart Contracts: Simply put, smart contracts are blockchain-based programs that execute in response to preset triggers. Generally, they are employed to automate the implementation of an agreement so that there is no need for an intermediary and no delay for any parties involved in knowing the outcome right away.
Cloud Computing: Delivering computing services via the Internet (also referred to as “the cloud”) allows for faster innovation, more flexible resource allocation, and economies of scale. These services include servers, storage, software, analytics, databases, networking, and intelligence. Cloud computing can transform trade finance through its ability to facilitate international goods transfer, automate approval workflows, and expedite calculation clearance.
Additionally, it might offer several significant advantages like improved customer support, more teamwork, and disaster recovery capabilities. Because cloud computing eliminates the initial expenses associated with setting up infrastructure, it lowers the cost of using technology. Processing costs can be lowered by up to 90% with a full-fledged cloud migration. In addition to increasing financial asset liquidity, cloud computing brings transparency and trust essential to modern trade. Cloud computing allows users to access information from anywhere, facilitating business continuity processes, which are essential for the international trade sector.
In the present globalized world, Trade Finance has become the foundation of trade at every level of the global supply chain. Trade finance guarantees that sellers receive payment and buyers receive their goods by reducing risks and supplying liquidity and cash flows. Thus, making the long-distance business easier and risk-free. Trade finance is necessary for the cross-border movement of goods and services today.
It is also not that every step in it is smooth. Trade finance also encounters various obstacles in the global marketplace. It has acquired prominent importance in the present trade scenario. It is vital to meet trade participants’ evolving demands and expectations. Trade finance providers and stakeholders must address these issues for better inclusivity in global trade.
About The Author
Aman Bora is currently a Ph.D. Candidate in the Department of Political Science of Soban Singh Jeena University Almora, Uttarakhand (India). He received his master’s degree in Political Science (Silver Medalist) from Kumaun University Nainital in Uttarakhand (India) and has passed the UGC-National Eligibility Test in Political Science subject. An ardent researcher and inquisitive learner, he has a keen interest in International Relations, Defense Studies, Geopolitics, and topics related to National Interests.