Trade Finance plays a critical role in facilitating international trade transactions between buyers and sellers, especially for small and medium-sized enterprises (“SMEs”). With a variety of financial instruments and services such as Letter of Credits, documentary collections, and trade credit insurance, Trade Finance can help SMEs mitigate risks and access financing to support their operations. In this newsletter, we will explore the significance of Trade Finance for SMEs involved in international trade, funding options available for SMEs, and the challenges faced in particular by e-commerce SMEs as these companies play an increasingly important role in international trade.
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What is Trade Finance?
Trade finance refers to financial instruments and services used to facilitate international trade transactions between buyers and sellers. It helps mitigate the risks involved in cross-border transactions and ensures that both parties fulfill their obligations. Trade Finance includes a variety of financial instruments and services such as Letters of Credit, documentary collections, and trade credit insurance. The illustration below shows the mechanism of one type of Trade Finance, the Cash Against Documents Process.
Other financial instruments such as the frequently used Letter of Credit are in general similar, but have slightly different mechanisms that we will discuss below.
In the following, we will briefly explain the most important or the most widely used categories of financial instruments of Trade Finance:
Cash Against Documents: In Cash Against Documents, the documents are delivered to buyers or importers in return for payment or against the acceptance of a draft for deferred payment. If the transaction is deferred and based on a draft acceptance, then it is called Cash Against Documents with Acceptance Loan.
Letters of Credit: A Letter of Credit is a document issued by a bank on behalf of a buyer, which guarantees payment to the seller as long as the seller complies with the terms and conditions specified in the Letter of Credit. This provides assurance to the seller that they will receive payment, and to the buyer that the goods will be delivered as agreed.
Documentary Collections: A documentary collection is a transaction where the seller ships the goods to the buyer and sends the shipping and other documents to his bank. The bank then sends the documents to the buyer's bank, which releases them to the buyer upon payment or acceptance of the seller's draft. Once the buyer has the documents, the buyer can collect the goods with those documents.
Trade Credit Insurance: Trade credit insurance protects the seller against non-payment by the buyer due to commercial or political risks. This can include insolvency, default, or political unrest in the buyer's country.
Bank Guarantees: A bank guarantee is a commitment from a bank to cover a specified amount if the debtor fails to fulfill their contractual obligations. This provides assurance to the seller that they will receive payment, even if the buyer fails to make the payment.
Factoring: Factoring is a financial instrument where a business sells its accounts receivables to a third party, known as the factor, at a discounted rate. This allows the seller in an international trade to receive immediate cash, while the factor assumes the risk of collecting payments from the buyer.
Forfaiting: Forfaiting is a form of financing where an exporter sells their medium to long-term receivables to a financial institution at a discounted rate. This enables the seller to receive cash upfront, while the financial institution takes on the risk of collecting payments from the buyer.
Export Credit Agencies (“ECAs”): ECAs are government-backed institutions that provide financing, guarantees, and insurance to support the export of goods and services. They help to mitigate the risk of non-payment and promote trade between countries.
Over the years, numerous types of Trade Finance have been developed, and some of them may appear quite similar at first glance. For instance, as mentioned earlier, we discussed the Letter of Credit and Cash Against Document processes, which may sound alike but actually possess distinct differences. First, Cash Against Documents is generally much cheaper and easier for both the seller and the buyer than using formal documentary credit processes, so it is suitable for transactions between smaller businesses. Second, with a Letter of Credit, the process is initiated by the buyer or the importer, whereas the seller or the exporter initiates the Cash Against Documents Process. Third, Letter of Credit provides a higher level of assurance to the seller, as the bank has a higher level of responsibilities to the seller. Due to these additional assurances, Letter of Credit is one of the most expensive payment methods in international trade.
Trade Finance is essential for SMEs that engage in international trade, as it allows them to mitigate risks and access financing to support their operations. It also provides assurance to their buyers and sellers, which can help build trust and facilitate trade relationships.
Why is Trade Finance so important for SMEs?
To better understand why Trade Finance is so important for SMEs, let’s first review the strategic funding options available for SMEs, such as traditional bank loans, crowdfunding, angel investment, and venture capital. Each funding option has its own advantages and disadvantages, and the best choice will depend on the SME's specific needs and circumstances.
Traditional bank loans: SMEs can apply for bank loans to finance their business operations. Bank loans usually have lower interest rates compared to other financing options, but bank loans usually require collateral because banks are highly regulated and have strict capital requirements. Therefore SMEs may face difficulty obtaining bank loans due to their size and limited assets.
Private lending: Private lending is more flexible, which involves obtaining financing from individual investors or lending institutions that are not traditional banks. As such, Private lending can be a good option for SMEs that need to access capital quickly or have a higher risk profile.
Issuing bonds in the markets: This can be an alternative, but bond issuance only works for larger companies as bond investors are mostly risk averse. There are also significant legal and administrative costs involved in bond offerings, which makes it only viable for larger sizes of funding.
Crowdfunding: Crowdfunding platforms like Kickstarter and Indiegogo allow SMEs to raise funds from a large number of people through “pre-sale” of the products which are not readily manufactured yet. This can be a good option for SMEs that have innovative products and need to raise smaller amounts of capital quickly to produce the products. However, SMEs must typically offer incentives to backers and may need to spend significant time and effort marketing their campaign.
Angel Investment: Angel investors are high net worth individuals who provide funding and mentorship to SMEs in exchange for equity in the business. This can be a good option for SMEs that have a strong business idea and potential for growth. However, the owners of SMEs must be willing to give up a portion of their equity in the business.
Venture Capital: Venture Capital firms invest, typically in equities, in high-growth companies with a proven business model and strong potential for returns. This can be a good option for SMEs that are looking to scale their business quickly. However, the SMEs must accept that the VC has a significant stake in the business. Over the past years, Venture Debt is a new alternative for SMEs to raise capital from VCs. But Venture Debt usually follows an equity round; it doesn’t replace it. Venture Debt also requires a clear plan for the intended timing and strategy for raising the next equity round, and how the loan will support or supplement those plans.
For SMEs, all the strategic funding options outlined above can meet the funding needs; however, Trade Finance also provides assurance and risk mitigation to both parties as international trade involves significant risks such as non-payment, fraud, and political instability. In addition, Trade Finance is directly linked to the products being sold or bought, but the strategic funding options discussed above are not. So the funding options above are widely used to cover the basic financing needs, but as the company buys / sells goods, the linkage between financing and goods bought and sold is very attractive.
By utilizing Trade Finance, SMEs can access financing to purchase or sell goods and services from international suppliers, while also providing assurance to their buyers and sellers that transactions will be completed as agreed. This can help SMEs build trust and facilitate trade relationships, which is essential for their long-term success.
E-commerce has become a crucial part of international trade, so next week we will briefly introduce the concept of e-commerce, the funding challenges faced by e-commerce SMEs, and how FinTech solutions have helped e-commerce SMEs.
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