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What Is Trade Finance? (Pushkar Mukewar)

Trade finance has been around for centuries – for as long as there’s been trade. You could say trade finance is central to global trade, as it lessens risks to both parties, whether it’s the risk of non-payment, currency fluctuations, or payment delays. 

Without trade finance, there would be far less global trade and economic growth. Global trade makes it easy to buy tea grown in China, avocados from Mexico, or the latest iPhone. According to the World Trade Organization (WTO), an estimated 80-90% of world trade relies on trade finance – a staggering $15 trillion a year. Yet, despite its tremendous influence, trade finance doesn’t get much attention. Even fewer understand how it works.   

How It Works: Lessening Risks

Trade finance encompasses several financial instruments and products that make it easier for both importers and exporters to conduct business. For example, let’s say a U.S. importer agrees to buy avocados from Mexico for a set price. Those avocados need to be harvested, loaded onto trucks, and shipped. The exporter worries about not getting paid and may want an upfront payment for a shipment. On the other hand, the importer may be concerned that they won’t receive their avocados after paying the exporter in full. Following up on delinquent or missed payments is complicated and time-consuming when dealing with multiple jurisdictions.

The Solution to This Problem? Put a Third Party in the Middle to Facilitate.

In a typical situation, the importer’s bank will present a letter of credit to the exporter’s bank, guaranteeing payment once the exporter presents a bill of lading or other documents to prove that the shipment of goods occurred. The letter of credit essentially makes it the bank’s responsibility to pay the exporter. Meanwhile, the exporter can get a short-term loan, usually less than four months, while waiting for the importer’s payment, so they don’t tie up their working capital. Once they receive payment from the importer, they can pay back the loan.  

Facilitating Market Growth 

Large commercial banks have long dominated trade finance. That puts smaller businesses at a disadvantage because most lending is doled out to large corporations. Moreover, given how global the economy is today, lack of credit puts smaller importers and exporters at a serious disadvantage.

Even though trade finance is already a multi-trillion dollar industry, there is still tremendous room for growth. Limited access to credit is especially acute in emerging and developing countries, which tend to be export-oriented. The International Finance Corp estimates that there is $5.2 trillion in unmet financing need in developing countries every year – that’s 1.4 times the current level of lending to micro-, small-, and medium-sized enterprises. 

Ultimately, focusing on trade finance in these markets levels the playing field and facilitates global trade. In addition, providing capital to small businesses helps them grow and allows them to place larger orders.

Why Invest in Trade Finance? 

While commercial banks still dominate the $15 trillion trade finance marketplace, there’s a shift occurring in the industry as regulations such as Basel III put a cap on how much banks can lend. That’s opened the door for institutional lenders, family offices, and qualified investors to step in and fill that need.

Investment in trade finance assets is appealing for multiple reasons. First, trade finance as an asset class is exceptionally short-term, making the investment relatively less prone to economic cycles than fixed-income credit notes backed by consumer, mortgage, commercial or credit card debt. The low volatility is attractive to investors who are seeking stable income and want to avoid the equity and bond market gyrations.

Another attractive feature is that trade finance assets historically have had a low default rate – even when financial conditions are rocky. During the 2008 global financial crisis, default rates for trade finance assets were low and recovery rates high. According to the ICC Trade Register, only 0.0021% of 8.1 million trade finance products defaulted between 2008 and 2011. Moreover, assets that defaulted showed a recovery rate of 52%. 

Unlike corporate bonds, where investors are exposed to a single counterparty risk, notes backed by trade finance assets are supported by cash flow generated from a diversified pool of receivables. This not only reduces the counterparty risk but also enhances portfolio diversification. 

Last, but not least, trade receivable financing helps to provide working capital to smaller businesses in emerging and developed markets. Because fostering small businesses is crucial to economic growth in most economies, investing trade finance assets helps with job creation across the supply chains.

Trade finance may not be widely understood, but it’s the engine that powers trade worldwide.

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