A QUICK GUIDE
Trade finance in a nutshell
Trade Finance is how a buyer pays or guarantees payment to the seller in a cross border sales transaction in physical goods.
In the following article we’ll look at the
- Trade Finance workings from the point of view of an importer, who fixes a sale and purchase agreement and then inbound delivery of goods.
- What are the generic arrangements
A cross-border trade in physical goods, includes
- A sales contract – evidenced by Commercial Invoice
- A freight contract – Transport invoice (For Seafreight – Bill of Lading, Waybill, Express, Combined)
- Insurance contract – Insurance Certificate/Policy, typically covering 110% CIF value
- Trade Finance arrangement – Letter of Credit, Documentary collection, Open account, Cash advance
Additionally, you would often need (you can still do the import but you’d need them onwards – clear, distribute);
- Documents specific for the goods – Certificates of Quality, Origin, Input / Content, Technology transfer, IP, Quota fills, Export clearances, etc.
- Optional – Pre-ship inspections, Product compliance, Cargo stowage and securing, Marks, Labeling, Hazmat/IMO/UN,
The Trade Finance Solution (payment method) reflects on risk tolerance. Or uncertainty. A counterparty may default, delay, change terms and price. Often, you can tell from experience and intuition if you need to put safeguards for a deal, even if onlyy to lock terms already agreed. And usually you would do checks on vendors too. In some industries, you would trade with white label manufacturers that are not typical household brands and not having their financial and sustainability reports up on their website. Think Foxconn for size or, Alibaba.com with 2 million qualified suppliers.
Depending on payment and delivery risk on both sides of the trade but also the preferred time to have options open:
- Cash advance -> buyer takes the risk
- Documentary collection -> buyer has some control on documents (fine-tuned directly with seller), commits to the trade when she accepts for payment (DAA -Documents Against Acceptance) or pays for the documents (DAP – Documents Against Acceptance). Often also referenced as Sight Payment or COD.
- Letter of Credit/Documentary credit (synonymous) -> buyer has full control, commits when orderes opening of Letter of Credit
- Open account -> Seller assumes the risk. Practically, not that risky as mostly used for regual trades, and contract/scheduled deliveries.
Documentary options (Letter of Credit, Documentary Collection)
- Letter of Credit – a formal contract buyer sets through her (opening/issuing) bank, having the details of the sale and delivery. Special requirements and Notify parties – e.g. clean B/L, commercial invoice parties full style, HS code or cross reference between comm and freight bills. Issuing bank interlocks with advising (sellers) bank which sends over the sellers documents pouch. Issuing bank checks paperwork for conformity and all being well, pays out to advising bank. Here buyer stipulates as much details as practicable in order for the sellers to bundle enough and correct documents to get paid, specifically:
- Goods – quantity, packaging, marks and numbers, weight, volume, content, measures
- Route, delivery – load and discharge ports, transport mode, transshipment – whether allowed or not, combined transport (yes/no)
- Timing – validity, expiry of L/C, shipping deadlines (Shipped on board, cut offs) and latest hand-in for documents.
- Documents content – commercial, transport, insurance, certificates, others
- Documentary collection – Exporter ships goods and presents documents into remitting bank, which in turn sends the document pouch over to buyer’s (opening) bank which then gets buyer confirmation as Documents against payment or Documents against acceptance (i.e. Bill of Exchange or equivalent) and pays out.
Cash options (Open account, Cash in advance)
3. Open account – buyers market: Seller ships out, gets paid on a schedule. This option is common for regular deliveries between trusted parties with no liquidity constraints (both not existentially dependent on this last delivery).
4. Cash in advance – sellers market (check the Lunar article and dynamics). This is for a buyer to get a slot on the production line. spot (reserve a batch
As Cash trading options are negotiated between buyer and seller direct, Cash advance can cover a percentage of the goods value, Open account payments can cover a couple deliveries, not easily distinguishable on a single batch per invoice, waybill etc.
A few parting notes on Documentaries:
Letters of Credits and Documentary Collections are governed by UCP 600 and ISBP rules. UCP 600 are issued by ICC (also issuing Incoterms® 2020) . Unlike merchants, banks trade in documents, so some knack for a quality paperwork can save time and charges. Also, the documentary credit is the most expensive option (flat fee or capped percentage of the total amount) and any discrepancy is penalized on top – i.e. added to the buyer’s charge or cut from the seller’s remit. At a rare extreme, payment can be rejected. Seafreight has more details. Not least because Original Bills of Lading (BoL), and specifically those BoL’s issued to ‘To order’ (i.e. blank endorsed) carry title to the goods, i.e. the de-facto security. So understanding how seafreight gets fixed, can help intuitively infer upon other modes (plain container shipment refresher in earlier theme article).
Trade Finance offer flexibility, enable trade further.
There are back-to-back L/C’s, where an intermediary opens up an L/C to buy merchandise from the end-exporter only after being issued an L/C from the end-importer for the same goods. Price and terms on both transactions should make sense, in that, middlemen gets profit and does not introduce trading parties direct.
This is often used in contract manufacturing or when buying from an umbrella organization with multiple production and supply facilities. These Intermediaries provide flexibility. Intermediaries and Buying groups offer capital to suppliers in Complex sourcing arrangements (think Ikea, Metro, or online marketplaces) with multiple smaller vendors. On the other hand, same intermediaries, maintain ‘live’ physical inventories, including goods ‘en route’ that could be re-routed and resold with end-buyer not having to lock-in liquidity or narrow product choice for the full lead time.
This part of the contemporaray trade is often related to as Vendor Managed Inventory or VMI and requires expertise in Trade Finance, procurement, transport and production logistics.
Trade Finance is the term for the payment mechanics for an overseas physical delivery of goods. There are 4 main options to pick from depending on risk profile and bargaining position. The 2 bank options – Documentary credit and Documentary collections are costly but allow for better control and reduced risk. This helps when starting off with a new supplier or needing to have paperwork shipshape and merchandise on time (think seasonal campaign or promotional items to clear customs on time).
Trade Finance is also part of the larger domain of the Supply Chain Finance. In the next article we’ll look into the tools and practice for
- export credit and guarantees,
- invoice and receivables finance,
- warehouse finance,
- factoring and
- what new products and platforms step into this traditional banking area.
Health, and all-good physical goods trading!
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