Although available data suggest that trade finance accounts for 3% of global trade, worth some $3 trillion annually, the subject of trade finance within the global financial ecosystem remains inexplicable to the financially uninitiated. Trade finance basically helps deal with some of the challenges with trading; both domestic and international.
Trade finance facilitates the exchange of goods and/or services for money. For instance, when two individuals, a buyer and a seller, want to transact business, they would want to agree on the terms and conditions under which the transaction would be done. These such transactions are sometimes surrounded with mistrusts and other uncertainties thereby highlighting the need for instruments which are appropriate for specific products/occasions to help deal with all those uncertainties.
A typical example is an exporter/seller in Ghana who is trying to deal with someone in the US to import items to Ghana. The entity in the US might not know the entity in Ghana (or might know them), and this may create challenges around how the foreign entity gets paid once the goods are transferred to Ghana. The Ghanaian entity will also have concerns about getting the goods after money has been transferred. Even in cases where there is trust, there may be concerns about meeting the required or promised standards. How confident can one be that they will get the exact specification of product that they ordered for?
It is in such situations that trade finance comes in to help deal with some of these challenges – payment concerns and product concerns. Flowing from the illustrations above, trade finance can basically be described as a financing product that helps a seller and a buyer transact business in a way that makes all parties involved satisfied, either from a finance perspective or a product specification perspective. There are also instances where the entities in two different jurisdictions will have issues with differences in trading currencies. In such cases, trade finance facilitates the trade through forex services.
In the specific case of traders that are not familiar with each other, trade finance steps in with a product called letter of credit. The letter of credit is like a manual or an agreement that specifies what the seller wants and what the buyer wants. For example, a buyer could request for 100 size 42 green male shoes, and 200 size 38 blue female shoes to be delivered in 30 days. The seller who confirms he will meet the specification will require an assurance that his money will be paid within 30 days of shipping the items. The letter of credit becomes a contract or a trade instrument that is used by these parties to facilitate the trade.
In the case where the two parties know each other and there is no issue of mistrust, open account is recommended. An open account means that there is trust between the trading parties such that one party can make payment and be sure that the goods will arrive. There is also a guarantee payment that commits a buyer to a product that takes a long time to produce or manufacture. Let’s say Ghana needs to procure a power barge, which takes years and a lot of resources to build. Often, the supplier requests for some payment as commitment before the commencement of the power barge. The payment guarantee is therefore structured in such a way that it is a confirmation or source of comfort that gives the supplier an assurance of payment once the product is produced to specifications.
A trade finance instrument used in very large projects is called the bid security. This payment guarantee can be structured to say that the buyer will pay a percentage of the agreed sum of the transaction as a guarantee. In the procurement of contractors or service providers for large projects, the procuring authority needs to make sure that the contractors who bid for the project have the capacity to execute the project when given the contract. To be certain of execution capacity, the procuring authority would require this bid security.
After the contract has been given, the procuring authority may decide to give the contractor some percentage of the contract sum to facilitate the execution of the project. To be sure that the contractor does not abscond after receiving the initial payment, the procuring authority can invoke a trade finance product called advance payment guarantee. Advance payment guarantee then guarantees the procuring authority of the execution of the project.
There is also performance guarantee, which guarantees that when the contractor is given the job, he will do the job as is required of him. Most times, a retention guarantee is also recommended in addition to the performance guarantee. The retention guarantee gives a form of assurance that the project will last beyond a stipulated period.
There are other aspects of trade finance that deal with different entities including supply chain financing. The second part of this article will delve into some more instruments, particularly within the supply chain framework and discuss who needs trade finance.
By Kodwo Arizie
The writer is the Head of Trade Management at Stanbic Bank