In its simplest form, trade finance works by reconciling the divergent needs of an exporter and importer. An exporter would prefer the importer to pay upfront for an export shipment to avoid the risk that the importer takes the shipment but refuses to pay for the goods. However, if the importer pays the exporter upfront, the exporter may accept the payment but refuse to ship the goods.
A common solution to this problem is for the importer’s bank to provide a letter of credit to the exporter's bank that provides for payment once the exporter presents documents that prove the shipment occurred, like a bill of lading. The letter of credit guarantees that once the issuing bank receives proof that the exporter shipped the goods, it will issue the payment to the exporter. The letter of credit system is cumbersome, but it is a popular trade finance mechanism.
The function of trade finance is to introduce a third-party to transactions to remove the payment risk and the supply risk while providing the exporter with receivables according to the agreement and the importer with extended credit. Suppliers, banks, syndicates, trade finance houses and buyers all provide trade financing.
Repayment terms for trade financing transactions are typically short term. This type of financing creates a safety net to protect the interests of buyers and sellers in the international marketplace and help complete transactions that may involve multiple currencies.
Although international trade has been in existence for centuries, trade finance facilitates its advancement. The widespread use of trade finance has contributed to enormous international trade growth. Trade finance is of vital importance to the global economy with the World Trade Organization estimating that 80 to 90 percent of global trade relies on this financing method.
General financing is used to manage solvency or liquidity, but trade financing may not necessarily indicate a buyer's lack of funds or liquidity. Instead, it may be used to protect against international trade's unique inherent risks, such as currency fluctuations, political instability, issues of non-payment or the creditworthiness of one of the parties involved.
Letter of credit : It is an undertaking or promise given by a Financial Institute on behalf of the Buyer/Importer to the Seller/Exporter, that, if the Seller/Exporter presents the complying documents to the Buyer's designated Bank/Financial Institute as specified by the Buyer/Importer in the Purchase Agreement then the Buyer's Financial Institute will make payment to the Seller/Exporter.
Bank guarantee : It is an undertaking or promise given by a Bank on behalf of the Applicant and in favour of the Beneficiary. Whereas, the Bank has agreed and undertakes that, if the Applicant failed to fulfill his obligations either Financial or Performance as per the Agreement made between the Applicant and the Beneficiary, then the Guarantor Bank on behalf of the Applicant will make payment of the guarantee amount to the Beneficiary upon receipt of a demand or claim from the Beneficiary.
Collection and discounting of bills: It is a major trade service offered by the Banks. The Seller's Bank collects the payment proceeds on behalf of the Seller, from the Buyer or Buyer's Bank, for the goods sold by the Seller to the Buyer as per the agreement made between the Seller and the Buyer.