While there are many risks inherent in international trade finance, there are also numerous methods of settlement in international trade available to exporters and importers to manage and mitigate risks.

In most developed countries, an organization can draw on a wealth of free or inexpensive expert opinions to assist with risk mitigation for financial transactions.

Major banks typically have large portfolios of international loan assets and maintain extensive international financial networks. To safeguard their interests and those of their customers, banks employ large staffs of political analysts and international economists, and are often willing to share their expert opinions and written reports.

Embassies and consulates abroad, as well as commercial officers, are valuable sources of political and economic risk information, and can refer their clients to local service providers abroad that can assist in obtaining more detailed information on commercial risks.

These resources can often provide information on a target country’s current business environment, as well as credit and business information about potential customers.

An organization should select the financial instruments that best address its needs and identified risks, as well as those that respond to the underlying dynamics of a commercial contract.

In general, importers and exporters must agree on terms and methods of payment based, in part, on the risks associated with planned transactions. Below you will find 4 methods of settlement in international trade you can use to reduce your risk.

Want to learn more about methods of settlement in international trade and other risk mitigation options? Check out the FITTskills International Trade Finance online course.

Risk Insurance

Businesses that engage in international trade can mitigate commercial risk and protect its interests through various forms of insurance, including:

• Political risk insurance
• Foreign accounts receivable insurance

Indeed, insurance options are available to address nearly every category of risk that suppliers and buyers could possibly encounter while conducting international commerce.

Political risk insurance (PRI) and accounts receivable insurance (ACI) are particularly common, and can be obtained from specialist private sector providers or, depending on the market, from public and private entities such as export credit agencies (ECAs).

Most ECAs were originally established as public sector entities that promoted exports by providing various financing and risk mitigation products and solutions.

In recent years, however, some of these organizations have been fully or partially privatized and have mandates that extend beyond their original public sector focus. In fact, just before the onset of the recent global financial crisis, many questioned the need for ECAs in international trade.

However, their critical value was demonstrated when the market collapsed and private sector providers retreated in panic. Variations on the ECA model continue to be numerous, with the approach and the scope of ECA-like organizations varying almost by country.

In any event, most ECAs continue to offer political risk insurance and foreign accounts receivable insurance, which are both important forms of coverage that can help exporters offset trade-related commercial risks. Some ECAs also offer medium-term buyer financing, which is another helpful tool for export promotion.

Risk Transfer

Many of the strategies mentioned in this section involve the transfer of risk from one party to another for a fee. Insurance, for example, transfers risk from an individual policyholder to a portfolio of clients managed by an insurer to disperse the risk among stakeholders whose premiums fund payouts against claims.

This usually occurs over time, as it is unlikely, under normal circumstances, that a material number of policyholders will present claims at the same time.

Another attribute of an organization that successfully mitigates and manages commercial risk includes the continual assessment of the relevant risks versus the associated costs of conducting global financial transactions.

For example, a very common loss suffered by exporters involves the commercial failure of the foreign importer, while, for importers, it is the failure or inability of the supplier to deliver the merchandise exactly as specified and when required. Sometimes, poor documentation will restrict or inhibit the export or import of merchandise.

Political and country risks account for a much smaller number of losses, but should also be considered when structuring a transaction.

The challenge for an organization trading internationally, whether importing or exporting, is to get to know and trust its foreign suppliers or importers and to balance this knowledge with the risk optimization tools available from a variety of sources.

An organization must then choose a form of settlement consistent with the assessed risk and its level of tolerance for that risk. The ongoing test will be to remain competitive—and commercially viable—while incorporating the risk of loss and the price of protection against such a loss, into the final price of the finished product.

Risk can also arise from factors beyond the good faith or control of the trading partners. If exchange controls are imposed by a government, the ability and willingness to pay is not sufficient to assure a successful conclusion to the transaction. The next section emphasizes the trade finance instruments which can be used to secure payment.

Learn about what impacts your cash flow and how to maximize it with this free FITTskills Lite resource. 

Open Account

Open account payments are essentially transfers of funds to the account of the exporter. Historically, open account payments have been used in trade between very stable and secure markets, such as the United States and Canada, or in intra-EU trade, and in cases where the trading relationship is established and trusted.

Open account payment terms are those under which the seller extends credit to the buyer, finances the whole sale and sends a standard invoice demanding payment within thirty to sixty days of receiving the goods.

In addition, terms are suitable for a very strong buyer-seller relationship with a creditworthy client. Much of the trade between Canada and the United States is done on an open account basis.

Trade on open account is also increasingly the preferred mode of payment across much of the globe.

This shift, driven by large global importers, introduces additional risk for exporters in that payment is affected after the delivery of goods and/or services, sometimes for as long as 90-120 days after delivery.

This method has some potential risks as the importer could, for example, become insolvent, or the country of import could experience political turmoil, preventing payment. In such cases, the exporter loses control, and usually title, to the goods and/or services and has limited recourse to recover payment.

From a documentation standpoint, aside from the commercial invoice that will be issued by the exporter in an open account transaction, this transaction normally also involves an ocean bill of lading (i.e. if ocean shipping was part of the agreed-upon terms and a shipping container of goods has been sent).

In these instances, the exporter will usually send all original copies of the ocean bill of lading (i.e. those issued by the shipper as receipt for the goods) to the buyer. The ocean bill of lading serves as the title to the goods so, upon receipt, the buyer (or the buyer’s designate) can present an original copy of the ocean bill of lading at the receiving port to get the shipment released.

Note that, in certain circumstances, it is possible for the exporter to authorize a release of the goods without an original copy of the ocean bill of lading. However, many exporters still rely on the courier to deliver original copies of the ocean bill of lading to the importer to prevent an unintended and unsecure release of the goods.

Payment in Advance

One of the methods of settlement in international trade not yet mentioned is payment in advance. In contrast, payment in advance (advance payment) is a payment that is made before receiving the good or service, so it presents the highest risk to the importer (i.e. given that the exporter could easily receive the funds and not carry through with the promised shipment).

Exporters sometimes require advance payments by importers as protection against non-payment or to purchase supplies to fulfill the order. Higher advance payments may be required for specialized products as a hedge against buyer default when it may be more difficult or impossible to sell the products to a another buyer.

If an importer wanted to have a pre-shipment inspection when paying cash in advance, he/she could hire a 3rd-Party Inspection service to visit the manufacturer and file an inspection report.

However, the cost of such an inspection would also add to the investment being made by the importer. So the credibility of the exporter in this sort of a scenario would typically have to be very high.

Even with the best intentions and good faith, factors such as political turmoil and other unforeseen events could prevent a willing and well-intentioned exporter from completing a shipment as promised.

As a result, payment in advance is rarely used for transactions that are structured on a recurring basis. However, advance payment is frequently used when the reputation of the exporter is well-established and the importer sees little risk in an advance payment.

Advance payment establishes the importer’s credibility when the exporter does not have sufficient confidence in the importer. In these situations, the initial payment in advance transaction is used to gain the confidence of the exporter, and it is often accompanied by negotiations that are intended to lead to better payment terms on subsequent transactions, such as open account, as described above, or documentary collections.

The post Getting paid: 4 trade finance instruments you can use to reduce your risk appeared first on Trade Ready.

Trade finance is about some combination of:

• enabling and facilitating payment across the globe;
• providing risk-mitigation options through trade finance mechanisms, structures and techniques;
• offering a range of financing options to importers and exporters (as well as banks, when needed); and finally
• ensuring access to timely information about any element of a given transaction, from the status of a payment to the location of a shipment.

1. Payment

Trade finance offers several mechanisms to facilitate and assure timely, authorized and secure payment in the course of a transaction.

For example, banks and financial institutions around the world are members of SWIFT, the Brussels-based organization that facilitates electronic communication and payments between banks, financial institutions and soon, corporate clients across the globe.

SWIFT is a member-based organization that has a global standardized messaging system that allows banks to authenticate and transmit various types of messages, including text messages and payment instructions, in a standard format across the globe.

From simple electronic funds transfers (EFTs) to complex trade finance instruments, SWIFT is an invaluable enabler of fast, secure and dependable communication between member organizations.

In addition to the basics of transmitting payment, trade finance instruments define prearranged conditions (agreed between importer and exporter, and regulated by a set of internationally recognized rules) against which payment will be triggered. Those conditions are meant to protect importers and exporters from risk.

2. Risk mitigation

Trade finance instruments are very effective options for reducing or eliminating a broad range of risks across the globe, in almost any market condition imaginable.

Individuals or firms venturing into international trade or global commerce will, by nature, have a certain tolerance for risk.

Provided that this tolerance is based on an adequate assessment of the risk involved through research, knowledge and due diligence, measures can be taken to ensure that the risk is calculated and is in proportion to the expected return. In most cases involving international trade, some risks will remain.

Trade finance instruments and practices are designed to assist importers and exporters with effective risk-mitigation techniques.

The risks, which can be mitigated through appropriately structured trade finance instruments or services, include:

• civil unrest and revolution or other financial crises in either the importer’s or the exporter’s country, generally referred to as country risk;
• commercial risks of insolvency or non-performance by either the importer or the exporter, or potentially, a bank involved in the transaction (the latter is also referred to as bank risk); and
• foreign currency risk, resulting from fluctuations in exchange rates, for either importers or exporters. This risk arises because transactions are most commonly denominated in U.S. dollars or, increasingly, Euros, with the importer and/or the exporter operating in an entirely different currency, and therefore being exposed to foreign exchange risk.

One of the key contributions of trade finance to facilitating international commerce is referred to as credit enhancement.

This occurs when the payment promise of one party (for example, the importer) is replaced by an independent payment promise from another, financially stronger party, such as a bank.

This type of risk-mitigation option can also apply between banks, when a payment promise is shifted from a small financial institution located in a high-risk market to a larger, stronger bank in a stable financial centre.

To illustrate, an exporter in France may be selling materials to a client in Ivory Coast, with the importer agreeing to pay within 30 days of receipt of an invoice and related shipping documents.

If the transaction is structured—as it can be using trade finance instruments—so that a bank in Ivory Coast takes on the payment obligation of the buyer, this shifts the payment promise or undertaking from the importer to the local bank.

Further, at the importer’s request, the exporter can, quite legitimately, arrange to have the payment promise shifted from the Ivory Coast bank to a bank in France—again, using trade finance techniques.

Ultimately, the payment undertaking or payment obligation has now shifted from a commercial party in Abidjan—a party with potentially questionable financial strength—to a French bank that is well known to the exporter.

In this way, trade finance has enabled the credit quality of the transaction, from the exporter’s viewpoint, to be enhanced.

In addition to mitigating risk, credit enhancement also has the effect of lowering the overall cost of a trade-financing transaction.

This occurs organically, given that the improved credit quality can drive down the cost of funds associated with the deal, as a result of the lower risk of the transaction.

Risk-mitigation solutions can also be provided by financial institutions working in partnership with government entities called export credit agencies, or ECAs.

These agencies offer a range of guarantee, insurance and financing products and services, which are often indispensable in the consummation of international transactions, especially in higher-risk markets.

3. Financing

Trade finance provides for numerous forms of financing across the lifespan of a trade transaction.

At its most basic level, financing involves the lending of funds to one party by another, whether in the common situation where monies are actually transferred or in a variation (with the same final outcome) where payments are delayed by agreement, which has the effect of making funds available to the debtor for the period of the delay in payment.

Whether a buyer borrows €10,000 for three months to finance the purchase of new inventory, or whether the supplier agrees to deliver the inventory today, but accept payment at a future date—perhaps 90 days hence—the outcome for the buyer is that they have been financed: €10,000 for three months.

An exporter may need funds to produce goods for shipment but may not have the necessary cash flow.

Once a sales contract is concluded between importer and exporter and a trade finance instrument is issued, usually by a bank or other financial institution, financing may be arranged to assist the exporter in producing the agreed goods for sale. This is often referred to as pre-shipment financing.

Similarly, when the importer receives goods and payment is due, the importer may not have immediate access to the funds necessary to effect payment.

Trade finance instruments provide a mechanism to facilitate immediate payment to the exporter, as originally agreed, while permitting the importer to delay payment to the bank for an agreed period.

Such arrangements allow importers to sell their goods, generate a profit and reimburse the bank from the proceeds of the sale.

Overall, the instruments that support the conduct of international trade are very versatile: they provide significant flexibility, offer a variety of options and are quite readily adaptable to a wide range of legal, political and geographic jurisdictions, business practices and financing requirements.

Trade finance instruments and processes have sometimes evolved in very specific ways to meet the business needs of a country or region.

The option of using certain trade finance instruments as collateral for straight loans, for example, is fairly common in parts of Asia (though less common in the Americas and Europe), and matches the financing needs as well as the banking relationships of the regions where this option is exercised.

A party providing financing, whether this is a bank or either trading partner, may choose to take on the risk of financing, or may reserve the right to claim monies back from the borrower in the event of default, delay or other unacceptable event.

These options are referred to as financing without recourse, or with recourse. With recourse indicates that the lender may, in the event of difficulty in recovering the funds advanced, claim the monies back from the borrower, and the terms of the financing provide that the borrower must return the funds borrowed.

Financing without recourse protects the borrower from any future claim by the lender, who must instead pursue recovery of funds from the original source— generally one of the other parties in the trade transaction.

Non-recourse financing tends to be more expensive for the borrower due to the higher risk to the lender.

4. Information

The latest pillar to be added to the value proposition of trade finance is the provision of timely, accurate and detailed information about every aspect of a trade transaction, from the status of the shipment to the precise reporting of financial flows, at any given moment in that transaction.

Access to timely information related to both the physical movement of goods and the financial flow of a deal is no longer just a matter of interest or preference but, rather, a critical dimension of business efficiency and competitiveness.

Trade finance and logistics providers are investing significantly in the enhancement of technology and related reporting capabilities, working to turn the provision of timely information and high transactional visibility into a significant element of their value proposition to importers and exporters on a global basis.

Technology—from processing systems to web-accessed software and sophisticated reporting systems—is enabling the delivery of trade finance solutions across the life of a transaction, and doing so at an ever-faster pace, to keep up with the evolving needs and increasing expectations of importers and exporters.

The latest developments in trade finance include significant forays by leading global banks into areas that traditionally have not been the purview of trade bankers but are increasingly so today.

Logistics, customs brokerage, supply chain finance and management are all areas where the informational pillar is of critical value to importers and exporters.

In the past decade, we have also seen the entry of non-bank players into the trade finance arena. Companies that have traditionally managed the physical aspects of the global supply chain are moving towards providing financing solutions as a complement to their traditional products and services.

The post Master the basics of international trade finance by learning these four pillars appeared first on Trade Ready.