International trade finance or simply trade finance is the financing of trade between parties located in different countries. The parties are primarily the buyer, the importer and the seller, the exporter.
Example of International Trade Finance
By way of an example, imagine that Acme LLC is based in Houston, Texas. Acme contracts to purchase garden furniture to sell in their outlets in Texas and on their Amazon store. Acme contracts with Xing manufacturing in China for the supply of furniture. Acme buyers and designers and Xing have exchanged designs and specifications and have agreed on a contract to purchase the furniture. The contract specifies among other matters, materials, packaging, delivery dates and other specifications.
Xing, the exporter must now order raw materials and set aside production time at their plant in order to fulfill the contract. This presents an investment of money and time for Xing, which in turn presents a risk of not being paid by Acme. Acme is also reluctant to pay any money upfront due to the risk that the goods may not be delivered. Both Xing, the exporter and Acme, the importer are in different jurisdictions with very different legal systems, recourse to which in case of a dispute is both time consuming, costly and difficult. If parties have traded with each other in the past, an element of trust would have been established, however international trade is risky due to external factors including currency fluctuations, trade agreements and political strife to name but a few.
Addressing trust in international trade
Over the years banks and other financial institutions have evolved instruments to address the trust gap. A commonly used instrument being a letter of credit or LC. Both suppliers and buyers engage with banks in their local jurisdictions. The banks in turn engage with each other to provide payment guarantees conditional upon performance of various elements of the contract. The LC system is criticized for being expensive with a large overhead of paperwork. Additionally, less established businesses both on the buyer and supplier side struggle to establish relationship with banks giving larger, old established players an advantage.
Government agencies such as EXIM bank in the USA or the ECGD in the UK provide insurances to exporters. Such agencies are in place to encourage exports and earn foreign revenue. Companies with relationships also trade on an open trade basis.
Acme and Xing may conclude their transaction using LCs or have an open trade relationship. Either way the number of parties involved grows significantly along the way as does the paper trail. Parties include ground transportation at both ends, the shipping line, customs and excise of the respective countries, freight forwarders, warehousing as well as of course banks and other financial institutions who deal with money transfers.