Trade Finance: An overview of the basics

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“Trade finance is fun, it’s exciting, and, most importantly, it’s real. That’s the message to anyone who’s thinking about making this their profession.”

With a career in trade finance dating back to the late 1980s, Geoff Wynne, partner at law firm Sullivan in London, seemed a credible source to outline what trade finance is, how it works, and why its wide range of products and processes make it a rewarding and enjoyable industry to work in. 

Q: What is trade and trade finance and why is it needed?

Wynne: Trade makes the world go around: people grow things, they manufacture them, they process them. It costs them money to do so. They then sell the goods to somebody, who buys the goods and gives them the money back. That’s trade. 

Trade finance is the financing of the production, processing, transportation and ultimate consumption of goods. It’s needed because there is a time lapse from when you start producing goods to when you get paid for the end product, and every stage of the so-called physical supply chain – the process by which something moves from growing in the ground or sitting in a mine to appearing on the shelf of a supermarket – requires financing. Each party involved in this process, from the person that produces the goods, to the person who owns the warehouse, and the company that transports the goods, for example – they all need to be paid.

Q: What challenges do companies face when they engage in trade and make use of trade finance?

Wynne: For those engaged in trade, the challenge lies in being able to produce something that somebody will want to buy and pay you a good sum of money for – so that you can live off the proceeds. 

The challenges of trade finance are around perception and reality. 

The perception, and one that is supported by the regulators, is that trade finance is ‘inherently risky’. Trade finance, they suggest, is used to commit financial crime and money laundering. That makes financing trade risky in their view. 

But in reality it’s safe. It’s a good way of financing goods, and you can count on one hand the number of large frauds involving trade. 

However, because of this negative perception, there is a great cost in financing trade. These costs are largely compliance-related – showing that you have taken steps to mitigate against all the theoretical risks. 

Q: How does trade finance work, and what are the trade finance products? 

Wynne: How do you finance trade? You lend money. This happens all the way along the physical supply chain. 

When you lend money at the very start of the supply chain – the production of the goods – you would call that pre-export finance. What you’re doing is lending money before the goods have been produced, in order to produce the goods so that they can be processed and so on. You might lend that money directly to a producer. Or you might prefer to find somebody who knows the market better – quite often a trader – and provide them with the money so that they can pay it to the producer, who then delivers the goods to the trader. This is normally called a prepayment facility. The prepayment finance to a trader can either be with full recourse to the trader, but most often is made with limited or no recourse to the trader. It relies on the producer performing. 

When you’re putting money into the supply chain where there is a raw material that is being processed before it’s bought, then that’s often called a tolling facility. That means that you’re lending the money for somebody to buy the raw material, process it, and then create a finished product. 

Where goods have already been produced or are in a warehouse, you have a series of different financing options, such as warehouse finance and pre-shipment, shipment and post-shipment finance. In all of these cases, the goods already exist, so you’d look to structure your transaction whereby you would take security over the goods, but keep watch over the goods in storage and while they are transported, before they’re ultimately bought. 

As a financer, you may also like to buy and resell goods, and for that you might do repurchase agreements

In terms of making payment, letters of credit, also known as a documentary credits, are one means of doing so. A letter of credit is essentially a promise to pay: it is a commitment that a bank gives on behalf of its customer to pay the exporter an amount of money within a specified time frame subject to the satisfaction of certain providing finance conditions. You can put a letter of credit anywhere along the supply chain. So, for example, instead of paying cash for a raw material, the buyer of the raw material would ask the seller if it could provide a letter of credit, and pay, say, in 60 or 90 days. The buyer’s bank would the issue the letter of credit. 

The very last bit of the supply chain – what people now call supply chain finance – is something called payables financing. In other words, documentary to somebody who is supplying goods but against the credit of the buyer, such as a big company like Walmart or Marks & Spencer. The buyer gets deferred payment terms. The seller is paid quickly. The financer usually structures this as a purchase of the payment obligation – the receivable – of the buyer.

Export finance and the involvement of export credit agencies happens right at the beginning of the supply chain. For example, the supplier of the equipment that will drill a mine, or build a factory, may seek long-term finance for its buyer at the outset of the project, and this is often accessed through its country’s export credit agency. These funds will be used to get the mine or factory up and running and able to produce the goods – the sale of which will then be used for the ultimate repayment. 

Structured finance is where, instead of just lending money and expecting a repayment with interest, you really think about what that money is being used for, and what the various options are. It’s structuring a transaction, taking security and actually understanding the flow of funds in and the flow of goods out through their various stages. 

Q: Who are the players in trade finance? 

Wynne: The providers of finance can be banks or non-banks.

You’ve then got those players that give credit support, of which the principal is the insurance market. Insurers provide credit insurance against the failure of a buyer to make a payment, but also insure the goods themselves in the event that they are lost or destroyed. 

There is also a vast range of third-party players involved in every step of the process, such as transporters, warehouse managers and collateral managers – all those that are involved in the growing, harvesting, storage, processing and transportation of the goods along the supply chain. 

They either help to add value to the transaction, or they make life difficult, which is often the case for players like government and customs authorities. 

The financers assesses the risk of the transaction at every stage, and then mitigates against that risk. That’s what trade finance is all about: looking at the risks, looking at the parties involved in the transaction, determining if they can do what they say they’re going to do, figuring out how you can help them to do that, and eliminating the risk of them not doing what they say they’re going to do. 

Q: What role does a lawyer play in trade finance?

Wynne: A lawyer’s role is to facilitate – to work out which parties need to be involved, to structure the financing around those parties, and then to document the transaction. 

There’s more than one way to skin a cat: financers can choose to make use of a pre-export finance facility or a pre-payment facility, for example – it depends on the parties and the level of risk that the financer wants to take. 

Quite often lawyers are brought into the process too late. Sensible financers talk to their lawyers about a transaction when they think it looks like a transaction and ask them about the best way to go about approaching it. 

Q: What’s the usual avenue into trade finance for lawyers?

Wynne: Historically, people sort of fell into trade finance in the sense that they went to a city firm and probably did some sort of banking and financing, and then came across trade finance quite by accident. 

This is what happened to me. I was involved in trade finance long before I knew what it was. As a very young lawyer I gave some advice to a confirming house which confirmed letters of credit. I had no idea what they were doing and only realised years later when I got more involved in trade finance. 

Sullivan, is a specialist firm, so people come here because they specifically want to do trade finance. 

There is always the question about whether or not one wants to specialise very early. Is trade finance that specialist? Yes, it is, but it’s over such a very wide range of products, so the world is your oyster.