Trade finance, explained: the instruments and what each one solves

Trade finance refers to the financial instruments and services used by businesses to facilitate domestic and international trade. The category exists to solve a problem that is structural rather than incidental: in most trade, the seller wants payment before parting with goods and the buyer wants goods before parting with payment.

Trade finance instruments resolve that standoff by inserting a bank between the two parties, and by financing the gap between shipment and settlement. What follows is a working explanation of the main instruments and the specific problem each addresses.

Letter of Credit

An LC is a bank undertaking to pay the seller on presentation of compliant documents. It converts the buyer credit risk into bank credit risk, which is why it is the default instrument where the parties do not know each other well.

Sight LC

Payment is made on presentation of compliant documents.

Usance LC

Payment is made at a future agreed date rather than immediately upon shipment, giving the buyer a credit period.

Transferable LC

The credit can be transferred to a second beneficiary — relevant where an intermediary is involved.

Back-to-back LC

A second LC issued on the strength of the first, used where a trader must pay a supplier before being paid.

Standby Letter of Credit

An SBLC generally acts as a financial assurance instrument rather than a payment mechanism. The practical distinction is expectation: an LC is expected to be drawn on in the normal course of the trade, whereas an SBLC is expected not to be drawn on unless the underlying obligation fails.

Bank guarantee

A bank guarantee is an undertaking to compensate the beneficiary if the applicant fails to perform. Guarantees are common in contract and tender-driven businesses, and the type is determined by the obligation being secured.

• Performance guarantee — securing performance under a contract
• Financial guarantee — securing a payment obligation
• Tender guarantee — supporting a bid
• Advance payment guarantee — securing an advance received from a customer

Financing the export cycle

The instruments above address risk. The following address cash — specifically, the period during which an exporter has incurred cost but has not yet been paid.

Packing credit

Pre-shipment finance against a confirmed order, funding procurement and production.

Post-shipment finance

Finance from shipment until payment is received from the buyer.

Export bill discounting

Converting an export bill into immediate cash at a discount.

Financing the import cycle

Buyers credit

A financing arrangement helping importers obtain short-term funding for imports, allowing deferred payment while the supplier is paid at sight.

Suppliers credit

Credit extended by the exporter or overseas supplier to the buyer, financing the gap on the supplier side.

Deferred payment structures

Arrangements extending the payment period on large or long-lead-time procurements.

Receivables finance

Invoice discounting, factoring and bill discounting all address the same problem from slightly different angles: work has been delivered, the invoice has been raised, and the cash will not arrive for another sixty or ninety days. Each converts that receivable into working capital ahead of settlement.

Can smaller businesses use these instruments?

Yes. Many trade finance solutions are available to eligible SMEs engaged in domestic or international trade, and eligibility is assessed on the transaction and the financial position rather than on size alone. In practice, smaller businesses more often assume they do not qualify than are told they do not.