What is Trade Finance? With Ellen Lauwers
Are you ready to unlock the secrets of trade finance? We have a special treat for you in this Corporate Treasury 101 podcast episode. We’re thrilled to introduce our very first guest, Ellen Lauwers, an accomplished finance manager with a wealth of experience from her time in a renowned big four consulting company.
Ellen’s expertise lies in the fascinating realm of corporate treasury called “Trade Finance.” If you’ve ever wondered how large-scale deals are secured, how trust is built between buyers and sellers, and what role banks play in facilitating these transactions, then you’re in for a captivating discussion. Get ready to dive deep into the intricacies of trade finance as we learn from Ellen’s extensive knowledge.
Our goal is to break down the concepts, demystify the terminology, and present the information in a friendly and approachable manner. With our comprehensive guide, you’ll gain a solid understanding of trade finance, regardless of your level of expertise. So, what can you expect from this article? We’ll take you on a journey through trade finance, exploring the different instruments and techniques used to ensure trust in large-scale transactions.
What You Will Learn:
- The essential role of Trade Financing in fostering trust and enabling large-scale deals.
- The key instruments used in Trade Financing are bank guarantees and letters of credit.
- How Trade Financing helps businesses navigate international and domestic transactions with confidence.
- The importance of specialized systems and tools for optimizing trade finance operations.
- Insights into the involvement of intermediary entities like banks and parent companies in Trade Financing.
- The significance of original documents in trade finance and the evolving role of digitalization.
- Ways to leverage Trade Financing to mitigate risks and protect your company’s interests.
- How technology, including blockchain and digitization, is revolutionizing the trade finance landscape.
- Understanding the different requirements and contexts where trade finance instruments are necessary.
- Strategies for building efficient trade finance policies and fostering collaboration between treasury, sales, and supplier departments.
So, let’s dive in and discover the hidden secrets of Trade Finance!
What is Trade Finance?
Let’s start our trade finance exploration with a clear understanding of what it is. Ellen describes trade finance as a collection of financial tools that help make international trades safer and more efficient. If you’re wondering what we mean by “international trade,” we’re talking about buying and selling goods across different countries.
Shipping goods from one place to another, especially across long distances, involves a great deal of uncertainty. Will the goods reach their destination on time? Will they arrive in good condition? The farther the distance, the greater the risks. This is where trade finance instruments come into play. These tools help businesses manage these risks effectively. But don’t worry; we’ll delve deeper into these instruments in the following sections.
(If you’re new to Corporate Treasury or just starting to learn about it, we recommend checking out the following articles: What is Corporate Treasury? and The 4 Pillars of Corporate Treasury)
Understanding International Transactions
To understand trade finance better, let’s dive deeper into international transactions. Guillaume’s question here is quite relevant. When we talk about “international transactions,” are we just talking about sending goods across the world?
According to Ellen, trade finance goes beyond simple buying and selling. It encompasses the transportation of goods over long distances, whether by shipping or air freight. But that’s not all. It could also involve large-scale projects like construction, which carry considerable risks in organization and execution. So, international transactions aren’t just about shipping goods; they encompass a broad range of activities, some of which might even be domestic.
The Role of Trade Finance
Here’s something to remember: Trade Finance is not a one-size-fits-all solution. It encompasses a variety of instruments, each designed to address specific challenges in international trade. This means the right tool for the job will depend on the situation.
The beauty of trade finance is that it gives businesses options. They can select the right tool for their needs, effectively mitigating risks associated with their transactions. This flexibility and risk management are crucial in today’s interconnected global economy, where even a minor hiccup can have major ripple effects. So, think of trade finance as your tool belt for navigating the complexities of international trade and transactions.
Why is Trade Finance a Topic in Corporate Treasury?
As you’re exploring the world of treasury, you might wonder why trade finance plays such a critical role, particularly in corporate treasury. Guillaume’s question hits the nail, and Ellen’s response sheds light on this intriguing relationship.
Corporate treasury focuses heavily on managing financial risks. When it comes to international trade, these risks can be considerable. For instance, imagine if the goods you’ve ordered for your business don’t arrive on time or the contractor on your big project isn’t performing as expected. Perhaps payment is delayed or doesn’t arrive at all. These are the kinds of scenarios where trade finance becomes crucial.
Let’s break down some of the common risks that trade finance instruments help to manage:
- Non-delivery of goods or services: This could be due to various issues, including transportation problems or supplier issues. Whatever the cause, non-delivery can disrupt your business operations and lead to financial losses.
- Poor performance: Sometimes, a contractor may not live up to the terms of their contract, leading to delays and added costs. In such cases, trade finance instruments like bank guarantees can help mitigate these risks.
- Payment risk: This is especially pertinent when dealing with new business partners or when trust has not yet been established. Instruments like letters of credit can help ensure payment is received on time and in full.
In essence, trade finance instruments act as a safety net, protecting businesses from these and other risks associated with international trade. But it doesn’t stop there. They also play a significant role in fostering trust and strengthening relationships in the supply chain. When both parties in a transaction feel secure, it’s easier to build a strong, lasting business relationship.
A Practical Example of Trade Finance in a Construction Project
Now, let’s delve into a practical example to better grasp how trade finance works in real-world situations. Imagine yourself actively participating in a construction project – it may be easier to visualize this scenario.
Suppose you are a construction company. A client comes to you, requesting to build a skyscraper. For this mammoth project, you realize you need a new crane – a custom one to meet the unique requirements of this skyscraper. This isn’t something off the shelf; it requires careful design and construction.
Remember that when you place an order for this crane, certain risks come into play:
- Time: Per your construction schedule, you need the crane in one year. What if the crane doesn’t arrive on time?
- Specifications: You need the crane to meet specific requirements to ensure the skyscraper’s construction goes smoothly. What if the crane doesn’t meet these requirements?
So, what’s your safety net? You approach the crane manufacturer and request a bank guarantee.
What is a Bank Guarantee?
A bank guarantee is a financial safeguard. It’s a promise from a bank (or another lending institution) that if a certain party fails to fulfil their obligations, the bank will cover the loss. In this case, the obligation is the delivery of the custom crane on time and meeting your specifications.
Let’s clarify what happens next with a bank guarantee:
- If the crane manufacturer fails to deliver the crane on time or doesn’t meet your specifications, you, as the construction company, can claim the guarantee from the bank.
- The bank guarantee has a predetermined value – the amount you can claim to cover your potential losses. This way, you can assure your client that the skyscraper construction will continue, even if the crane delivery goes awry.
- With the bank guarantee, you transfer the risk from yourself to the bank. This helps you keep your project on track, safeguard your financial interests, and maintain your reputation with your client.
Who Requests a Bank Guarantee in Trade Finance – Client or Supplier?
The great thing about trade finance is that it’s not one-sided. It’s a flexible solution catering to both parties’ needs – the client and the supplier. This raises a pertinent question that many treasury professionals might ponder: who typically requests a bank guarantee or trade finance instrument?
It’s a Two-Way Street
Interestingly, the client and the supplier can request a bank guarantee or trade finance instrument, depending on the circumstances. Yes, that’s right – it works both ways.
In the skyscraper construction scenario, you, as the client (the construction company), request a performance guarantee from the crane manufacturer. A performance guarantee is a type of bank guarantee that ensures the satisfactory completion of a project (in this case, the manufacturing and delivery of the crane). Its purpose is to ensure that you don’t find yourself in a difficult situation if the crane fails to arrive on time or doesn’t meet the required specifications.
But let’s flip the scenario. What if you’re the supplier? Imagine you’re the crane manufacturer and want to ensure that the construction company will pay you for the custom crane. In this case, you can request a bank guarantee from the client. This ensures that you’re financially protected and paid for your services.
The Cost Factor
A key point to remember is that bank guarantees come with a cost. The party that provides the guarantee has to pay for it. Therefore, it’s a strategic decision to request a bank guarantee. You’d want to balance the cost of the guarantee against the potential risk and the financial stability of the other party.
So, trade finance instruments like bank guarantees have the advantage of being customizable to the specific requirements of either party involved in a transaction. They provide a safety net that ensures each party can uphold their end of the agreement without financial worry.
What are Other Instruments in Trade Finance Besides Bank Guarantees?
Just as bank guarantees provide security in trade, other instruments in trade finance also come into play to ensure smooth and risk-free transactions. One such significant tool is the Letter of Credit (LC).
Letter of Credit: A Safety Net in International Trade
Unlike a bank guarantee, a Letter of Credit primarily aligns the buyer’s and seller’s interests in international trades. It essentially takes away the risk of prepayment from a buyer’s end and the risk of non-payment from a seller’s perspective.
Here’s how it works: let’s say you’re importing goods from the other side of the world. Paying for the goods upfront without having them in your hands can be daunting. On the flip side, the seller wouldn’t want to ship the goods without the assurance of payment. This is where a Letter of Credit comes in handy.
The buyer’s bank guarantees to pay the seller once all obligations are fulfilled. These obligations typically include completing specific documents and confirming the satisfactory shipment, inspection, and receipt of the goods. Therefore, as a buyer, you won’t need to pay upfront, and the seller can ship the goods confidently, knowing payment is assured.
Trust in Banks: A Key Element in Letters of Credit
Both parties say a construction company and a crane manufacturer might not trust each other fully, but they both trust their respective banks. So, the buyer’s bank acts as the neutral middleman holding the funds until the agreed conditions are met.
Consider a scenario where the construction company purchases a crane worth 1 million euros. The construction company pays its bank the total sum, and the bank, in turn, creates a Letter of Credit for the crane manufacturer. The Letter of Credit essentially confirms that the bank has the necessary funds and will make the payment once the delivery of the crane is confirmed.
One critical point is that Letters of Credit are usually used for goods shipment, such as spare parts for the crane from China to Europe.
Comparing Bank Guarantees and Letters of Credit
When differentiating between a bank guarantee and a Letter of Credit, it mostly depends on when and if these instruments are paid out.
A bank guarantee acts like insurance. It mitigates the risk, and the bank won’t need to pay anything if all goes well. On the other hand, a Letter of Credit is meant to be paid out upon fulfilling certain conditions.
Not only does a Letter of Credit secure the transaction, but it also assists you in forecasting cash flow since you know approximately when the bank will be making the payment. This way, you can ensure the bank has your funds ready for the transaction.
What other Trade Finance Instruments do People commonly Use besides Bank Guarantees and Letters of Credit?
While bank guarantees and letters of credit dominate the landscape of trade finance instruments, there are several others that play a significant role. Each comes with nuances that suit different project phases or specific trading scenarios.
More Types of Bank Guarantees
Bank guarantees aren’t one-size-fits-all. They can come in many forms to accommodate different project stages. Here are a few examples:
- Bid Bonds: In the initial stages of a project, bid bonds come into play when you’re competing with others for a project contract. This type of bank guarantee assures the project owner that you can fulfil the project as described in your bid proposal. It gives the owner peace of mind knowing that you are serious and capable of completing the project.
- Advance Payment Guarantees: Suppose you’ve won the bid, and it’s time to start the work. But before any work begins, the project owner might ask you to make an advance payment. An advance payment guarantee ensures you can reclaim your money if nothing is delivered. It’s a security measure that safeguards your advance payment.
- Performance Guarantees: These guarantees ensure the completion of a project according to the contract terms. If the contracted party fails to meet the specified standards, the bank guarantee compensates the project owner.
- Retention Guarantees: If you’ve made an upfront retention payment to a supplier, a retention guarantee can help ensure you get your money back at the end of the project.
Performance and advance payment guarantees are usually the most commonly used among these different types of bank guarantees.
Building Trust Through Trade Finance Instruments
The underlying theme in all these instruments is trust or, rather, the lack thereof. When entering trade deals, you often deal with third parties or counterparts you might not know well or trust fully. With the help of intermediaries like banks, these instruments are designed to ensure that trade agreements are fulfilled and everyone can proceed with a degree of trust.
How Does Trade Finance Function in a Treasury Department, and What Does it Look Like in a Best-in-class Treasury Department?
The involvement and usage of trade finance instruments can vary significantly depending on a company’s size, sector, and the extent of international trade they’re engaged in. As a treasury professional, understanding these differences can help you appreciate how trade finance functions within different organizational setups.
Trade Finance in Different Company Sizes and Sectors
For small companies, especially those not involved in a lot of international trade, there might not be a heavy reliance on trade finance instruments. However, trade finance instruments become significantly more prevalent for a larger company involved in international trade or business-to-business (B2B) transactions, particularly in sectors like construction. In such cases, the organization usually has a team of experts dedicated to handling these instruments.
The Role of a Trade Finance Team
A trade finance team plays a crucial role in a large corporate setting. These professionals are well-versed in the nuances of different trade finance instruments. They’re also adept at navigating the often-legal language involved in agreements with banks. Another key aspect of their role is dealing with time-sensitive tasks. For instance, when the sales department needs a bid bond for a project bid, the trade finance team’s responsible for coordinating with the bank and securing the bond in time.
The close relationship between the trade finance team and the sales department is crucial. The team ensures timely responses to trade finance needs and fosters effectiveness in the overall company operations.
Best Practices in Trade Finance Management
In a best-in-class treasury department, there’s a dedicated team for trade finance and a well-established policy around it. This policy isn’t confined to the treasury department alone; it extends to other departments like sales.
This policy guides:
- When and how to issue guarantees: Itβs essential for the sales teams to know when to provide a guarantee and, more importantly, when not to. Issuing a guarantee exposes the company to risk, so it must be done judiciously.
- How to deal with suppliers: The policy also defines the circumstances under which the company should ask for suppliers’ guarantees. This is another layer of risk mitigation.
These policies need to be in place before a project starts or contractual negotiations end. Once these steps have been taken, the company loses the leverage to ask for a guarantee. That’s why having a specialized trade finance team is beneficial; they can help formulate and enforce these policies, ensuring the company’s risks are well-managed.
What Size of Trade Require Consideration of Trade Finance Instruments, and When Are These Instruments Mandatory?
Understanding the size of trades that necessitate trade finance instruments can help you gauge when and how to use these tools as a treasury professional.
Trade Sizes and the Use of Trade Finance Instruments
Trade finance instruments can be employed across various trade sizes and amounts. Bank guarantees, for instance, can be as low as a couple of hundred euros or soar up to millions. The size of these guarantees hinges on the size of your underlying project because the guarantee will never exceed the project’s cost. Typically, it covers only a portion of the full project value.
You might be wondering why small trades need a bank guarantee. While it might seem more straightforward to pay a couple hundred euros in advance and be done with it, sometimes it’s a requirement. For instance, if the other party insists on involving the bank, you may need to issue a guarantee, regardless of the trade’s size.
Moreover, companies usually have policies indicating specific percentages assigned to particular bank guarantees. For instance, you might cover 50% of a project’s total amount with a performance guarantee. But remember, the need and size of these instruments depend greatly on your company and the industry you’re operating.
When is Trade Finance Mandatory?
There are circumstances when trade finance instruments become mandatory in a trade. For instance, they may require a guarantee during big bids for government contracts. But it’s not just government entities; other companies might also stipulate in their bid requirements the need for a guarantee issued in time. Failure to do so can result in disqualification from the bid.
So, when involved in such trades, you must be aware of these requirements and act accordingly. After all, being proactive and meeting the requirements can make a big difference in whether your bid is accepted or rejected. So, always understand and follow these requirements to ensure smooth and successful trades.
Who Issues Trade Finance Documents, and Who are the Different Counterparties Involved?
Understanding who issues trade finance documents and who is involved in a trade finance deal is fundamental for treasury professionals. This knowledge helps to facilitate smoother business transactions and foster better relationships with all parties involved.
Who Issues Trade Finance Documents?
The most common issuers of trade finance documents like guarantees or letters of credit are banks and insurance companies.
As you can guess, banks don’t issue a guarantee just because they like you. They require something more tangible – your creditworthiness. They assess your ability to repay debts and decide if they can give you a credit line, essentially a preset borrowing limit you can use at any time.
Insurance companies also provide guarantees or letters of credit. These businesses take on the role of guarantor in case of non-payment, non-performance, or other trade risks.
For either banks or insurance companies to issue you a guarantee, they usually bundle it with other financing services. You might see this as a “combo deal”.
And remember, these services are not for free. You have to pay a fee to get a guarantee issued. But there’s a silver lining. If you have a good relationship with your bank, you can negotiate a discount on these fees. So maintaining a good rapport can be beneficial in more ways than one!
Who are the Counterparties in a Trade Finance Deal?
Along with banks and insurance companies, another party that could be involved in a trade finance deal is an export agency. This involvement is especially seen when dealing with letters of credit.
Let me explain a bit more. With a letter of credit, you need to fulfil certain document requirements to ensure payment happens. This is where the export agency steps in. They help ensure that a bill of lading – a document issued by a carrier (or their agent) to acknowledge cargo receipt for shipment – is correctly filled out and processed.
The export agency’s role is crucial. They are your stakeholder, helping ensure you receive both the goods and the necessary documentation on time, enabling you to make the payment.
So, in a nutshell, while the bank or insurance company issues the trade finance instruments, you also need to keep a close eye on your relationship with them and the export agencies.
Can Trade Finance Instruments be Issued Internally by a Parent Company?
A trade finance instrument is a crucial financial tool that assures all parties involved in a business transaction of each other’s financial credibility and trustworthiness. But there’s a question that can pop up in this context. If these instruments are so important, can they be issued internally by a parent company? Let’s delve into this.
What is a Parent Company Guarantee?
Parent company guarantees are sometimes issued by companies in place of traditional bank guarantees. This is especially true in the context of large multinational corporations.
Let’s paint a picture here. Imagine you’re part of a global construction company with subsidiaries in Europe, China, and the US, with your head office in the US. This head office is what we call your “parent company”.
Now, if one of the European branches decides to participate in a bid, it can ask the parent company in the US to provide a bank guarantee. This means the parent company assures that even if the small subsidiary in Europe goes bankrupt, the parent in the US will step in to pay out the amount of the bank guarantee.
It’s a way for businesses to leverage their financial strength and reputation to support their subsidiaries without involving a third party, like a bank.
The Trust Principle and Third-Party Involvement
However, there’s a catch. This approach depends heavily on the trust principle. For the external party, a guarantee from a parent company might not feel as secure as one from a bank or an insurance company. This is because a bank or insurance company provides an extra layer of reassurance, given their business is specifically about assessing and covering financial risks.
While some external parties might accept a corporate guarantee, others might insist on having a third-party-issued bank guarantee.
So, in conclusion, while a parent company can issue a guarantee in a trade finance scenario, it’s not always accepted by other parties. Sometimes, you might still need to go to the bank for a traditional guarantee. The decision depends on the level of trust between businesses and the acceptance criteria of the external parties involved.
Can Systems Be Leveraged to Optimize Trade Finance?
Treasury Management Systems (TMS) and payment hubs are widely used in corporate treasury for managing the company’s financial operations. But when it comes to trade finance, can these systems help, or are there other specific systems tailored for this purpose? Here’s what you need to know.
Trade Finance-Specific Systems
Trade finance operations can benefit from specific systems tailored for this purpose. These systems allow you to properly record your trade finance instruments. This means every bank guarantee, letter of credit, and other instrument you use in your business transactions will be in the system.
What makes these systems even more interesting is their capability to communicate directly with banks. Picture this: you request a new bank guarantee within the system, which automatically communicates with the bank to issue that guarantee. How convenient is that?
This communication with the bank can happen through a system like SWIFT, which enables financial institutions worldwide to send and receive information about financial transactions. Specific SWIFT messages only for trade finance ensure that all the details of your instruments are sent to the bank in a structured format.
Considering the Size and Maturity of Your Treasury Department
However, like with any other tool, whether these systems are useful depends on your treasury department’s size and maturity.
A specialized trade finance system can be a game-changer if you’re part of a larger company with a dedicated trade finance team. It can streamline your operations and make your team’s work more efficient.
But if you’re smaller, you might not need a specialized system. Some banks provide tools that allow you to see outstanding bank guarantees. For some of you, a good old-fashioned Excel might even be sufficient.
Document Management in Trade Finance
While we’re on managing trade finance operations, let’s touch on how to handle the documents involved. You could go old-school and keep your documents in a physical vault. It might sound archaic, but it’s fireproof and very secure.
However, remember that you usually must return original documents to the bank to close out a guarantee. If you can’t find these documents, you might run into problems.
As many companies are embracing digitization, digital originals are becoming more common. Specific tools can issue these and ensure there’s only one specific copy. Some of these tools even work on blockchain, making trade finance a typical example of how blockchain can be used in finance.
So, in conclusion, there are systems you can use to optimize your trade finance operations, but their usefulness depends on the size and maturity of your treasury department. Whether you go for a specialized system, use your bank’s tools, stick to Excel, or explore blockchain solutions, always remember to manage your documents carefully.
Why Are Original Documents So Important in Trade Finance?
In trade finance, it may strike you as odd that original documents hold such immense value, especially when digitization has made it possible to retain copies of important contracts and agreements. Let’s explore why this is the case and whether it’s time for a change.
The Historical Importance of Original Documents
Original documents have historically played a crucial role when enforcing trade finance agreements. Let’s imagine a situation where a deal turns sour, and you end up in court trying to enforce your rights under the agreement. In this scenario, the original document will be your best ally.
Why? It’s simple: in the eyes of the law, the original document serves as the most reliable proof that an agreement was indeed made. It’s your best defence against any claim that the agreement was fake or altered. That’s why banks often require the original document to close a deal.
So, it’s not so much about the document itself but what it represents: an assurance that the parties involved in a transaction have fulfilled their commitments. With the original document and an explanation stating that the deal is done, the bank can confidently stop invoicing for the guarantee.
The Shift Towards Digitization
As more and more business operations go digital, the demand for original physical documents is starting to seem outmoded. Nowadays, digital contracts, supported by a unique blockchain reference, are gaining acceptance in many areas.
But can digitized documents replace physical originals in trade finance? Let’s hope so.
Blockchain technology could be the key to making this happen. It allows the creation of an original digital document with a unique reference that can’t be duplicated. That means you can prove the document’s authenticity without producing a physical original.
Even though physical originals have their roots in historical practices, the shift towards digitization and blockchain technology might be the future of trade finance. It’s a thrilling prospect, isn’t it?
So, while the importance of original documents is rooted in tradition and law, the shift towards digitization opens up new possibilities.
Conclusion:
In the world of business, trust is the foundation of successful transactions, especially when it comes to large-scale deals. Trade Financing is crucial in ensuring trust between buyers and sellers, even when they may not know each other well or have concerns about fulfilling their obligations. By using intermediary entities like banks or parent companies, Trade Financing provides security that encourages parties to move forward confidently.
Throughout this article, we’ve explored the key aspects of Trade Financing, focusing on its purpose, instruments, and the importance of trust. Bank guarantees and letters of credit are two common instruments facilitating trade by offering insurance-like protections and secure payment mechanisms. These instruments help build trust and mitigate risks, making it easier for businesses to engage in transactions across borders or in complex situations.
While Trade Financing can involve complex processes and legalities, it’s important to note that specialized systems and tools are available to streamline and optimize these operations. Technology is vital in simplifying Trade Financing procedures and reducing manual efforts, from trade finance systems with bank connectivity to digital document management solutions.
So, Trade Financing is all about instilling trust in large-scale transactions, ensuring that buyers and sellers can move forward confidently. By embracing the available instruments, systems, and best practices, you can optimize your trade finance operations, streamline processes, and protect your company’s interests. Remember, fostering trust is key, and Trade Financing offers the tools you need to make it happen.