Trade finance. Is it just business jargon? How does it work? How is it different from corporate finance? Do you need it? In this guide we answer these questions, de-mystify key terms, delve into how the process of trade finance works, discuss how future changes in trade finance could affect your business and ultimately explain why you need trade finance. 

What is trade finance? 

We asked Jayshree Barnes, an Associate Director and Head of Trade Finance at Czarnikow. Here’s what she had to say: 

If you’re looking for a textbook definition: trade finance is the process of funding trade flows and mitigating risk for the buyer and the seller. Trade finance should not be conflated with corporate finance which aims to maximise the value of a business. Structured trade finance is more specific: it’s an alternative to conventional lending, typically for commodity trades or high value and/or large quantities of products, where the flow of commodities repays a loan. It’s important to note that trade finance is not just for multinational companies, it is key in the success of small business as well.

Trade finance lets you covers your bases: Credit risk and insurance 101 

Trade involves goods switching hands from seller (or exporter) to buyer (or importer), which brings risk for both parties. One of the ways to mitigate that risk is with a letter of credit (LC) issued by a bank, insuring the exporter is reliant on the bank for payment instead of the buyer thereby reducing the risk of the buyer defaulting. An LC is similar to a contract stating the conditions under which the exporter will be paid and is issued by the importer’s bank. Importantly, a LC prevents the importer from refusing to pay for goods because of a complaint. 

Imagine you are the exporter. What happens if your buyer defaults, becomes insolvent or bankrupt? That’s when Trade credit insurance comes in to cover you for losses if your buyer doesn’t pay. Although credit insurance protects against buyer non-payment, an insurer will not cover the full amount owed by a buyer. The indemnity, or the amount an insurance underwriter is obliged to pay you as per your policy, is typically between 80 and 95% of the debt owed. It may surprise you to learn that most companies’ assets are tied up in receivables (debts owed by its clients).

Before we delve into the different types of insurance policy, we need to get up to speed on some terms: 

• Credit limit (one you’ve probably heard before): the maximum amount an underwriter will cover if a customer fails to pay their debts. 
• Indication: not the limit but the underwriter’s confirmation that they would be comfortable offering a certain limit in the future. For a cover to begin, an indication must become a credit limit. 
• Discretionary credit limit: gives an insurance underwriter the right to provide you with a limit without having to check with the insurance company. 
• Excess: the extra amount an underwriter will ask you to pay towards a claim. 
• Maximum extension period (MEP): how long you have after the date your client must settle their debt before you have to inform your insurer of unpaid invoices. 
• No claims bonus/ discount: if you do not file any claims during the insured period, you can be offered benefits like a reduction to an otherwise flat-rate payable. 
• Premium: the fixed amount you pay an insurer for a period in order for your trades to be covered 

How credit insurance works

How credit risk is calculated and internal risk grades

To determine your credit limit and premium an underwriter will calculate your credit risk which is the likelihood that your client will default on payment for goods or that you will not recover part or all the goods. Despite best intentions, sometimes external factors mean that trades cannot go ahead as planned. 

In a scenario where you want to provide an advance payment for a commodity that has not yet been produced, you need performance risk cover in case the producer fails to provide the product by the date stated in your agreement. On the other side of this arrangement is credit insurance to cover you in the event that the buyer does not pay for the product by the agreed maturity date. 

Internal risk grades (IRG) rate the credit risk of a counterparty — the debtor not an asset – the product. An asset is seen as a receivable (a financial obligation that the debtor owes to a company) by the credit risk insurer. This means that you can claim against the insurance if the producer (which is the debtor in this scenario) fails to deliver the product. The credit insurance can be provided by a single underwriter insurer or a syndicate of (multiple) underwriters.