20.1 Introduction to Trade Finance Instruments

International Markets are more complex than local markets. Dealing locally with suppliers, parties can build trust in a short period of time, whereas, in international markets where parties operate from different parts of the world, it is very difficult to trust the counterparty on payment and performance. Commercial risk, discussed in Chapter 16, deals with non-payment and non-performance issues; managing this risk reduces the chances of failure in the international market. Specifically, in trade finance, organizations always struggle to determine the pattern of payment methods to allocate responsibility for financing transactions, thus knowing who would most need liquidity support (Ahn, 2014). Using different trade finance instruments (also referred to as methods of payment or payment methods) in different situations is one way companies can reduce this struggle and manage commercial risk present in foreign transactions.

As trade flourished after World War II, many trade finance instruments evolved over time. An exporter/seller is always concerned about getting paid in full and on time using an appropriate method of payment as it helps minimize the payment risk while also accommodating the needs of the buyer (International Trade Administration, n.d.a).

The Forum of International Trade Training explains that

an organization should select the financial instruments that best address its needs and identified risks, as well as those that respond to the underlying dynamics of a commercial contract. In general, importers and exporters must agree on terms and methods of payment based, in part, on the risks associated with planned transactions. (FITT, 2030, p. 46)

Types of Trade Finance Instruments

Finance is the backbone of any business, be it domestic/international, small/medium or large. It is even more required when companies decide to expand internationally. Historically, Trade finance is considered the oldest domain of international finance whose purpose in early ages was to support a firm’s working capital needs, which extended to supporting trade organizations by reducing risks in long-distance trade by providing different methods of payment options (Accominotti & Ugolini, 2019).

A variety of methods of payment have evolved over time. Different studies have categorized them differently; some have divided them into pre-shipment, post-shipment and letters of credit (Ahn, 2014), but most have categorized them into basically four methods of payment: Advance Payment, Open Account, Collections and Letters of Credit (FITT, 2023, Bhogal & Trivedi, 2019). In this chapter, we will divide methods of payment as:

• open account
• advance payment/cash in advance
• documentary collections
• documentary credit

The major distinction between these methods of payment is the trust level between the importer and the exporter. If both parties can trust one another easily, they can choose advance payment or open account methods. However, if parties are working together for the first time or they operate in a highly risky environment, the appropriate methods would be documentary collection or documentary credit. There are some other innovative methods of payments, such as factoring and forfaiting, which are used by organizations to reduce the impact of imbalanced cash flow.

References

Accominotti, O. & Ugolini, S. (2019, August 7). The evolution of international trade finance explained. World Economic Forum. https://www.weforum.org/agenda/2019/08/the-structure-of-global-trade-finance-a-very-long-run-view/

Ahn, J. (2014). Understanding trade finance: Theory and evidence from transaction-level data [PDF]. International Monetary Fund. https://www.imf.org/external/np/seminars/eng/2014/trade/pdf/ahn.pdf

Becker, R. (2018, April 30). 7 factors for determining the right method of payment for your exports. Shipping Solutions. https://www.shippingsolutions.com/blog/seven-factors-for-determining-the-right-method-of-payment-for-your-exports

Bhogal, T. & Trivedi, A. (2019). International trade finance: A pragmatic approach. Springer.

FITT. (2023). FITTskills: International Trade Finance (7.3 ed). Forum for International Trade Training.

International Trade Administration. (n.d.a). Methods of payment. https://www.trade.gov/methods-payment