Trade & Its Finance
Our free trade plan is quite simple. We say that every [citizen] shall have the right to buy whatever he wants, wherever he wants, at his own good pleasure, without restriction or discouragement from the state. — Winston Churchill
The idea of Trade and Trade Finance is more likely to bring a long “Yaaaaaawn” instead of a loud “Yeaaah!”. We get it — just hearing the words alone are enough to get you to click to another article about which celebrity bought their spouse a Lamborghini for a three-month anniversary present. But the reality is that Lamborghini didn’t just appear out of thin air. Before said celebrity was able to buy the car from a dealer, the dealer had to get the car from Italy — something that definitely required trade and trade finance.
Welcome to Bonorum’s series on trade. We want to explore the world of international trade and highlight its importance not just to corporate entities you’ve never heard of, but also how it affects you as an individual consumer.
How does Trade Happen?
Until teleportation is invented, there is no substitute for the tried-and-true process of shipping massive amounts of products (including anything and everything from aluminum ingots and footballs to Lamborghinis and milk) from one country to another.
Trade is the process of buying and selling products from one entity to another. A buyer and seller decide they want to do business together, negotiate an agreed price, and exchange money for the product. In international trade, there are a few additional nuances such as the involvement of brokers/agents, shipping companies, and customs duties.
What is Trade Finance?
It is estimated that between 80% to 90% of global trade relies on trade finance. Trade finance sounds like a financial thing, but in reality you can think of it as short-term insurance. A seller will want assurances that if it makes something and agrees to ship it, that the buyer will accept it and pay for it. In a local setting, or between two parties that have worked together in the past, this process is easy and sometimes informal. But as the world expands, parties that do business with each other for the first time face higher risks and need this insurance.
In its simplest form, trade finance works by resolving the different needs of a buyer and a seller. A seller would prefer the buyer to pay upfront for an export shipment to avoid the risk that the buyer doesn’t pay. However, if the buyer pays the seller upfront, the seller may take the money and not ship any goods. This is where trade finance comes in with the buyer’s bank providing a something called a “Letter of Credit” (an “ LC”) to the seller’s bank. The LC guarantees the seller payment once the goods are shipped and the seller can present documents that confirm the same. So even if the buyer refuses to make a payment, the bank will step up and fulfil the terms of the contract.
Who’s Involved?
To guarantee payments between a buyer and a seller, there are several layers of people and processes that are involved with every trade transaction. Oftentimes, there are the buyer’s and seller’s banks, brokers, third-party surveyors, insurance companies, credit agencies, third-party financing companies, and others. Each layer and process has a specific role in making the transaction secure for the buyer and the seller. While this is great on paper, in reality, each layer adds significant time, effort, and cost to even the simplest of trades.
A buyer’s and seller’s banks are both necessary because how else could the buyer send the seller money for a product? Short of physically handing over cash and having that cash stored in a mattress, the buyer and seller have no reasonable alternatives for large-scale and/or international trade to happen.
Brokers are agents who introduce buyers and sellers to each other in exchange for an arrangement fee. Independent surveyors provide certificates or confirmation which guarantee that the product being purchased by the buyer is exactly what the seller says it is. Insurance companies provide security and peace of mind to the buyer that nothing negative will happen to the product when the seller ships it out.
Export-import credit agencies and trade finance companies are essentially the same kind of entity. Their goals are to financially support trade between buyers and sellers. In many ways, these agencies and companies compete with the buyer’s and seller’s banks because they try to facilitate trade by providing the same kinds of money used for trade.
It costs how much?!
Let’s not beat around the bush — trade finance ain’t cheap.
On top of paying for the goods in question, a buyer is also paying its bank to issue any “comfort letters” (which is like a personal reference) and LCs. The LC itself comes with a litany of costs, including margin money of up to 100%. That means that if you’re trying to issue an LC of $100, your bank may ask you to deposit the $100 with them until the LC is cleared! None of these costs include brokerage fees, surveyor fees, or any extra insurance or freight charges.
A lot of these costs also apply to sellers. Upon receiving an LC, the seller may need to have it confirmed, which means verifying that the LC is appropriate for the seller. This adds to the seller’s cost of doing business. In lieu of issuing LCs, a seller may require a working capital loan just so that it can actually produce the goods that its contracted to sell!
There is a cost associated with every layer of process and protection between a buyer and a seller. And due to the nature of issuing LCs and international trade in general, a lot of the processes are conducted manually and not very transparently. This is one of the primary reasons that there is a scarcity of trade finance in the world today.
Is that all?
Unfortunately no — but we feel that this is a pretty good start. In the next post, we’ll take a closer look at the tools of trade finance and what money means for a buyer and a seller.
This blog post is the second in a mini-series looking at Global Trade Finance. For more posts on trade finance and the Bonorum Platform:
Part 1 — Introduction
Part 2 — What Is Trade?
Part 3 — Trade Finance Instruments
Part 4 — Why Trade?
Part 5 — Problems With Trade Finance
Part 6 — An Example
Part 7 — Digitizing Trade
Part 8 — Sow Me The Yield!
Part 9 — What’s Bonorum?
Part 10 — Meet The Team
All articles and posts have been written and produced by team members of the Bonorum Platform. Click here to learn more about Bonorum and how it can help you as business or as an individual.
