Explained: How these 5 trade finance instruments can help your business grow in 2022

Estimated reading time: 7 minutes

Letters of credit, forfaiting, factoring, export finance, and trade credit: these are the most popular trade finance techniques that companies are using to finance their international trade

In this short guide, we cover the following five trade finance instruments:

1. Letters of credit
2. Forfaiting
3. Factoring
4. Export finance
5. Trade credit insurance

Trade finance – All you need to know

1. Letters of credit (LCs)

Letters of credit (LCs) are one of the most common types of trade finance instrument, and are also one of the easiest to understand.

An LC is a legally-binding document issued by a bank or a specialist trade finance institution, which ensures that a seller of goods or services will get paid, as long as the terms set out in the LC are fulfilled.

An LC therefore requires an importer, who works with an ‘issuing bank’, and an exporter, who works with a ‘confirming bank’.

The issuing bank ensures that the confirming bank will receive payment for the transaction as per the terms of the LC – usually on receipt of the goods – thus reducing the risk of non-payment for the supplier (and non-delivery for the buyer).

This is called credit enhancement, and it also explains why creditworthiness is so important when using LCs.

2. Forfaiting

Forfaiting is a less common technique in trade finance, but it has a sizable market share nonetheless.

New forfaiting transactions typically amount to around $30 billion every year, and at any given time, there are $60 billion to $75 billion in forfaiting transactions outstanding.

Forfaiting is a trade finance technique that allows exporters to obtain cash by selling their medium and long-term foreign accounts receivable at a discount to a forfaiter.

This is done on a ‘without recourse’ basis, which means that the forfaiter, typically a bank or financial institution, assumes 100% of the risk of non-payment from the exporter.

The receivables are then guaranteed by the importer’s bank, which allows the exporter to remove the transaction from their balance sheet, and allows the forfaiter to turn a profit when the foreign buyer receives the goods.

3. Factoring

Factoring is similar to forfaiting, albeit with some important differences.

For one, the global factoring market is much smaller. In 2019, for example, the global factoring market was estimated to be worth €2.9 billion in 2019, according to factoring association FCI.

When an exporter sells an invoice to a trade financier at a discount, the financier then becomes known as the ‘factor’.

Having acquired the invoice – i.e. the right to the goods – at a discount, the factor is then able to sell the goods to an importer at full price, thus making a profit on the sale.

In other words, the exporter accepts a slightly lower price for the product, in exchange for the increased security of immediate payment from the factor.

4. Export finance

Export finance, also known as export credit, is a trade finance technique favoured by small and medium-sized enterprises (SMEs), as it is often issued through government agencies (export credit agencies), although can also be accessed through banks and lenders.

Most major economies have their own export credit agency (ECA), such as UK Export Finance (UKEF) or the Export-Import Bank of the United States (US EXIM Bank).

ECAs supply working capital to exporters so that they can reach a larger, more distant, or more high-risk market.

Using direct credit from an ECA, an exporter can supply goods using cash that they might otherwise not have access to.

Once the trade transaction is complete, and the exporter receives payment from the importer, the exporter then pays back the credit borrowed from the ECA at a slight premium.

Likewise, an importer can use direct credit from an ECA to purchase goods from abroad with cash they don’t have immediate access to.

Then when the goods arrive, and the importer sells them on to his next-in-line buyer, the importer pays back the credit borrowed from the ECA – once again, at a slight premium.

5. Trade credit insurance

Trade credit insurance is a straightforward technique used by exporters to protect against risk of non-payment.

Before entering a trade transaction, an exporter can purchase trade credit insurance from an insurance broker or directly from an insurance underwriter, who will price the insurance policy based on the perceived risk of the transaction. 

Such risk factors include distance, mode of transport, value of goods shipped, political risk, and buyer creditworthiness.

Drawing credit from an insurer allows an exporter the comfort to ship goods in lieu of payment from the buyer.

What’s convenient about trade credit insurance is that every invoice an exporter has with a particular buyer could be covered for each year in a single policy.

And if for some reason the buyer decides not to pay for the goods shipped, the exporter simply makes a claim on his insurance policy, and the insurer will pay the exporter directly instead.