TRADE FINANCE

Trade finance is a third party or external means of financing the purchase of goods in support of a buyer or the production of goods in support of the seller. It can be done domestically or internationally. Unlike factoring, it is done on a transaction-by-transaction basis and only for creditworthy parties.
Payment is generally accomplished by a documentary or standby letter of credit for the protection of all parties. The third party providing the trade finance takes a percentage of the transaction price as compensation for the financing and related services. An assignment of proceeds from the letter of credit assures payment to the third party providing the trade finance.
Trade finance can also be used to support the true trader or value-added reseller who buys from one party and sells to another. When both the purchase and sale are locked in by contract with reputable and creditworthy suppliers and end users, the trade finance is virtually risk free and can even be monetized when provided to finance a long-term output, requirements or supply contract.
Trade financing (also called merchant banking in much of the rest of the world) is attractive not only because risk is mitigated or eliminated, but because of the ability to turn the trade finance line over multiple times a year. The velocity of the turnover allows a high rate of return on a revolving line of trade credit. For example, a modest 2% return on a transaction repeated 12 times a year provides a 24% annual return on investment.
In many other countries, there are actually separate financial institutions called merchant banks. For many reasons far back in U.S. history, merchant banking did not establish itself in the United States as it existed and developed in England and elsewhere. There are relatively few private companies playing the role of the merchant banks.
A merchant banking or trade finance company finances the production of goods for resale for sellers and the acquisition of goods for resale for buyers. Trade finance can also be extended to true trading companies or value-added resellers that buy from established sellers and resell to creditworthy buyers. Trading exists because niche markets are often more efficiently served by small, nimble trading companies than by larger less efficient companies. However, some trading companies, such as Mitsubishi, became quite large.
Trade finance is not limited to imports or exports of goods, but can be used for domestic transactions as well. Merchant banking/trade finance is handled by lines of credit and usually is implemented through letters of credit.
The letter of credit substitutes the creditworthiness (and purchasing power) of the bank for that of the buyer or seller. Letters of credit are great for the banks because they earn fees for the service at virtually no risk. Letters of credit are always 100% backed. They are highly liquid, but they do not themselves trade; they are payment arrangements for specific transactions. There are clearly established rules for them. Finally and crucially, a private company can legally act as the equivalent of a merchant bank, utilizing the services of an actual bank for issuing and handling the letters of credit.
Once established with the trade finance department of several major European banks, a credit-worthy trade finance company can borrower up to 90% of the amount of letter of credit either with the issuing bank of through a third party credit facility. Although there is up to 10:1 leverage, 4:1 or 3:1 is more common today. And absolutely best of all, a line of credit supporting a letter of credit can be used over and over, potentially generating high velocity for repeatable transactions under a supply contract for a year or even longer.
Before the financial meltdown, some trade finance departments of the large European banks used to provide 100% of the trade finance through letters of credit for a share of the profits, which gives a good idea how safe these transactions are considered to be. Currently this kind of leverage is not taking place, but leverage will return because it is so profitable for the banks.
Trade finance is used for oil and other bulk commodity transactions. It is used to buy and resell goods of all kinds. Purchase order trade finance is used to actually produce the goods for sale. Trade finance is also used in project finance to purchase the raw materials used in construction. There may be some velocity in a large project with a long construction time, but typically these are single transactions for which the percentage return may be higher and the line is used to support multiple projects in a given period to achieve the desired velocity.

John W. Tulac is an international business attorney practicing in Claremont, adjunct professor of law at University of La Verne College of Law, and Lecturer Emeritus (retired) at Cal Poly Pomona. He is peer recognized as preeminent in international business law and holds the highest ratings for competence and ethics from the Martindale Hubbell National Law Directory.