Trade Finance

Trade finance refers to a range of banking products and services that facilitate domestic and international trade by reducing payment risk, improving trust between trading partners, and providing working capital. Banks act as intermediaries between importers and exporters, helping bridge the time gap between shipment of goods and receipt of payment.

These services are essential because exporters seek assured and timely payment, while importers prefer to receive goods before paying. Transaction banking complements trade finance by handling payments, collections, guarantees, and escrow arrangements, ensuring smooth settlement of trade transactions.

Letters of Credit (LC)

A Letter of Credit (LC) is a written, irrevocable undertaking by a bank (issuing bank) to pay the exporter (beneficiary) on behalf of the importer (applicant), provided the exporter submits documents strictly complying with LC terms. Payment is made against documents, not goods.

LCs are widely used in international trade to mitigate non-payment and country risk. In higher-risk situations, an LC may be confirmed by another bank, adding an additional layer of payment assurance. Key Features of LC are:

• Primary payment instrument
• Document-based
• Irrevocable in nature
• Transfers payment risk from exporter to bank

Bank Guarantees (BG)

A Bank Guarantee is a contingent obligation where a bank promises to compensate the beneficiary if its customer fails to fulfil contractual or payment obligations. Unlike LCs, guarantees are invoked only upon default.

Bank guarantees are extensively used in domestic trade, infrastructure projects, government tenders, and project finance. Common forms include performance guarantees, bid guarantees, and advance payment guarantees.

Escrow Services

An Escrow Account is a neutral account maintained by a bank where funds are held until pre-agreed contractual conditions are fulfilled. The bank acts as an impartial custodian and releases funds only when milestones are met.

Escrow arrangements are common in real estate transactions, mergers & acquisitions, PPP projects, fintech settlements, and large trade contracts. They significantly reduce counterparty risk and trust deficits.

Documentary Collections

Under Documentary Collection, banks act only as document-handling intermediaries, not as payment guarantors. The exporter ships goods and hands over documents to the bank, which releases them to the importer under agreed terms.

There are two main forms:

• Documents against Payment (D/P) – documents released after payment
• Documents against Acceptance (D/A) – documents released after acceptance of a bill of exchange

This method is cheaper than an LC but offers lower security, as banks do not assume payment risk.

Bills Discounting & Negotiation

Banks support exporters by discounting export bills or invoices, providing immediate liquidity before payment is received from the importer.

When exports are backed by an LC, the exporter’s bank may negotiate the documents, pay the exporter upfront, and later claim reimbursement from the issuing bank. This improves exporters’ cash flow and reduces waiting time.

Pre-Shipment and Post-Shipment Finance

Banks provide working capital at different stages of the export cycle.

• Pre-shipment finance (Packing Credit) funds procurement, processing, and packing of goods before shipment.
• Post-shipment finance provides funds after shipment through bill discounting or advances against export bills until payment is realized.

These facilities often carry preferential interest rates to promote exports.

Factoring and Forfaiting

Factoring involves selling short-term export receivables to a bank or specialized institution (factor) for immediate cash. It may be with recourse or without recourse to the exporter, and may include collection and credit management.

Forfaiting applies to medium- to long-term export receivables, usually backed by bills or promissory notes guaranteed by the importer’s bank. It is typically without recourse, fully insulating the exporter from non-payment risk.

Collection & Remittance Services

Remittance services involve the transfer of funds between parties without linkage to trade documents. Banks facilitate domestic and cross-border remittances using systems such as NEFT, RTGS, IMPS, SWIFT, and correspondent banking networks.

Remittances are used in advance payments, open-account trade, service payments, and international settlements. While fast and simple, they expose exporters to higher counterparty risk compared to LC-based trade.

Export Credit & Insurance

In India, exporters are supported through concessional export credit and insurance mechanisms. Banks provide export finance at preferential rates, while the Export Credit Guarantee Corporation of India (ECGC) offers insurance against foreign buyer default and political risks.

The Export-Import Bank of India (EXIM Bank) provides specialized export finance, overseas buyer’s credit, and support for international projects, strengthening India’s external trade.

Risk Mitigation in Trade Finance

Trade finance instruments are designed to address key risks inherent in trade. Payment risk is mitigated through instruments like L/Cs and bank guarantees, which shift risk from exporter to bank. Production and performance risk is managed through pre-shipment finance and performance guarantees. Foreign exchange risk is handled using hedging products such as forward contracts and options. Country and political risks are covered through export credit insurance and confirmed letters of credit from reputable international banks.