Trade finance is the provision of any form of financing that enables a trading activity to take place. This finance could be provided by a buyer to a seller in order to enable the seller to finance his production. Often this finance is allocated to allow access to better inputs that would not be accessed otherwise due to unavailability of credit, transportation, storage, or other costs. The buyer has the incentive to provide this type of finance to ensure the quantity and quality of the specific goods needed for his business. In addition, in order to increase sales volumes, sellers of inputs or other services also have incentives to extend credit to increase their sales volume.
In well developed markets that are characterized by transparency, sophisticated risk hedging instruments,pricing of risk, and a variety of effective collaterals, buyers and sellers often use the credit terms of trade finance to differentiate commercial counterparts and negotiate the terms of the transaction. Conversely,producers and agrobusinesses that form the base of the productive chain in developing countries often have difficulty even entering into financing arrangements within the supply chain, let alone negotiating terms. Credit constraints for agricultural producers and agroprocessors within emerging markets create problems for purchasing inputs, hiring labor for production, storage, processing transportation, and accessing markets. Both open account financing and advanced payment financing provide some solutions to these constraints.
One can generalize trade finance into two different categories. The first category is open account financing where the seller provides goods in advance of payment such as an input provider giving fertilizers in March with the expectation that he will be paid in September when the crop is harvested. The second type of financing is advanced payment financing where the buyer provides some payment for the goods trusting that the seller will ship the specified goods at a later date.
Through open account arrangements with input providers, producers are able to access fertilizers, pesticides, and more in exchange for payment at sale, or in some cases in exchange for delivering to the input providers. In some commodities this same type of open account arrangement can be made with processors who agree to mill or process the commodity in exchange for payment at a later date. While open account financing allows producers to access the necessary goods and services for their production and allows service providers and input providers to have a market for their goods, this type of
arrangement creates default risk particularly for the seller. Default on payment by the buyer could be caused by a number of different factors, including yield shortfalls due to weather and pests, price declines that impact the value of the goods, illness in the family, or a variety of other causes. By providing goods or services on credit the supplier begins taking on the same risks as a formal financial institution, often without undertaking the same types of due diligence or using risk mitigating instruments that banks require.
Advanced payment arrangements also provide a means by which producers can secure inputs and provide farmers with the liquidity to facilitate their production and trade. This type of advance payment allows the producer to hire labor, procure inputs, and pay for transportation and storage of goods. Advance payment facilities could be extended by exporters, processors, or traders. Advanced payment arrangements provide producers the capital necessary to run their business while allowing buyers to guarantee supply. This type of arrangement creates its own set of risks for the buyer, including default by the seller on delivery of the physical product (seller), late delivery by the seller, or failure to meet the contract stipulations agreed upon.
Financing both through open account and advance payment arrangement can be facilitated with or without the intermediation of a bank. In those cases where the bank is the intermediary, this type of financing requires that the bank takes on default risks by ensuring that the buyer and the seller meet their obligations and paying the costs if they do not.
While this type of finance should not be labeled “innovative,” expanding its use to small actors will require innovation. Private traders, exporters, and importers have been looking for these types of market opportunities in almost every agricultural sector, and in many cases have already been successful in extending financing through these means.