International trade depends on financial instruments to bridge gaps of trust between exporters and importers. The World Trade Organization estimates a substantial 80-90% of global trade relies on trade finance.^1^ Yet despite its immense value in facilitating worldwide commerce, the field remains poorly understood by most outside of banking and logistics.
In this comprehensive guide, we will illuminate the inner workings of the top three trade finance instruments—open account, letters of credit, and bank guarantees—and how they are being transformed through automation. Drawing from my decade of experience in data extraction and analytics, I will analyze the mechanisms underpinning over $9 trillion in annual trade finance volume.^2^
What is Trade Finance?
Trade finance eases the flow of goods across borders by mitigating risks and distrust between buyers and sellers:
- Exporters want assurance they will receive payment for shipped goods as contracted.
- Importers want confidence goods will arrive as advertised before remitting payment.
This predicament is why banks stepped in as intermediaries to guarantee obligations are fulfilled. Instruments like open account arrangements, letters of credit, and bank guarantees emerged over centuries of trade to lubricate transactions.
Figure 1: Letters of credit have facilitated trade for over 200 years. (Source: ICC)
With banks assuming risks, exporters can offer flexibility while importers gain security. Next we‘ll analyze the top three instruments in detail.
1. Open Account
In an open account transaction, the exporter ships goods and invoices the importer, who then has up to 90 days to remit payment. This resembles a standard cash deal, except the buyer formally agrees to pay later instead of upfront.
Open accounts first emerged in the 1950s as a way to finance trade between suppliers and buyers with established trust and creditworthiness. They reduce paperwork versus other instruments.
Advantages
For exporters, open accounts allow them to be more competitive than rivals by extending payment timelines. They can also build in higher prices to account for the risk and cost of waiting for funds.
But with open accounts, it‘s critical for sellers to thoroughly vet the importer‘s creditworthiness before proceeding. The table below highlights key open account pros and cons:
| Pros | Cons |
|---|---|
| More competitive terms to attract buyers | Risk of nonpayment |
| Ability to markup prices | Resource costs to vet buyers |
| Less paperwork than other instruments |
Table 1: Pros and cons of open account trade finance
Automation
Automating open account processes can speed up order-to-cash cycles. Technologies like robotic process automation (RPA) can quickly:
- Evaluate customer credit
- Generate invoices
- Recognize revenue and debts for accounting
- Estimate working capital needs until payment
- Log sales in journals
- Email buyers with payment links
- Reconcile accounts receivable
By digitizing these workflows, exporters can scale open account trade with reduced risk and overhead. McKinsey estimates RPA can cut processing costs by 40-75%.^3^
2. Letters of Credit
With letters of credit (LCs), the importer‘s bank guarantees payment to the exporter once goods are shipped. The LC must outline the terms needed for the bank to release funds. This shifts risk from the buyer to the issuing bank, which must pay if shipping terms are met.
LCs were developed in the 19th century to bring accountability to trade finance. They rose to prominence internationally by the 1920s.
Advantages
LCs create a win-win-win for exporters, importers, and banks:
- Exporters get assurance they‘ll be paid as long as they fulfill the contract.
- Importers know sellers are motivated to comply or they don‘t get paid. Their risk transfers to the bank.
- Banks collect LC fees for taking on payment risk.
The table below summarizes the benefits and drawbacks:
| Pros | Cons |
|---|---|
| Payment guarantee for exporters | Complex paperwork |
| Importers offload risk to banks | Bank fees |
| Banks collect fees | Slower process than open account |
Table 2: Pros and cons of letters of credit
Automation
New technologies are automating cumbersome LC processing:
- RPA and OCR extract data from documents into structured templates.
- NLP and machine learning assess applications against bank criteria.
- Systems instantly output automated credit decisions rather than manual review.
- RPA emails approved LCs to exporters for fulfilled contracts.
According to an Accenture study, applying RPA in trade finance can improve turnaround times by 80% and cut costs by 60-80%.^4^ This automation delivers faster, low-touch LC issuance to smooth trade finance.
3. Bank Guarantees
Bank guarantees are similar to LCs, but payout is triggered by importer default rather than fulfilling shipping terms. The bank vows to cover payment if the buyer can‘t pay.
Guarantees safeguard exporters from nonpayment risks beyond their control. They emerged as key trade instruments in the 1960s and 70s.
Advantages
Guarantees give exporters confidence they‘ll be paid regardless of who‘s responsible. Meanwhile, importers have incentive to pay, otherwise the bank seizes their collateral to pay the exporter. The bank collects a fee for taking on this risk.
| Pros | Cons |
|---|---|
| Payment guarantee for exporters | Buyer may lack adequate collateral |
| Importers stay incentivized | Added bank fees |
| Banks earn fees | Slower than open account |
Table 3: Pros and cons of bank guarantees
Automation
E-guarantees are digital versions of traditional guarantees:
- Importers apply and submit data online.
- RPA extracts data into structured formats.
- ML algorithms approve based on policies.
- RPA emails issued guarantees to exporters.
- Blockchain permanently stores and verifies guarantees.
Research suggests blockchain could reduce bank guarantee costs by up to 80% while improving security.^5^ This end-to-end digitization brings guarantees into the modern era.
In closing, open accounts, LCs, and guarantees comprise the foremost trade instruments underpinning trusted global commerce. Automating these processes with technologies like RPA, blockchain, and AI promises to increase efficiency, reduce risks and costs, and improve access to capital. As world trade expands, innovation in trade finance will remain mission-critical.
References:
- "Trade Finance." World Trade Organization. https://www.wto.org/english/thewto_e/coher_e/tr_finance_e.htm
- "Trade Finance." BAFT. https://baft.org/policy/trade-finance
- Mehrotra, Prayag, et al. "Laying the foundation for robotic process automation in trade finance." McKinsey & Company. May 10, 2019.
- "How Robotics Process Automation Can Simplify Trade Finance." Accenture. https://www.accenture.com/us-en/services/banking/trade-finance-robotics-process-automation
- "How Blockchain can Revolutionize Bank Guarantees." Finextra. May 17, 2019. https://www.finextra.com/blogposting/17134/how-blockchain-can-revolutionise-bank-guarantees