Understanding Trade Finance: The 5 Major Categories

By Soko Directory Team / Published April 30, 2021 | 8:12 am

KEY POINTS

Documentary trade finance, a collective term used for traditional trade finance instruments that leverage letters of credit (LCs), guarantees, and documentary collections.

By accelerating trade in goods and services both within the continent and between Africa and world markets, African economies have the potential to unlock transformational growth.

Trade finance can be grouped into 5 categories:

Documentary trade finance, a collective term used for traditional trade finance instruments that leverage letters of credit (LCs), guarantees, and documentary collections.

Given their internationally accepted status, LCs have historically been commonly used in East Africa, though there has been an increasing shift towards less traditional trade finance solutions like open account trade terms.

Structured commodity finance, which leverages the underlying cash flows of an asset, commodity, or commercial off-take contract as security in providing a financing solution (examples include warehouse receipt financing or revolving credit facilities).

Trade credit insurance (TCI), used in the event of credit risks such as bankruptcy or default, and political risk insurance (PRI), used in the event of unforeseeable political circumstances.

Supply chain finance, comprising either receivables purchase solutions (allowing supply chain parties to sell against all or part of their receivables) or loan-based solutions (whereby loans and advances are made against receivables). Usage of these instruments has been low historically, primarily due to high country risk perception.

Export and credit agency (ECA) finance, which includes guarantees, loans, and political and trade credit insurance provided by ECAs to promote exports by removing the uncertainty around export payments. ECA finance is, however, impeded by factors such as the limited availability of information needed for due diligence on SMEs in East Africa.

In Africa, barriers to uptake exist at both the ecosystem and trade finance provision level, emphasizing the importance of holistic interventions.

In the agriculture sector, inhibiting factors revolve around the high collateral requirements and pricing that result from high-risk perception, in addition to a lack of both trade finance instruments tailored to agriculture SMEs (such as supplier finance, factoring, and forfeiting) and tailored risk mitigation instruments like agri-insurance and guarantees (important to pre-shipment finance in particular).

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