According to the world trade organization, some 80 to 90 per cent of world trade relies on trade finance. In 2016, world merchandise trade recorded its lowest growth in volume terms since the financial crisis of 2008, increasing by just 1.3 per cent. This is half the level achieved in 2015 and well below the 4.7 per cent average annual growth rate since 1980. In 2009, the volume of Nigeria’s international trade amounted to circa US$80.74 Billion constituting about 22.6% of its total Gross Domestic Product (GDP).
What is Trade Finance?
Trade finance is a way for manufacturers to export their goods knowing the importer who may be on the other side of the world and someone they’ve never met but only corresponded with will pay them.
The Development of Trade Finance
Trade finance developed out of bills of exchange. A bill of exchange is a promise-to-pay under which a company (the buyer) agrees to pay the seller a given sum of money at some point in the future – usually three months ahead. It’s a sort of post-dated cheque. To make it more acceptable, bills of exchange were endorsed by prominent merchants.
Bills of exchange are similar to bankers’ acceptances (which are also promises-to-pay issued by companies to banks in return for short-term loans). The banks resell these bills in the market at a discount but guarantee payment. Discount houses developed by buying bills of exchange at a discount to face value, holding them to maturity and gaining their full value. They funded their holdings of bills by short-term borrowing from banks, one of the precursors of the money market. These bills were either held to maturity or sold in the discount market and brokers developed to match buyers and sellers in return for a commission.
This was how international trade grew – at a time before email or even the telephone when exporters (sellers) and importers (buyers) on different sides of the world might not know each other and business was conducted by letter. The exporter wouldn’t ship goods without being sure of payment. The importer wouldn’t pay for the goods in advance without sight of them or, at least, assurance as to their quality and proof of shipping and insurance.
This is where trade finance houses and merchant banks stepped in. The exporter would have the goods inspected by an independent third-party agency and deposit the bill of landing (shipping confirmation) and certificates of inspection and insurance with its bank.
The importer would deposit the purchase price with its bank, which would issue a letter of credit (like a bill of exchange) payable in three months’ time. With the respective banks holding the money and the documentary confirmations of quality, shipping and insurance, the exchange of good for the letter of credit could be completed.