Financial Workflows and Trade Finance Instruments

trade finance tools

Financial requirements differ from one service to another regarding conditions, timing, currency, accompanying documents, and payment methods. These factors are determined by the deal’s equilibrium between trust and risk.

Transforming Modern Trade Finance

Trade documents and financial workflows are interconnected and vary tremendously from one commercial agreement to another. Payment is a trigger for a document transfer from the seller to a buyer: the buyer completes the payment, and in exchange, the seller transfers the Bill of Lading and any other trade documents to the buyer.

Financial requirements differ from one service to another in terms of conditions, timing, currency, accompanying documents, and payment methods. These factors are determined by the deal’s equilibrium between trust and risk. For instance, when there is a high level of trust between parties, both will often opt to use simple payment methods and conduct the transaction directly between themselves, without the involvement of a third party. Alternatively, low trust and high risk mean the parties may prefer to employ more secure trade finance instruments via a bank or non-banking financial institution (NBFI).

This article will present the various payment methods available and in what circumstances to do so. For brevity, we’ll refer mainly to banks, but NBFIs often play the same role in transactions.
trade finance tools

How to choose a Trade Finance Instrument

Sellers and buyers choose their commercial agreements individually per transaction; no one model fits every deal.

When there is complete trust and minimal risk, the seller and buyer generally prefer to handle the payment process between themselves, without involving banks or non-banking providers. The reason is that the latter’s involvement is expensive and tends to slow down workflows.

When there exists some risk, and the trust level is not high, a seller often prefers to involve a trusted third-party bank to supervise the deal’s workflows. This adds trust to the agreement and formalizes it, imposing various terms and conditions.

Payment often involves a transfer of documents and requires a document management process, which, like the payment process itself, can be managed either by the bank or individually between sellers and buyers.

Payment Instruments

Telegraphic Transfers (open account transaction):

An electronic means of transferring funds via the SWIFT messaging network. They are considered payment orders between banks. Telegraphic Transfers (TT) are also described as wire transfers or SWIFT transfers. TT is usually more expensive than other electronic transfer methods due to the rapid nature of the transaction.

When is Telegraphic Transfer used?

  • 1. When the payment method is managed by banks.

  • 2. When there is no trust between parties, the seller might demand the entire payment transaction pre-production by TT. In this case, the documents’ envelope is transferred directly between the parties when the seller receives the payment.

  • 3. When there is complete trust between parties and no need for involvement by banks. In this case, the payment process begins once an invoice is submitted, and the envelope of documents is transferred directly between the parties.
financial workflows

Cash Against Documents (CAD):

A process between the seller’s and the buyer’s banks. A seller instructs their bank to release documents to the buyer’s bank only after the buyer completes the payment transaction. The payment conditions can be against cash or open account, with or without a bank guarantee.

When is Cash Against Documents used? 

  • 1. When the seller has some concerns about the deal and can’t be certain, the buyer will complete their side of the transaction.
trade finance tools

Letter of Credit (LC):

Letters of Credit (LC) are exclusively offered by the bank and a solution that can only be administered by financial institutions. LC is a payment mechanism that provides an economic guarantee from a creditworthy bank to a seller. A Letter of Credit is a trade finance instrument used to mitigate risks between buyers and sellers. It is essentially a letter from a bank guaranteeing that a buyer’s payment to a seller will be received on time and for the correct amount. Banks verify that the documents presented by the seller match the relevant commercial agreements; upon verification, the banks pay on behalf of the buyers. Letter of Credit transactions used to be a standard tool and were even used purely for document verification. An LC is also known as a documentary credit, bank commercial credit, or letter of undertaking.

When is a Letter of Credit used?

  • 1. When transaction risk is high, and there is no trust between parties. It is also a financing solution and means to reduce political risk.
trade finance tools
Today, many banks and non-banking financial institutions enable their customers to use electronic document platforms such as WAVE BL to reduce their customers’ costs of doing business and improve the customer experience. When sellers and buyers provide the electronic documents and envelopes required by their chosen trade finance instrument, the document verification process can be automated, greatly speeding up the service banks and financial institutions provide.

Until now, we’ve talked about how risk and trust affect the choice of payment method. Now we’ll explain how risk and trust also affect the timing of the payment.

Timing of Payment

When risk is high, and trust is low, sellers generally prefer to take the safest path and require payment as early as possible in the process. In some cases, the risk is so high that a seller won’t even start processing the sale before receiving full payment for the goods.

When risk is low and the seller’s trust is high, payment timing and conditions can be flexible and adjustable to the buyer’s request. Sometimes trust is so high that payment can be transacted 30 or 90 days after the cargo has been released from customs.

Payment timing options

  • 1. Pre-production
  • 2. Pre-delivery
  • 3. Post-delivery

  • After the cargo is released from customs

As we have seen, the terms and conditions of a sale, specifically the payment method, the payment timing and documents required, are determined according to the level of risk and trust between parties. WAVE BL enables sellers and buyers to digitize the document exchange process, cut courier costs and paper expenditures, and ultimately reduce the cost of trade. Banks and non-banking financial institutions that offer trade finance solutions similarly benefit from rapidly issuing and transferring documents while expediting verification and improving the customer experience.