Trade finance helps exporters and importers complete international transactions safely. It reduces risks, ensures timely payments, and provides financial support for global trade.
Here is an easy step-by-step explanation of how trade finance works.
Step 1: Buyer and Seller Finalize the Trade Terms
Before finance or payment arrangements begin, both parties agree on:
- Price of goods
- Delivery terms (INCOTERMS)
- Payment terms (LC, advance, open account, etc.)
- Shipping timelines
- Required documents
Clear terms help avoid misunderstandings.
Step 2: Choose the Right Trade Finance Instrument
Depending on risk and trust level, businesses select one of these common tools:
1. Letter of Credit (LC)
Bank guarantees payment to the seller if documents are correct.
2. Bank Guarantee (BG)
Bank promises to pay the beneficiary if the buyer fails to meet obligations.
3. Bill of Exchange / Documentary Collection
Banks help collect payment based on documents.
4. Export Packing Credit (EPC)
Pre-shipment loan for exporters to buy raw materials and prepare goods.
5. Invoice Discounting / Factoring
Exporter gets cash early by selling invoices to a bank/financer.
6. Buyer’s Credit / Supplier’s Credit
Short-term finance to support international trade payments.
Step 3: Buyer Approaches the Bank
The buyer applies for trade finance (usually LC or BG).
Bank checks:
- Buyer’s credit rating
- Past banking history
- Trade documents
- Transaction purpose
After approval, the bank issues the chosen instrument.
Step 4: Seller Prepares and Ships the Goods
Once the bank instrument is active, the seller:
- Manufactures or collects goods
- Packs them for export
- Books shipping/air cargo
- Prepares export documents
Step 5: Seller Submits Documents to the Bank
Common documents include:
- Commercial invoice
- Packing list
- Bill of Lading / Airway Bill
- Certificate of Origin
- Insurance certificate
- Inspection certificate (if required)
These documents prove that goods were shipped as per agreement.
Step 6: Bank Verifies the Documents
The buyer’s bank checks if documents match the LC/contract terms.
If correct:
- Bank releases payment to seller
- Buyer receives documents for customs clearance
If incorrect:
- The bank may reject or ask for corrections
Step 7: Buyer Makes Payment (Direct or Through Bank)
Depending on the finance method:
- Under LC → Bank pays the seller
- Under collection → Buyer pays after receiving documents
- Under credit facility → Buyer repays the bank later
Step 8: Goods Arrive & Customs Clearance Happens
The buyer uses bank-released documents to:
- Get goods cleared at the port
- Transport the goods to their warehouse
Step 9: Settlement and Closing the Transaction
After payment and delivery:
- Banks close the LC/BG
- Exporter claims incentives (if applicable)
- Both parties settle accounts
- Documents are archived for record-keeping
Why Trade Finance Is Important
- Reduces risk for both buyer and seller
- Ensures secure and timely payments
- Helps businesses trade internationally
- Provides working capital for exporters
- Builds trust in cross-border trade
FAQ
Q1. What is the safest payment method in trade finance?
Letter of Credit (LC) is considered one of the safest because the bank guarantees payment.
Q2. Can small businesses use trade finance?
Yes. Many banks offer trade finance products to MSMEs and small exporters/importers.
Q3. Is collateral required?
Depending on the bank, credit history, and transaction value, collateral may or may not be required.
⚠ Disclaimer
This article is for general informational purposes only. Trade finance rules, bank procedures, and eligibility criteria vary by institution and country. Always consult your bank, trade advisor, or financial expert before selecting any trade finance product.