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Risk Mitigation in Trade Finance

Executive summary

Running a successful trade finance business involves understanding and mitigating the risks inherent within the transaction. All commercial transactions contain risks. These risks refer to the likelihood the seller, buyer, or financier will make or receive a payment. The challenge for a trade financier is to minimise, or where possible, eliminate those risks.

Key learning objectives:

  • Define Supplier Performance Risk and Purchaser Performance Risk
  • Explain how these risks can be mitigated
  • Understand what other considerations need to be made, especially when dealing with foreign countries

What are the risks associated with a trade finance transaction?

The risks can be broken down into three sections:

  1. Risks relating to the ability of the seller to perform and trigger the payment obligation
  2. Risks relating to the ability of the buyer to make timely payment subsequent to that performance
  3. Risks relating to the ability of the financier to receive repayment

What is Supplier Performance Risk, and how can it be mitigated?

Supplier Performance Risk is where the supplier may fail to deliver the goods required under the contract.

This is the hardest risk to mitigate. Generally, the trade financier will look to the track record of the supplier as a guide to the likelihood of successful performance. In order to minimise the risk, especially where there is a generic commodity involved, it is common to use an independent inspector of goods before export.

Generally, ownership passes at the point of delivery to the buyer, so it is also important to ensure that a reputable logistics company is being used.

What is Purchaser Performance Risk, and how can it be mitigated?

Purchaser Performance Risk relates to both the ability and the willingness of the buyer to send payment upon delivery. Track record is very important and caution should be taken where a client has a new buyer with no history.

The best ways to mitigate the risk of non-payment is to require a Letter of Credit from the purchaser. This financial instrument is effectively a guarantee from a bank that as long as certain objective circumstances occur (typically presentation of a Bill of Lading, invoice, packing list and certificate of origin), the bank will release the funds.

Alternatively, credit insurance can be taken out on the receivable, so that in the event of protracted non-payment, the insurer will repay the financier. Both of these measures are not without legal intricacies and should never be depended upon.

What is the purpose of a Collection Account?

Assuming that the quality and quantity of goods have been certified, there should be no strong reason for the purchaser not to pay. However, one key difference between trade finance and traditional lending is that the client is normally required to direct funds into a Collection Account. This minimises the risk of a loss if the client becomes insolvent. This “control of funds” is key when structuring a transaction.

What considerations need to be made when it comes to dealing with foreign countries?

Interest rate and foreign exchange risk can be easily handled by the right experts. Geopolitics and sanctions also need to be considered especially where there is a risk that the ultimate destination of goods may be sanctioned.

When financing any new goods, the best starting point is to look at the purchase contract to understand how the specifications can be objectively measured and met.

Given the potential jurisdictional and contractual issues, it is essential to ensure that trade finance documentation is well drafted and suited to the transaction.

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