What Is Trade Finance, and Why Does It Matter?

The global financial crisis demonstrated that trade finance is a broad concept that encompasses various products, mechanisms, and players. When trade collapsed in the fall of 2008, trade finance rapidly became the focus of attention. Foremost, the crisis illuminated the dearth of data and information on trade finance. Trade finance differs from other forms of credit (for example, investment finance and working capital) in ways that have important economic consequences during periods of financial crisis. Perhaps its most distinguishing characteristic is that it is offered and obtained not only through third-party financial institutions, but also through interfirm transactions. Table O.1 lists the major trade finance products. The vast majority of trade finance involves credit extended bilaterally between firms in a supply chain or between different units of individual firms.2 According to messaging data from the Society for Worldwide Interbank Financia Telecommunication (SWIFT), a large share of trade finance occurs through interfirm, open-account exchange. Banks also play a central role in facilitating trade, both through the provision of finance and bonding facilities and through the establishment and management of payment mechanisms such as telegraphic transfers and documentary letters of credit (LCs). Among the intermediated trade finance products, the most commonly used for financing transactions are LCs, whereby the importer and exporter entrust the exchange process to their respective banks to mitigate counterparty risk. The IMF/BAFT-IFSA bank surveys during the crisis helped gather information on the market shares of financing products and suggested that about one-third of trade finance is bank intermediated, as figure O.2 shows. Relative to a standard credit line or working-capital loan, trade finance—whether offered through banks or within the supply chain—is relatively illiquid, which means that it cannot easily be diverted for another purpose. It is also highly collateralized; credit and insurance are provided directly against the sale of specific products or services whose value can, by and large, be calculated and secured.3 This suggests that the risk of strategic default on trade finance should be relatively low, as should be the scale of loss in the event of default.