In trade transactions, payments need to be made in a secure and timely manner. When establishing a new relationship, buyers and sellers usually use intermediaries, such as banks, to limit risk. The intermediaries can guarantee that payments are made on schedule. As trust develops between a buyer and seller, businesses may switch to cash advances or providing trade credit on open account terms.

Payments in trade finance have varying types of risk: for the importer and the exporter. In this section, we may consider the importer as the buyer and the exporter as the seller.

Here we cover 4 types of payment methods: cash advances, Letters of Credit (LCs), Documentary Collections (DCs) and open account sales. As a business owner, it is important to understand the different risks for each type of payment method, to see which one is most favourable and suitable for your business requirements.

Cash Advance

A cash advance requires payment from the buyer (importer) to the seller (exporter) before the goods have been shipped. Therefore, the buyer assumes all the risk.

Cash advances are common with low-value orders. For example, when purchasing from online retailers."

For a seller, a cash advance is by far the least risky payment method. It provides a seller with upfront working capital to produce and ship the goods, as well as security (there is no risk of late or non-payment). Conversely, as a buyer, a cash advance is the least favourable payment method. It may lead to cash flow issues for the buyer and increases exposure/ risk to the seller. It can also be problematic if the delivered goods aren’t up to standard, faulty, or not delivered on time.

Letters of Credit (LCs)

Letters of credit (LCs) are financial, legally binding instruments, issued by banks or specialist trade finance institutions. An LC guarantees that the seller will be paid on behalf of the buyer, if the terms specified in the LC are fulfilled.

An LC requires an importer and an exporter, with an issuing bank and potentially a confirming (or advising) bank respectively. The financiers and their creditworthiness are crucial for this type of trade finance. The issuing and confirming bank effectively replace the guarantee of payment from the buyer, reducing the risk to the supplier. This is called credit enhancement.

LCs are flexible and versatile instruments. An LC is universally governed by a set of guidelines known as the Uniform Customs and Practice (UCP 600), which was first produced in the 1930s by the International Chamber of Commerce (ICC).

The beauty of an LC is that it can meet a variety of needs, that benefit both the buyer and the seller. For this reason, the terms in an LC are important to understand

Documentary Collections (DCs)

A Documentary Collection (DC) differs from a Letter of Credit (LC). In the case of a DC, the seller (exporter) will request payment by presenting its shipping and collection documents to their remitting bank. The remitting bank will then forward these documents on to the bank of the importer. The importers bank will then pay the exporters bank, which will credit those funds to the exporter.

The role of banks in a Documentary Collection is limited. They do not verify the documents, take credit or country risks, or guarantee payment. The banks just control the flow of the documents.

DCs are more convenient and more cost-effective than Letters of Credit, and can be useful if the exporter and importer have a good relationship.

DCs are often used if the importer is situated in a politically and economically stable market."
Open Account

In an open account transaction, the buyer pays the seller after the goods have arrived (typically 30-90 days after). This is obviously advantageous to the buyer and carries substantial risk for the seller. It often occurs if the relationship and trust between the two parties is strong.

Open account trade helps to increase competitiveness in export markets, and buyers often push for sellers to trade on open account terms. As a result, sellers are more likely to seek trade finance to fund working capital while waiting for the payment.

Trade credit insurance may be used to reduce the risk of commercial losses, which could result from the default, insolvency or bankruptcy of a buyer.