Supercharging Trade Finance with Data, AI, and Software
Overseas trade and shipping are costly endeavors that require a large amount of capital and a high tolerance for risk. Banks play a crucial role in facilitating trade by providing Letters of Credit and other trade finance services to reduce this risk and provide more financial flexibility to buyers and sellers. These traditional banking institutions have historically controlled the market for trade finance, but increasingly there are signs that the winds are shifting and 3PLs, Freight Forwarders, and even startups might be able to gain a foothold in the space.
To start, trade finance can be roughly broken down into three categories:
1. Advance payment
This is when money is transferred from buyer to seller before the goods have been shipped; I pay you for something and you send it to me. It’s the most simple method but requires a large amount of trust on the part of the buyer, who incurs the risk while the seller does not. By using a different method of payment, sellers can gain a competitive advantage, so the one-sided advanced payment method is rarely used.
2. Open account
Almost the opposite of advance payment, open account is when a seller ships goods to a buyer who then pays over a set course of time. For this method to work, the seller must trust the buyer, as there is no third party guaranteeing payment and the seller takes on all the risk.
3. Documentary collection and Documentary credit
This method comes in a number of varieties but is mainly concerned with reducing risk and information asymmetries for both buyers and sellers. Taking a common Documentary Credit example, a Letter of Credit (LC) can be used by a buyer to guarantee payment to a seller after a shipment has occurred. Banks sit in the middle of these transactions and guarantee payment assuming a set of mutually agreeable terms are met.
After a sales contract is agreed upon, the buyer acquires a LC from a bank who guarantees payment to the seller. The seller sends the goods to the buyer while banks file paperwork back and forth to ensure accurate information is transferred and all contract agreements are met. In short, both parties enlist large, trustworthy financial institutions to make sure everyone gets what is agreed upon. However, that might make things sound more simple than how it actually plays out:
If this seems confusing, we’ve made our point. Trade finance is not only slow and cumbersome but inaccessible to the vast majority of the world. Technology alone cannot solve these problems entirely, but the limitations of trade finance present a multi-trillion dollar opportunity — more than enough for a few unicorns.
For starters, we’d like to see more people exploring…
1. New ways of using data to enable more accessible pre-production finance
One of the biggest problems with LCs is that pre-production and pre-shipment finance for sellers is hard for banks to underwrite. These types of financing require a deep understanding of a buyer’s likelihood of making good on their purchase and a seller’s likelihood of delivering on time. Factories sit on data, including manufacturing cycle time and on-time deliveries, that would make this process easier — but they’ve so far been reluctant to share this data with banks. Whether this is a logistical or philosophical issue, the end result is that information is not getting into the necessary hands. We’re getting more data off of factory machines to the point where it might actually be possible to give people money upfront to produce products. This would get even more interesting if it were to be combined with inventory data and raw materials procurement data (a potentially savvy GTM here) to close some of the gap on pre-production uncertainty.
2. Enabling 3PLs and Freight Forwarders to leverage trade finance as an ancillary
While banks were once the only players in trade finance, logistics companies like FlexPort, Amazon, and UPS have begun providing trade financing services, putting pressure on traditional Freight Forwarders. Other companies have begun exploring ways to get in on trade finance because it generates additional margin and would make them competitive with big players like FlexPort. We’re excited by the potential for data-driven startups to take advantage of this trend by making it extremely simple for these margin-starved players to up-sell without the operational challenges of managing a bank.
3. Digital solutions making open account terms financing faster and more accessible
Most of this post has focused on Letters of Credit, but the vast majority of global trade doesn’t happen with one. When open account transactions are possible, they’re less painful and preferable to just about anything else for the buyer; the key is removing risk from suppliers and making terms operationally easy to offer. This is where startups can come in: processing, underwriting, and guaranteeing terms on behalf of suppliers to their respective buyers. With the rise in B2B eCommerce and significant improvements in OCR and entity extraction technologies, it’s easier than ever before to automate these processes and make them available to a whole new class of buyers — better, faster and cheaper.
While the trade financing process is complex, there are plenty of areas where it could be improved — and where there’s room for improvement, there’s opportunity for entrepreneurs to act. What role could a startup play in trade financing and how can modern technology be used to improve the flow of data to all entities involved in a trade? These are issues that can and should be fixed, and if you think you’re the person to fix them then BSV would love to hear from you.
Authored by John Mannes, investor at Basis Set Ventures