Trade Finance | Foreign currencies effect on Trade Finance
When purchasing from abroad foreign currencies is something that your business will have to deal with. The mammoth 6.6 trillion USD per day market that enables international trade does affect your costs of financing business overseas.
In this article, we look at how this affects your trade financing and what you should know to make sure you are not paying too much.
What does foreign currency have to do with trade finance?
When conducting global trade you will encounter foreign exchange unless you are paying in your native currency. When you finance the purchases with a financial institution you also have to take into consideration what currency it is that they are ultimately funding.
Whether you are sending currency abroad through financing or not you are going to have to deal with exchange rates and fees that come with conducting those transactions. With exchange rates moving by the second the wrong move in the market can eat into your profit margins.
Trade financing payment terms depend on what product you are using and likewise how long it takes your business to ultimately sell those products you are purchasing. For that period you are leaving the order value of your purchases to the mercy of the currency market.
Large movements are not a regular occurrence in the currency market but do happen. We all remember the day that the Brexit vote came out dropping the value of the Pound to USD by 13% on the day, if you are caught on the wrong side with no protection on your trades you would have just lost a big chunk, if not all of your profit.
Trade Finance suppliers do not always but most of the time lock you into conducting your foreign exchange with them for you to get access to the financing. This means that the financier can make a margin on both the liquidity they are providing you and on the foreign exchange.
By financial service companies doing this, they create a captured market, meaning you can’t go elsewhere. From our experience, this increases the amount you are ultimately going to pay for those foreign currency transactions.
We do a deep dive into limiting foreign exchange costs in all circumstances here.
How to limit costs
Limiting costs on the foreign currency you transact with your trade financing can be tricky. Even if your supplier doesn't lock you into a contract margins can still be high elsewhere in the market.
When working at a large financing company in the UK that did lock in their clients when they took a trade finance facility it was not uncommon for the foreign exchange department to make more money on the customer than the actual financing did.
From experience, the best way to limit the costs in the first instance is to negotiate. A lot of companies don’t think that it is possible but at the end of the day, foreign exchange and finance providers alike are going to try everything they can to keep you as a customer if they think you are going to leave them.
This is especially true with foreign exchange as providers have a high turnover of clients due to increased competition. Our team have a ton of experience in this realm and they delve into how to keep your foreign exchange costs down here.
Local currency vs Foreign currency
You have two options when paying suppliers abroad, whether you are using financing or not. Do you pay in your local currency or the exporters local currency who is selling you the product or service?
Paying in your local currency does make your life a bit easier, you don’t have to buy the currency to send to your customer you just use British Pounds. This eliminates one of the headaches of trading internationally but is it always the best way?
Your suppliers will quote you with a price in your local currency but ultimately once they receive that currency they will be (most of the time) converting that back into their native currency. This means that your suppliers have to formulate a quote for you that takes those extra fees of doing the conversion into account.
Often the supplier will put an extra margin on top of these fees so they can more profit. Likewise, if your supplier is quoting you a month before you ultimately pay they will take into account the currency risk and add extra margin onto their pricing just in case of any movements in the currency market.
As a former currency dealer, I have seen it all too often that companies paying for imports of goods or services in their native currency end up paying more for their products than they would have if they paid in foreign currency. Exporters can of course hedge their exposure with forward contracts which would eliminate the extra margin they take for currency market fluctuations but not all of them do.
On the other hand, you have to contend with banks high fees when undertaking your currency trades or likewise the fees of a 3rd party supplier. Even if you are locked into doing your foreign currency with a funder because of financing there are still ways to get an effective exchange rate which we look into here.
Hedging foreign currency risk with Trade Finance
There are different ways to hedge your financial risk which we cover in this article here. For foreign currency accompanied with Trade Finance, there are some useful tools available for you to consider.
Forward contracts allow you to lock in an exchange rate ahead of time for a certain amount of funds that you can then use at a later date. This takes away from the risk of leaving the currency to the markets between the period you place your order and pay for your products or services.
Providers allow you to lock in as far as 24 months in advance and likewise, if your business is in good standing they will not take a deposit on the transaction. One thing to be wary of with this product is that you can get ‘margin called’ where you need to pay an amount to the provider if the contract moves too far out of the money. We look into this further here.
Multiple Market orders
Clients do this to limit the downside risk of a currency pair moving against them. They set a bottom price with a provider (they don’t want it to go lower than this price) and also a price that they would like to achieve if the market goes up.
It can of course trade within the middle of those two prices which would result in you booking your contract on the day it needs to be paid and cancelling the market orders. There can be downsides to this method, the price can move down to hit your bottom price but then move straight back up to the price you would achieve. Check out our guide on market orders here.
There are other products available like options which we look into here but they are inherently more complex and come with more risk if not handled correctly.
All in all foreign currency has a large part to play in Trade Finance and if not handled correctly can cause issues with your profit margins. Suppliers can be profiting from your orders in more ways than you might have thought but there are ways to combat this.
Managed well both products together have created a great team and have helped businesses to conquer international trade costs effectively and efficiently.
Our team have industry experience in both markets and are always happy to have chat.