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1 INTERNATIONAL TRADE INTERNATIONAL TRADE FINANCE FINANCE by Frida Youssef 27/April/01
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INTERNATIONAL TRADE INTERNATIONAL TRADE FINANCEFINANCE
by Frida Youssef27/April/01
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OutlineOutlineI. INTRODUCTION
II. DOCUMENTARY CREDITA. Principles of Documentary Credit B. The role of the International Chamber of Commerce (ICC)
(1) INCOTERMS(2) UCP 500
III. OVERVIEW OF PAYMENT METHODS A. Open AccountB. Cash in AdvanceC. Documentary CollectionD. Documentary Credit
(1) Types of L/C (Revocable/irrevocable -Confirmed/unconfirmed)(2) Documents associated with an L/C(3) Methods of Settlement.
IV. OVERVIEW OF BASIC FINANCING METHODS A. Financing Importers
(1) Letter of Credit (financing with the use of an L/C)(2) Bill of Exchange
B. Financing Exporters(1) Special Type of L/C(2) Forfaiting
I. INTRODUCTION
II. DOCUMENTARY CREDITA. Principles of Documentary Credit B. The role of the International Chamber of Commerce (ICC)
(1) INCOTERMS(2) UCP 500
III. OVERVIEW OF PAYMENT METHODS A. Open AccountB. Cash in AdvanceC. Documentary CollectionD. Documentary Credit
(1) Types of L/C (Revocable/irrevocable -Confirmed/unconfirmed)(2) Documents associated with an L/C(3) Methods of Settlement.
IV. OVERVIEW OF BASIC FINANCING METHODS A. Financing Importers
(1) Letter of Credit (financing with the use of an L/C)(2) Bill of Exchange
B. Financing Exporters(1) Special Type of L/C(2) Forfaiting
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I.I. IntroductionIntroduction
What is Trade Finance?Basic Concepts
This is the provision of any form of financing that enables a trading activity to take place. Trade financing could be made either directly to the supplier, to enable him procure items to produce, or for immediate sale, and/or for storage for future activities. It could also be provided to the buyer, to enable him meet contract obligations. Whichever way it goes the underlying principle is that the party more able to bear the risk is made the reimbursement source for the facility.
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I.I. IntroductionIntroduction
What is Trade Finance?
Buyers and sellers in international trade are confronted with diverse geographic, social, economic and political conditions.
In general trade is built on trust, without trust trade would not exist. Every one relies on the honest and integrity of those in the trading cycle, however there are always adverse elements (or unscrupulous parties) that could to upset this cycle, this is where the bank can intervene and help to bridge the trust gap. One major instrument that is used in international trade to circumvent such problems is the Documentary the Letter of Credit. .
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DOCUMENTARY CREDIT IS AN ESSENTIAL PART OF THE TRADE PROCESS
Documentary credit or letter of credit is an undertaking issued by a bank (Issuing bank) for the account of the buyer (the Applicant) or for its own account, to pay the Beneficiary the value of the Draft and/or documents, provided that the terms and conditions of the Documentary Credit are complied with.
Source: ICC Guide to Documentary Credit Operations. For further detailed explanation of the definition refer to UCP 500 Article 2.
II.II. Documentary CreditDocumentary Credit
Documentary credit is a trade payment (and finance) mechanism that was developed to add a measure of security to trade transactions, particularly between buyers and sellers from different countries, and to assert sufficient pressure in case of any violation or non-performance to the L/C.
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Issuing BankIssuing Bank
Negotiating BankNegotiating Bank
ExporterExporter(Beneficiary)(Beneficiary)
ImporterImporter(Applicant)(Applicant)
Advising BankAdvising Bank
7.
2.
Sales contract agreement (specifyingquantity, payment terms and documents)
Request to open L/C by completing application form specifying termsand conditions of the transaction
Opens L/C and forwards details for delivery to exporter
Advises L/C (validates authenticity of L/C, checks its workability and completeness from a bank perspective, and forwards details to exporter)
After examining documents and clearing up any discrepancies, Negotiating bank presents documents to Issuing bank for payment
Checks documents and pays Negotiating bank and forwards documents for importer to claim the goods
Adv
isin
g B
ank
can
also
act
as
Neg
otia
ting
Ban
k
** Letter of Credit Flow ChartLetter of Credit Flow Chart
Presents L/C and require documents for settlement once shipment of goods is arranged
6.
5.
4.
3.
1.
The Issuing Bank substitute for the credit-worthiness of the BuyerThe Issuing Bank substitute for the credit-worthiness of the Buyer
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A.A. Principles of Documentary CreditPrinciples of Documentary Credit The underlying principles of the letter or credit are that it must be
autonomous and the exporter must strictly comply with the written terms of the Documentary Letters of Credit. In documentary credit operation, banks deal only with documents and not with the goods to which the documents relate. Any disagreements arising from contracts or dispute relating to the goods or services must be dealt with directly between buyer and seller.
Although DC are completely separated transactions from the underlying commercial contracts on which they may be based, however, the importance of the commercial contract to the documentary credit process cannot be under emphasized. It is usually at the contract negotiation stage that the responsibilities of each party are defined, the price and terms of payment are agreed upon and the mode of transport is determined. As far as possible, the terms and conditions of the DC should also be agreed at this stage.
Each element of the contract needs to be accurately reflected in the subsequent documentary credit to ensure that the transaction can be completed successfully, without creating undue difficulty for either party.
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B.B. The role of the International Chamber of The role of the International Chamber of Commerce (ICC)Commerce (ICC)
There are strict requirements that govern the formulation of documentary credit. The International Chamber of CommerceInternational Chamber of Commerce is the organization which has developed the most extensive and most commonly applied rules, models, and materials related to documentary credit.
The International Chamber of Commerce (ICC) is a non-governmental organization which was founded in 1919 with the aim of facilitating and helping the world's businesses, by promoting trade, investment, and open markets for goods and services, as well as the free flow of capital.
Among the most well-known ICC products in relation to international trade practices are the IncotermsIncoterms and the ICC Uniform Customs and Practice for Uniform Customs and Practice for Documentary credit (UCP).Documentary credit (UCP). Their objective is to facilitate trade, increase the efficiency and decrease the cost of international transactions by promoting the standardization of international banking and commercial practices and procedures.
http://www.iccwbo.org/
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(1)(1) Incoterms (International Commerce terms)Incoterms (International Commerce terms)
Incoterms are uniform sales and shipping terms used in foreign trade and are accepted by the banks as legal terminology for letter of credit transactions.
The ICC published in 1936 the first set of rules specifying contract obligations and assigning the responsibilities of buyers and sellers involved in international trade. These Incoterms have been updated regularly since, most recently in 2000 (with 13 standardized foreign sales terms) to reflect new techniques of international trade.
Incoterms provide generally three basic pieces of information: • Information on the transfer of risk: it defines at which place the risks of cargo
loss and damage is transferred from the seller to the buyer during transport operations.
• Information on the division of costs: it defines how costs resulting from the transport operation are shared between the buyer and seller (i.e. cost of dispatch, carriage and delivery; customs clearance for export and import; service or assistance rendered by one party to the other; and insurance).
• Information on the documents: it defines who will provide the required documents (i.e. transport document, proof of delivery, certificate of inspection, insurance, etc.).
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(1)(1) Incoterms (International Commerce terms)Incoterms (International Commerce terms)
EXAMPLE:EXAMPLE:
Ex Works (named place): where the seller make available the goods to the buyer at his premises. The seller here does not bear any risk.
Ex Works - XYZ International,Geneva, Switzerland.
CIF - Cost, Insurance, and Freight (named port of destination): where the seller bear the risk of the main transport cost but not the risks after shipment. CIF - Port of Kaohsiung, Taiwan
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(2)(2) UCP (Uniform Customs and Practices for UCP (Uniform Customs and Practices for Documentary Documentary Credit)Credit)
ICC has established a set of standard rules and practices called the "Uniform Customs and Practices for Documentary Credits" (UCP) to govern trade transactions.
The UCP describes customary practices and standard performance for letters of credit and provides a comprehensive and practical aid to bankers, lawyers, and all businesses involved in international trade. The UCP lays down a code of practice for the issuing of documentary credits. For many years most documentary credit transactions have been carried out in accordance with the "Uniform Customs and Practice for Documentary Credits". (the UCP had been modified 5 times with the latest in1993 - UCP 500)
The objective of the new UCP is to enhance international trade and facilitate the use of letters of credit by reducing the level of discrepancies and disputes. It should be noted that not all banks in the world conform to the UCP rules but, in principle, it is clearly stated in Article 1 of UCP 500 that UCP rules apply to a documentary credit when they are included in the contract. Therefore, it is always preferable to refer to the UCP when setting up a contract.
Letters of credit are reviewed by all banks according to these rules, and persons dealing in letters of credit should be well-aware of them.
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(2)(2) UCP (Uniform Customs and Practices for UCP (Uniform Customs and Practices for Documentary Documentary Credit)Credit)
§ The UCP of 1993 (ICC publication no. 500) contains 49 articles under seven headings:
1. General Provisions and Definitions2. Forms and Notification of Credit (provides consistent standards
in connection with the issuance, amendment, advisement, payment and confirmation of letters of credit)
3. Liabilities and Responsibilities4. Documents (defines the elements of acceptability and content of
each type of transport document)5. Miscellaneous Provisions6. Transferable Credit7. Assignment of Proceeds.
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III.III. International Trade Payment InstrumentsInternational Trade Payment Instruments
Introduction
DCs are one of the most widely used methods of settlement for international trade transactions because the security they offer is well balanced between the two commercial parties. Various payment instruments have been designed to take into account, not only the payment risk of the buyers, but also the risks inherent in their countries of domicile. The overall aim is to ensure that the buyer receives the consignments of the right quantity, quality at the right price and time, and on the other hand it ensures also that the seller receives due payments.
The are four principal payment mechanisms for settling international trade transactions. These are: Open AccountOpen Account, Advance PaymentAdvance Payment, Documentary Documentary CollectionsCollections and Documentary CreditsDocumentary Credits.
Introduction
DCs are one of the most widely used methods of settlement for international trade transactions because the security they offer is well balanced between the two commercial parties. Various payment instruments have been designed to take into account, not only the payment risk of the buyers, but also the risks inherent in their countries of domicile. The overall aim is to ensure that the buyer receives the consignments of the right quantity, quality at the right price and time, and on the other hand it ensures also that the seller receives due payments.
The are four principal payment mechanisms for settling international trade transactions. These are: Open AccountOpen Account, Advance PaymentAdvance Payment, Documentary Documentary CollectionsCollections and Documentary CreditsDocumentary Credits.
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Open account
Documentary collections
Documentary credits
Payment/cash in advance
Most secured for Exporter/Seller
Most secured for Importer/Buyer
Least secured for Importer/Buyer
Least secured for Exporter/Seller
Risk Perspective
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Payment mechanismsPayment mechanisms
Documentary Credit
Documentary Collections
Payment in Advance
Open Account
Document against Payment
Documentagainst
Acceptance
Revocable D/C
IrrevocableD/C
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Open account means exporter selling on credit terms to the buyerOpen account means exporter selling on credit terms to the buyer
This is the most secure method of payment for the importer. It allows the importer to make payments at some specific date in the future and without the buyer issuing any negotiable instrument evidencing his legal commitment to pay at the appointed time. On the part of the seller, it is therefore the most
risky payment mechanism the buyer bears the cost of financing and the credit risk of the buyer Open account does not involve the bank very much except in moving the funds from buyer to seller, in due course. This mechanism offers the seller no protection in case of non-payment. However, an exporter can structure his open account sale transaction to minimize the risk of non-payment; for example, reducing the repayment period and retaining title to the goods until payment is made. Even then, it is difficult to enforce this especially if the goods have been either resold by the buyer or consumed in some other processing activity.
A.A. Open AccountOpen Account
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When Open account should be used?
1. This payment mechanism is used when the exporter has a well-established commercial relationship with a credit-worthy importer and when the importing country enjoys reasonable political and economic stability.
2. When the exporter is shipping goods to a parent or subsidiary company.
3. When the exporter is faced with excessive inventory. In this case, he seeks markets desperately and would take the risk of delivering even to a seller without excellent credit records. This is more relevant for items with short expiration dates, which could go bad, any way.
4. A seller faced with a very strong competition may also decide to ship goods on open account as a way to squarely face the challenges posed by the competitors. It is a way of making his products visible in the international market.
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Open Accounts - summaryOpen Accounts - summary
Informal arrangement whereby goods are shipped and the importer is billed later (Invoice sent with or after shipment).
Provides great flexibility. Useful when customers are well known good credit risks and common
with longstanding good customer-supplier relationships
Typical risks include:
– Customer refuses to take possession
– Customer unable or unwilling to pay
– Customer restricted from paying by its central bank
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B.B. Payment/Cash in Advance Payment/Cash in Advance
In contrast to open account, payment against documents is the most secure payment method for the exporter but most risky for the buyer since goods are not shipped until payments are received in part or full.
In this arrangement, the seller retains total control over the transaction and there is no guarantee that goods paid for will even be delivered in good time. There is very limited bank involvement in this method of payment since the seller sends the documents directly to the buyer. The bank only comes in to effect payment which is usually wired from the buyer’s bank to the seller’s bank.
Cash in advance can be expensive to the exporter since buyers who are forced to pay in advance may ask for a discount on the value of the exports.
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When is Payment in Advance used?
1. This method of payment is usually used only for small purchases.
2. Essentially, sellers request payment in advance when foreign buyer's credit status is doubtful and unsatisfactory and/or the country political and economic risks are very high. In this circumstance, the seller does not want his funds to be trapped in a foreign land on grounds of buyer failure or difficulties in remittance due to exchange restrictions by the government.
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Cash in Advance - summaryCash in Advance - summary
Occurs when exporter is in strong bargaining position relative to importer
Relationship between parties unestablished
Typical Risks include:
– Supplier may not ship
– Supplier may ship late, low grade or less than agreed
– Supplier may not be permitted to export by authorities
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C.C. Documentary CollectionsDocumentary Collections
This is a method of payment by which the sale transaction is settled through an exchange of documents, thus enabling simultaneous payment and transfer of title. The principal obligations of parties to a documentary collection arrangement are set out in the guidelines of the ``Uniform Rules for Collection’’ (URC) drafted by the Paris-based International Chamber of Commerce.
This method makes use of Bill of Exchange or Draft supported with other shipping documents.
Documentary collections offer a middle-of-the road approach to satisfying both the exporter and importer. In the arrangement, the importer is not obliged to pay for goods prior to shipment and the exporter retains title to the goods until the importer either pays for the value of the draft upon presentation (sight draft) or accept to pay at a later date and time (term draft).
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Role of Banks in Documentary Collections
Banks play essential roles in transactions adopting documentary collections. Two major banks come into the scene:
Remitting Bank: This is the exporter’s bank and acts as the exporter’s agent in collecting payment from the importer. It basically transmits the exporter’s instructions along with the terms of the draft to the importer’s bank. The bank does not assume any risks and does not undertake to pay the exporter but can influence to obtain settlement of a bill. Collecting Bank: This is the importer’s bank and takes up the role of ensuring that the buyer pays (or accept to pay) for the goods before shipping documents are released to him.
Generally, the banks in the transaction control the flow and transfer of documents and regulate the timing of the transaction. They must ensure the safety of the documents in their possession but are not responsible for their validity and accuracy.
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Flow of Transaction in a Documentary Collections Deal1. Exporter/drawer and Importer/drawee agree on a sales contract, including payment to be made under a Documentary Collection.
2. The Exporter ships the merchandise to the foreign buyer and receives in exchange the shipping documents.
3. Immediately thereafter, the Exporter presents the shipping documents with detailed instructions for obtaining payment to his bank (Remitting bank).
4. The Remitting bank sends the documents along with the Exporter’s instructions to a designated bank in the importing country (Collecting Bank).
5. Depending on the terms of the sales contract, the Collecting Bank would release the documents to the importer only upon receipt of payment or acceptance of draft from the buyer. (The importer will then present the shipping documents to the carrier in exchange for the goods).
6. Having received payment, the collecting bank forwards proceeds to the Remitting bank for the exporter’s account.
7. Once payment is received, the Remitting bank credits the Exporter’s account, less its charges.
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Collecting/Presenting
Bank
Collecting/Presenting
Bank
Exporter (Drawer)Exporter (Drawer)
Remitting Bank
Remitting Bank
Importer(Drawee)Importer(Drawee)
1. Contract of sale
2. Delivery of goods
3. S
hip
pin
g do
cum
ents
an
d
i nst
ruct
i on
s f o
r pa
ymen
t
7. p
aym
ent
6. Payment
4. Documents and collection order
5. Presentation of documents and receipt of
payment
Documentary Collections Flow Chart
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Variations of Documentary Collections
• Cash against documents/Sight Drafts:In a transaction on documents against payment, the exporter releases the shipping documents to the importer only on payment for the goods. In this arrangement, the exporter retains title to goods on board and may decide to refuse their discharge if payments are not received. This arrangement which demands the buyer’s immediate payment of the exporter relies on the a sight draft drawn on the buyer.
• Document against Acceptance/Term Drafts:An exporter may decide to release shipping documents to a buyer on acceptance of the exporter’s drafts. In this case, the importer is under an obligation to pay at a future date. This method satisfies both parties since the importer is able to receive the goods before payment and the exporter has a firm assurance that payment will come at a future date.
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Risks in Documentary Collections
• To the ExporterTo the ExporterIf it is a sight draft, the exporter will reduce the risk of non-payment but will not eliminate it totally since the importer may not be in a position to pay for the goods or may not be able to procure sufficient foreign exchange to make the payment. In this case the exporter may be forced to either call back the goods or negotiate sale to some other interested party, may be at a reduced rate. In the case of term draft, the risk to the exporter is higher since the foreign buyer will take possession of the goods and may not pay at due date, forcing therefore the exporter to try and collect payment from the foreign buyer in the foreign buyer's home country.
• To the ImporterTo the ImporterThe importer faces the risk of paying for goods of sub-standard quality or even with shortages. In such a circumstance, it would take some time to get refunds from the exporter. It could also happen that the exporter refuses to make refunds, leading the importer to lengthy legal proceedings.
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When to use Documentary Collections?
Since Documentary Credit transactions entail some measure of differed payment it advisable to use when the following conditions apply:
when the exporter and importer have a well established relationship
when there is little or no threat of a total loss resulting from the buyer’s inability or refusal to pay
when the foreign political and economic situation is stable and when a letter of credit is too expensive or not allowed.
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D.D. Documentary CreditsDocumentary Credits
Documentary credit is for an exporter the next best thing after Payment in Advance.
Compared to other payment forms, the role of banks is substantial in documentary credit transactions.
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Role of Banks in Documentary Credits
• The banks provide additional security for both parties in a trade transaction by playing the role of intermediaries. The issuing bank working for the importer and the advising bank working for the exporter.
• The banks assure the seller that he would be paid if he provides the necessary documents to the issuing bank through the advising bank.
• On the other hand, the banks also assure the buyer that his money would not be released unless the shipping documents evidencing proper and accurate shipment of goods are presented.
• On the basis of these roles, it can be properly said that banks are the beacon which guide parties in an international trade transaction, without which, pitfalls would abound.
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A letter of credit may be of two forms: Revocable or Irrevocable
Revocable L/CThis is one that permits amendments or cancellations any time by the issuing bank. This means that the exporter can not count on the terms indicated on the initial document until such a time as he is paid. It is hardly in use in modern day trade transactions.
Irrevocable L/C Such a letter of credit cannot be changed unless both buyer and seller agree to make changes. Usually an L/C is regarded as irrevocable unless otherwise specified. Therefore, in effect, all the parties to the letter of credit transaction, i.e. the issuing bank, the seller and the buyer, must agree to any amendment to or cancellation of the letter of credit. Irrevocable letters of credit are attractive to both the seller and the buyer because of the high degree of involvement and commitment by the bank(s). By the 1993 revision of the UCP, credits are deemed irrevocable, unless there is an indication to the contrary.
(1)(1) Types of L/CTypes of L/C - 1- 1
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A letter of credit may be of two forms: Confirmed or Unconfirmed
Confirmed L/CIf the exporter is uncomfortable with the credit risk of the issuing bank or if the country where the issuing bank is situated is less developed or politically unstable, then as an extra measure, the exporter can request that the L/C to be confirmed. This would add further comfort to the transaction, an exporter may request that the L/C be confirmed. This is generally by a first class international bank, typically the advising bank (now the Confirming Bank). This bank now takes the responsibility of making payments if no remittance is received from the issuing bank on due date.
Unconfirmed L/CIn contrast, an unconfirmed credit does not require the advising bank to add its own payment undertaking. It therefore leaves the liability seller with the issuing bank. The advising bank merely as a channel of transmission of documents and payment.
NOTE NOTE The lowest risk form to the exporter is a confirmed and The lowest risk form to the exporter is a confirmed and irrevocable letter of credit.irrevocable letter of credit.
(1)(1) Types of L/CTypes of L/C - 2- 2
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Documents are the key issue in a letter of credit transaction. Banks deal in documents, not in goods. They decide on the basis of documents alone whether payment, negotiation, or acceptance is to be effected.
Bill of Lading
– Contract with carrier, shipper’s receipt and control Commercial Invoice
– Authoritative description of product Insurance
– Under a floating policy for all cargoes Certificate of inspection
– Attesting the specification of the goods shipped Consular Invoice
– To allow items to enter country
(1)(1) Documents associated with an L/CDocuments associated with an L/C
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The documentary letters of credit can be opened in two ways:
1. Sight Letter of Credit: A Sight Letter of Credit is a credit in which the seller obtains payment upon presentation of documents in compliance with the terms and conditions.
2. Timer or Usance Letter of Credit: A Time or Usance Letter of Credit is a credit in which the seller will be paid a fixed or determinable future time. A time or usance letter of credit calls for time or usance drafts to be drawn on an accepted by the buyer, provided that documents are presented in good order. The buyer is obligated to pay the face amount at maturity. However, the issuing bank¹s obligation to the seller remains in force until and unless the draft is paid.
(3)(3) Methods of SettlementMethods of Settlement
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Special Note on Documentary Credits
Documentary credits hinge much on the appropriateness of documents. Banks involved in the transaction do not need to know about the physical state of the goods in question but concern themselves only with documents. If proper documents are presented, banks will make payment whether or not the actual goods shipped comply with the sales contract.
Thus, special care needs to be taken in preparation of the documents since a slight omission or discrepancy between required and actual documents may cause additional costs, delays and seizures or even total abortion of the entire deal.
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Letter of credit SummaryLetter of credit Summary
Provides exporter the greatest degree of safety when extending credit Useful when importer is not well known Useful when exchange restrictions exist or are possible
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In this section we will see how exporters and importers can obtain finance on the back of a simple trade transaction, first with the intervention of an L/C and second without necessary intervention of an L/C.
Importers may need financing to be able to carry out their trade activities.
Exporters may need liquidity to cover the financing requirements for the period before and/or after shipment of goods and until payment is received. Financing the period prior to shipment is referred to as pre-shipment financing and that for the period following shipment is the post-shipment financing.
III.III. Basic Sources Of FinanceBasic Sources Of Finance
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(A)(A) Financing ImportersFinancing Importers
(1)(1) Letter of CreditLetter of Credit (financing with the use of an L/C) (financing with the use of an L/C)
While the L/C can be used as payment mechanism, it can also be used to provide financing to the applicant (importer).
a.a. Deferred and Acceptance creditsDeferred and Acceptance credits (i.e. term credits) are considered to be financing instruments for the buyer, since during deferred payment the buyer can often sell the goods and pay the amount due with the proceeds.
– By Deferred PaymentPayment is made to the seller at a specified future date, for example 60 days after presentation of the documents or after the date of shipment (i.e. the date of the bill of lading).
– By AcceptanceThis type of credit requires the exporter to draw a draft (bill of exchange) either on the issuing or confirming bank. The draft is accepted by the bank for payment at a fixed date. For example, payment date under an acceptance credit may be at sight or after 90 days from presentation of the documents or from the shipment of goods.
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(A)(A) Financing ImportersFinancing Importers
(2)(2) Bills of ExchangeBills of Exchange (financing without the use of an L/C) (financing without the use of an L/C)
In the absence of a letter of credit, the exporter (beneficiary) can also grant extended payment terms directly to the importer and generally would issue bills of exchange addressed to, and accepted by, the importer (drawee and acceptor) who commits to pay on demand, or at a fixed or determinable future time, a certain sum to the exporter (drawer and, generally, payee).
Bills of exchange are similar to invoices: the exporter issues a demand for payment to an importer (or to a guarantor). This is a trade bill, drawn by one commercial party on another. Once it has been accepted or endorsed by the importer, it becomes a trade acceptance, which, with a bank guarantee, becomes negotiable.
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(B)(B) Financing ExportersFinancing Exporters(1)(1) Special Type of L/CSpecial Type of L/C
While L/Cs can be used strictly as a tool to ensure safe payment procedures, they are often also used to provide financing to the beneficiary (exporter).
aa.. Red Clause L/CRed Clause L/CRed-clause letters of credit enable an exporter to obtain Red-clause letters of credit enable an exporter to obtain pre-pre-shipment financeshipment finance (a percentage of the L/C amount) from the (a percentage of the L/C amount) from the advising or confirming bank. The loan can be made by the advising advising or confirming bank. The loan can be made by the advising bank against either a simple written statement of purpose form the bank against either a simple written statement of purpose form the exporter, guaranteeing that the advance will be used for the purpose exporter, guaranteeing that the advance will be used for the purpose stated (stated (clean red-clauseclean red-clause) or against an undertaking to provide certain ) or against an undertaking to provide certain specified documents (e.g., warehouse receipts) and to deliver specified documents (e.g., warehouse receipts) and to deliver shipping documents in accordance with the terms of the L/C shipping documents in accordance with the terms of the L/C ((documentary or secured red-clause L/Cdocumentary or secured red-clause L/C). ).
Under a red clause L/C, the importer is actually granting an unsecured loan to the exporter and is therefore incurring risks for all advanced credits. He is made liable for repayment of the advance and interest.
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IMPORTER(Applicant)
EXPORTER(Beneficiary)
ADVISING/CONFIRMING
BANK
OPENING/ISSUING BANK
1Sales contract agreement (specifying goods, quantity,
payment, and documents required)
2
Requests to open a red-clause L/C by completing application form specifying terms and conditions of L/C (details of the parties, sum of transaction, time limit, delivery dates and terms of goods, and list of required documents)
3Opens a red-clause L/C and forwards details to exporter through the advising bank
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NEGOTIATING BANK
Adv
ising
ban
k ca
n al
so
act a
s neg
otia
ting
bankAfter examining documents and
clearing up any discrepancies, Negotiating bank presents documents to Opening banks for payment
5
Checks documents and pays Negotiating
bank, and forwards documents for
importer to claim the goods
Exporter requests loan from advising bank against either clean red-clause L/C or for secured (or documentary) L/C
Makes loan
6 Exports commodity
7Present documents for negotiation and payment
89
Pay
men
t (ne
t of
the
loan
and
rel
ated
inte
rest
and
fee
s)
10
Red Clause L/C FlowchartRed Clause L/C Flowchart
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(B)(B) Financing ExportersFinancing Exporters
bb.. Green Clause L/CGreen Clause L/CGreen-clause letters of credit serve the same purpose as red-clause Green-clause letters of credit serve the same purpose as red-clause credits but differ in that the exporter can only obtain advance payments credits but differ in that the exporter can only obtain advance payments against actual production not just undertaking to produce, certain against actual production not just undertaking to produce, certain documents.documents.
The loan is made available by the advising bank against production of certain documents (e.g., warehouse receipts) evidencing that goods are held to the order of the bank.
From the perspective of banks, green-clause L/Cs are more secure than red-clause L/Cs because the loan is also with full recourse to the goods. From the perspective of exporters, green-clause L/Cs are more attractive than red-clause L/Cs because the amount of the advance can be much higher, say typically up to 85% of the L/C amount.
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(B)(B) Financing ExportersFinancing Exporters
bb.. Green Clause L/CGreen Clause L/CThe transaction flow can be summarized as follows:
1. Buyer issues green-clause L/C in favor of Exporter (Beneficiary)2. L/C is issued by Issuing Bank3. L/C is advised (and may be also confirmed) by Advising Bank 4. Exporter request Loan from Advising Bank5. Advising Bank makes Loan to Exporter (provided that the required
documents are submitted)6. Commodity is exported7. Documents are presented by Exporter for negotiation and payment to
Advising Bank8. Payment (net of the Loan and related interest and fees) is made to
Exporter by Advising Bank which claims reimbursement on Issuing Bank
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(B)(B) Financing ExportersFinancing Exporters
cc.. Revolving L/CRevolving L/CA Revolving Letter of Credit is one where, under the terms and A Revolving Letter of Credit is one where, under the terms and conditions thereof, the amount is renewed or reinstated without conditions thereof, the amount is renewed or reinstated without specific amendment to the credit being needed. It can revolve in specific amendment to the credit being needed. It can revolve in relation to relation to timetime or or valuevalue. .
In the case of a credit that revolves in relation to time, the amount available per month during a fixed period of time, say, six months, the credit is automatically available for the same amount each month irrespective of whether any sum was drawn during the previous month. A credit of this nature can be cumulative (i.e. any sum not utilized during the first period carries over and may be utilized during a subsequent period) or non-cumulative (i.e. any sum not utilized in a period ceases to be available, that is, it is not carried over to a subsequent period).
In the case of a credit that revolves in relation to value, the amount of the credit is reinstated upon utilization, within a given overall period of validity. It is a commitment on the part of the issuing bank to make the L/C available in the original amount whenever it has been used or drawn down.
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(B)(B) Financing ExportersFinancing Exporters
cc.. Revolving L/CRevolving L/C
Revolving L/Cs cover multiple/continuous shipments of merchandise, i.e. the buyer anticipating regular flow of goods from same seller.
Revolving L/Cs enable borrowers (sellers) to rely on ongoing sources of short-term financingshort-term financing. When a buyer and seller have arranged for goods to be shipped on a continuing basis over a designated period, it may be suitable to establish a revolving L/C to handle the shipments as they occur, rather than having an individual L/C for each shipment. This would avoid the fixed costs of entering each time.
The credit will contain instructions allowing the seller (beneficiary) to draw designated amounts over specified periods and may also restrict the amount available for each shipment or control the frequency of shipments during a specified period.
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(B)(B) Financing ExportersFinancing Exporters
dd.. Transferable L/CTransferable L/C
A letter of credit may also be transferred by the original (first) A letter of credit may also be transferred by the original (first) beneficiary to one or more second beneficiaries under various beneficiary to one or more second beneficiaries under various circumstances. For an L/C to be transferable, the first beneficiary must circumstances. For an L/C to be transferable, the first beneficiary must arrange for the (ultimate) buyer to have an L/C opened expressly arrange for the (ultimate) buyer to have an L/C opened expressly stipulating that it is transferable. stipulating that it is transferable.
It is normally used when the first beneficiary does not supply the merchandise himself, but is a middleman (or a trading company) and thus wishes to transfer part, or all of his rights and obligations to the actual exporter(s)/supplier(s) as second beneficiary(ies). The advising bank will then make the L/C available in whole or in part, to one or more other beneficiaries. This type of credit can only be transferred once, i.e. the second beneficiary(ies) cannot transfer to a third beneficiary.
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BUYERTRADER(AGENT)
SELLER
ADVISING/CONFIRMING
BANK
CONTRACT CONTRACT
PRODUCTPRODUCT
ISSUING BANK
Beneficiary 1 Beneficiary 2
Docum
ents
Paym
ent
Transferable L/C FlowchartTransferable L/C FlowchartThe transaction flow can be summarized as follows :1. Ultimate Buyer issues L/C in favor of Trading Company (Beneficiary No 1)2. L/C is issued by Issuing Bank3. L/C is advised (and maybe confirmed) by Advising Bank4. Trading Company instructs Advising Bank to transfer the L/C to Exporter (Beneficiary No 2).
The respective rights under the L/C are transferred to Beneficiary No 2 (transferee) who must comply with the terms and conditions of the transferred L/C in order to receive payment
5. Commodity is exported6. Documents are presented by Exporter for negotiation and payment to Advising Bank7. Advising Bank informs Trading Company that it is holding the Exporter's documents8. Trading Company may substitute its own invoice and documents9. Payment is made to Exporter by Advising Bank which claims reimbursement on Issuing Bank10. Buyers pays Issuing Bank.
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(B)(B) Financing ExportersFinancing Exporters
ee.. Back-to-Back L/CBack-to-Back L/C
Back-to-back L/Cs are an alternative to Transferable letters of credit as a method of facilitating transactions arranged by a trading company.
Back-to-back L/Cs can be used in similar circumstances than those supporting Transferable L/Cs, i.e. back-to-back L/Cs are often used when the beneficiary is not the ultimate supplier of merchandise but the middleman between the seller and a buyer.
This also would be the case if the exporter (ultimate supplier) insists on a letter of credit or wants to be paid before the trading company receives payment from the ultimate buyer. This is because the credit rating of trading companies is often weak and banks would be unwilling to make an advance or issue a letter of credit on behalf of the trading company without the security of another letter of credit issued by another bank for the beneficiary of the trading company. The steps taken in effecting a payment under a back-to-back credit and a substitution of invoices under a transferable letter of credit are similar.
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BUYER(Ultimate
buyer)SELLER BUYER
SELLER(Ultimate
seller)
ADVISING BANK 1
ISSUING BANK 1
ADVISING BANK 2
ISSUING BANK 2
CONTRACT CONTRACT=
L/C 1 Back-to-Back L/C 2
=
payment payment
Trading company
Back to back L/C FlowchartBack to back L/C Flowchart
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(B)(B) Financing ExportersFinancing Exportersee.. Back-to-Back L/CBack-to-Back L/C
However, there are inherent risks associated with every back-to-back credit arrangement since performance under the original L/C is conditional upon the perfect and timely execution of the second L/C. The original L/C which is used as a collateral to issue the back-to-back L/C may not be a good security for payment because a problem or discrepancy with the documents under the first L/C can lead the issuing bank of the first L/C to refuse payment and therefore to the issuing bank (of the back-to-back L/C) to be reluctant in paying the back-to-back L/C. That is basically why, sometimes, banks would prefer to issue an L/C for a creditworthy and reliable enough trading company rather than to rely on a backing L/C opened in favor of this trading company. Alternatively banks advise trading companies to conduct their trade transactions under a transferable letter of credit . The main reason for the banks' reluctance to arrange back-to-back L/Cs is that there isn't any provision in the UCP for this type of L/C (unlike in the case of transferable L/Cs) which, therefore, makes it more difficult for banks to deal with it; banks are not clear and certain about their rights and responsibilities in the back-to-back letter of credit system. However, only one thing is certain and that is the two L/Cs are two separate independent instruments; they are in no way legally connected although they both are part of the same transaction.
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Comparaison between back-to-back and transferable L/CComparaison between back-to-back and transferable L/C
Back-to-back credits can be used as an alternative to transferable credits when the buyers refused a transferable credit, the importing bank does not allow transferable credits, or when the beneficiary is buying and selling on different terms.
Back-To-Back LCs are used when the seller/trader needs funds to purchase merchandise from his supplier but does not qualify for an unsecured bank credit. Back-to-back L/Cs are usually requested by trading companies which do not have sufficient credit in their accounts to open their own L/Cs in favor of the ultimate exporter (or supplier).
Transferable L/Cs are more transparent and more secure, from a credit standpoint, than back-to-back L/Cs. The relative advantage of transferable L/Cs is that they are governed by the rules and regulations of UCP 500 (Article 48 and 49). The UPC offers legitimate ways of safeguarding the interest of trading companies as beneficiaries under transferable L/Cs.
Both forms of L/C typically provide payment or short-term financing to a trading company for a relatively small, one-off transaction. However, traders in many cases may not wish to use what banks advise them to use, i.e. transferable L/C. One of the main reasons is the disclosure of the original exporter (or supplier) to the ultimate buyer; traders in general may not wish to reveal the identity of their suppliers. Another reason would be the limited ability of the trader to prevent delays in shipment and presentation of documents from the exporter (supplier) side.
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(B)(B) Financing ExportersFinancing Exporters
(2)(2) ForfaitingForfaiting
Forfaiting is post-shipment finance instrument. It is the term generally used to denote the purchase at a discount (LIBOR +) by a forfaitor of obligations (i.e. trade debt or receivables) falling due at some future date, which arise from deliveries of goods and services, without recourse to the exporter or any previous holder of the obligation if the negotiable instrument evidencing the debt is not paid at maturity by the obligor or guarantor. The forfaitor then takes over the responsibility of collecting the invoices from the importer, and bearing the risks and losses of unpaid credits.
The term forfait originated from the French word forfait which means to give up. In this circumstance, it means to give up one’s rights to receive payments under the underlying transaction. i.e. the seller giving up his rights to receive future payments to the forfaiter in consideration for a discounted value received immediately. In this arrangement, the face value of the Notes is discounted at an agreed rate from the date of purchase until a future maturity or due date.
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Exporter Buyer
International bank/forfaiter
Buyer’s bank/Guaranteeing
bank
1. Bindingagreementon theforfaitingterms
3. Shipment of the goods4.(a) P
resents documents (or
notes, etc.) for avalization.
2. Sales Contract
4.(b
) P
rovi
des a
vali
zati
on
5. Hands over avalizeddocuments
6. Delivers docum
ents 7. D
isco
unts
and
pay
sag
ains
t th
e do
cum
ents
8. Presents documents forpayment at maturity
9. Repays at m
aturity
9. Repay at maturity
Forfaiting FlowchartForfaiting Flowchart
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Fundamentals of forfaitingFundamentals of forfaiting1. Forfaiting aims at creating a source of finance by the purchase from a seller/exporter
of receivables due from a buyer at a future date.
2. Forfaiting maximizes cash flow, reduce transaction risks, and may enhance competitiveness by offering flexible payments terms to the buyer.
3. The risk of delivery of satisfactory goods or services and the fulfillment of the underlying contract remains with the seller, while the buyer of receivables (the forfaitor) assumes the commercial, political and economy risks of the buyer's country.
4. Forfaiting deals with one single existing and known transaction
5. In forfaiting finance can be provided to 100% of the present value (future value minus the interest discount) is always disbursed.
6. Forfaiting is mostly used for medium- and long-term deals involving cross-border transactions. However, nowadays forfaitors are discounting short-term deals mainly in commodity transactions.
7. Forfaiting deals with negotiable instruments, like bills of exchange, letter of credit, and mainly promissory notes. The Promissory note has the following characteristics:· An unconditional (an irrevocable) promise in writing,· Made by one person to another,· Engaging to pay: at a fixed future dated;
a certain sum in money;to or to the order of a specified person or to the bearer/order .
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FORFAITING - CASE STUDY FORFAITING - CASE STUDY
Exporter : Fox Fresh Exports Zimbabwe
Client : Tesco Supermarket, U.K.Export Value : USD 1,000,000Discounting Bank : RabobankDiscount Rate : 5% flatDays to Payment (Maturity) : 90 days Value to Exporter : USD 950,000
Exporter : Fox Fresh Exports Zimbabwe
Client : Tesco Supermarket, U.K.Export Value : USD 1,000,000Discounting Bank : RabobankDiscount Rate : 5% flatDays to Payment (Maturity) : 90 days Value to Exporter : USD 950,000
The Transaction: Tesco/Fox Fresh Export Zimbabwe The Transaction: Tesco/Fox Fresh Export Zimbabwe
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(1)(1) FlowchartFlowchart
Fox Fresh ExportsFox Fresh ExportsZimbabweZimbabwe
Tesco Tesco SupermaketsSupermakets
United United KingdomKingdom
RabobankRabobank Guaranteeing Guaranteeing bankbank
1. Binding 1. Binding agreement on agreement on the forfaiting the forfaiting termsterms
4. Issues avalized tenored promissory
3.1 Presents notes to his
bank for avalization
2. Airfreights its flowers or fresh vegetables
3.2
Pro
vide
s a v
a l
5. Subm
it the notes
6. D
isco
unt (
5%)
and
pays
aga
inst
the
note
s
7. In 90 days, presents notes for payment
ProceduresProceduresa- Fox Fresh Exports Zimbabwe receives confirmation of value of their exports and settlement dates from Tesco.
b- Fox Fresh Exports Zimbabwe instructs Tesco to issue promissory notes to be paid through its bank to Rabobank.
c- Tesco issues avalized promissory notes to the exporter (this is the traditional way, nowadays it is done more on a bank to bank basis where the buyer's bank issue notes to the exporter bank directly).
d- Rabobank pays Fox Fresh Exports Zimbabwe less the discount (5%).
e- In 90 days Tesco's bankers make final settlement with Rabobank.
ProceduresProceduresa- Fox Fresh Exports Zimbabwe receives confirmation of value of their exports and settlement dates from Tesco.
b- Fox Fresh Exports Zimbabwe instructs Tesco to issue promissory notes to be paid through its bank to Rabobank.
c- Tesco issues avalized promissory notes to the exporter (this is the traditional way, nowadays it is done more on a bank to bank basis where the buyer's bank issue notes to the exporter bank directly).
d- Rabobank pays Fox Fresh Exports Zimbabwe less the discount (5%).
e- In 90 days Tesco's bankers make final settlement with Rabobank.
8. Repaym
ent
8. Repayment
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1. To the exporter (Fox Fresh Exports Zimbabwe):1. To the exporter (Fox Fresh Exports Zimbabwe):
a.a. Fox Fresh Exports Zimbabwe is paid within 7 days of exporting. Once the aval is added, the exporter, instead of waiting for 30 to 180 days for payment and/or borrowing money on the local market to finance his working capital needs, can approach a bank for immediate payment in foreign currency less a discount rate. The exporter would then use the confirmed receivables backed by the aval of the bank as security and would thus receive payment within 7 days days after exporting. In this way, he is able to effectively borrow off-shore without any exchange rate risks, and benefiting also from all interest rates advantages - hence, borrowing costs are reduced dramatically.
b.b. This facility does not require any rigorous credit rating for F. F. Exports Zimbabwe and all the inconveniencing procedures an exporter usually has to go through to obtain an off-shore facility (to obtain for working capital purposes). In this case, all that is required is a promissory note or equivalent guarantee on the part of the foreign buyer unequivocally indicating through his bank that he will pay within the agreed period.
c.c. Fox Fresh Exports Zimbabwe's competitiveness is enhanced as he can afford to give good credit terms to its foreign clients without worrying about cashflow.
(2)(2) Advantages in the Tesco/Fox Fresh Export Advantages in the Tesco/Fox Fresh Export Zimbabwe TransactionZimbabwe Transaction
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1. To the exporter (Fox Fresh Exports Zimbabwe):1. To the exporter (Fox Fresh Exports Zimbabwe):
Now that Fox Fresh Exports Zimbabwe will be getting their payment earlier than before, they can:
Invest any idle portion of their foreign currency (after repatriating what is immediately needed for working capital) for a period of 60 days, in the case of Zimbabwe, before liquidation into Zimbabwe dollars as per the RBZ requirements. This in effect means that Fox Fresh Exports Zimbabwe can recover some of the costs or charges made in the attempt to obtain prompt payment
Fox Fresh Exports Zimbabwe can repay some of their loans (local loans), thus avoiding further crippling interest accruals particularly if the loans are denominated in Zimbabwe dollar terms.
Fox Fresh Exports Zimbabwe can now increase their export turnover and plant efficiency because payment for sales is now on a cash basis.
(2)(2) Advantages in the Tesco/Fox Fresh Export Advantages in the Tesco/Fox Fresh Export Zimbabwe TransactionZimbabwe Transaction
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2. To the buyer (Tesco):2. To the buyer (Tesco):a.a. The buyer (Tesco) will enjoy a bit of credit terms and as such will not be under too much pressure to pay immediately.
b.b. The buyer can now get the product, sell, receive money and invest it before final settlement in 90 - 180 days.
3. To the bank (Rabobank):3. To the bank (Rabobank):a.a. Rabobank (the forfaiter) does not need to worry about country risk (Zimbabwe risk).
b.b. The facility is based on a transaction basis and the risk that Rabobank is taking is with the foreign buyer Tesco, and not with Fox Fresh Exports Zimbabwe.
4. To the country (Zimbabwe):4. To the country (Zimbabwe):a.a. The country, in this case, Zimbabwe, is now collecting its foreign currency receipts faster than before, thereby improving on its balance of payments or foreign currency reserves.
(2)(2) Advantages in the Tesco/Fox Fresh Export Advantages in the Tesco/Fox Fresh Export Zimbabwe TransactionZimbabwe Transaction
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Forfaiting information on the InternetForfaiting information on the Internet Credit Suisse First Boston offers a 12-page “comprehensive introduction to the basic principles of
forfaiting” (adobe format) on web page: http://www.finanzag.csfb.com/html/introduction_to_forfaiting.html or downloaded file: Forfating: an introduction
It also offers a spread sheet for calculating discounts on web page: http://www.finanzag.csfb.com/html/discount_calculation.html
A similar spread sheet is available on http://www.afia-forfaiting.org/forf.htm
“A small business exporter's guide to forfaiting practices in international finance” can be found on web site http://wwwsbanet.uca.edu/docs/proceedings/85sbi154.txt
Further literature
Andy Ripley, Forfaiting for Exporters : Practical Solutions for Global Trade Finance, International Thompson Business Printers, 1996,US$74.95
Margrith Lutsch-Emmenegger, A Guide to Forfaiting, Euromoney, 1998, 128 pages, £125/225 US$
(these books are available through Amazon.com and similar services)
