Demystifying Trade Finance
Trade is one of the oldest human commercial activities. The benefits of trade are far reaching, as it has shaped and transformed the world as we know it today. Trade has lifted people out of poverty, forged alliances between people, companies, regions and countries. Unfortunately, trade also has a darker side to it, having been the cause of conflict and war between nations throughout history.
As trade is very often a cross-border activity, it soon became evident amongst practitioners that unless some form of common understanding and mutually agreed trade finance payment mechanisms were put in place and accepted by all players, trade could not be conducted safely. Well established and traditional payment instruments such as Documentary Letters of Credit (LCs) and the fast-growing structures such as Supply Chain Finance, supplemented with risk mitigating instruments, such as Credit Insurance, proved essential towards ensuring that trade is possible and safe.
The backbone of any trade deal is the contract agreed between the parties. The contract needs to be clear, and as much as possible not subject to misinterpretations. One needs to be mindful as to which jurisdiction or arbitration the contract is made subject too, as this will be the jurisdiction used in case of a dispute and ultimately any litigation in court. Many companies would prefer to have the contract issued subject to their home jurisdiction. In cross-border trade, the choice of jurisdiction may be a bone of contention between parties, with each party pushing to make the contract subject to his/her domestic law. In order to reach middle ground, many contracts are made subject to well-established jurisdictions such as those of the United Kingdom or Switzerland. It is common to witness contracts which are subject to these jurisdictions, even when the parties involved are based elsewhere.
In contracts involving the movement of goods, parties need to pay special attention to their respective responsibilities and obligations. The contract needs to be clear with regards to where one’s responsibility commences and finishes, and the obligations of each party. Up to which point is an exporter responsible for paying freight? Where does the risk lie, if any loss or damage to the goods occurs? In order to establish some common ground, the International Chamber of Commerce (ICC) issued guidelines known as ‘Incoterms, the first edition of which was published in 1936. These guidelines have been revised over time to keep abreast of commercial and transport practices. The current edition was officially published on 1 January 2011. Contracts which are made subject to the latest Incoterms make reference to ‘Incoterms 2010’.
A typical example of an Incoterm is CFR – Name port of Destination. Incoterms 2010 (Cost and Freight – Name port of Destination)
In a contract made subject to say CFR – Name port of Destination. Incoterms 2010, the parties may have agreed, amongst other conditions, that the seller (exporter) would be responsible to load the goods sold on board a vessel chartered by the exporter. The exporter would also be responsible for the freight until arrival at the port of destination. On the other hand, the buyer (importer) would assume responsibility of the goods once loaded on board the vessel. The buyer (importer) would also be responsible for unloading the goods once these have arrived at destination.
Once the relevant obligations and responsibilities are agreed upon, the parties will need to concur on the method of payment. Payment terms may vary from ‘payment in advance’ to settlement on ‘open account terms’; the former being the most advantageous to the seller, and the latter to the buyer. The method of payment that is used will depend on the goods traded, the parties involved, and the geographic context within which the trade is done.
Documentary Letters of Credit (LCs)
A Documentary Letter of Credit (LC), is an instrument which guarantees the payment to the supplier, and extends comfort to the buyer in terms of receiving the goods of the agreed quality and within the agreed delivery period.
An LC may be described as a conditional bank guarantee issued by a bank on behalf of the buyer (importer), to pay the seller (exporter) an agreed sum of money, provided that the documents called for under the LC are presented, and that all other terms and conditions are met.
In order to ensure quality, the buyer, may call for an independent third-party quality inspection certificate. The latest date of delivery or shipment is included in the LC. Documents with a shipment/delivery date after the date stated in the LC will invalidate the LC and its guarantee of payment.
LCs may make reference to the contract agreed between the seller and the buyer. However, the LC and the contract are distinct from one another. Banks will only make reference to the LC’s terms and conditions to determine payment, and are not bound by the terms of the contract. Whether the payment is guaranteed depends solely upon the documents presented under the LC. Any shortcoming identified under the contract will need to be settled between the parties.
LCs are governed by the ICC Uniform Customs and Practice for Documentary Credits – UCP 600.
Documentary Collections (Collections)
A seller may choose to export the goods but without giving access/possession of the goods to the importer unless payment is received. Under the Collections sytem, it is customary that the Bills of Lading (which are documents of title), together with other documents, are sent to the buyer’s bank with instructions only to release these documents to the buyer against payment. Once the buyer effects payment, the Bills of Lading are released and used in order to take possession of the goods.
Collections are handled according to ICC Uniform Rules for Collection, as per ICC Publication No. 522, 1995 Edition, or URC522 in short. One needs to keep in mind the fact that different countries may also apply local rules and customs when handing Collections.
Whilst for sales supported by LCs, banks would be guaranteeing payment to the supplier, in the case of Collections, banks play a more passive role for sales i.e. the bank’s role is to forward the supplier’s documents to the bank of the buyer, and act as the payment channel.
LCs and Collections have shown a downward trend over the years, but still account for about USD1.5 trillion in annual mechanise traded, with Vietnam ranking first as the market receiving the largest volume of export LCs, and Iran showing the highest yearly growth in import LCs.
Open account trade is nowadays used inthe majority of trade deals. This reflects the increase in importance of Supply Chain Financing. As many of the major deals take place between well established companies with robust balance sheets, the need to use secured instruments, such as LCs, becomes less relevant. One major factor contributing to this change is that of cost, since LCs tend to be costlier than working with open account trade. Additionally, many deals are conducted intra-company, i.e. between companies of the same group. For example, a manufacturing company may be purchasing its raw materials from a mine in which it holds a majority shareholding, and selling to a retailer which belongs to the same shareholder.
In recent years, we have also witnessed a substantial increase in ‘factoring’ and ‘invoice discounting’, which are financing tools associated with open account sales. Factoring and invoice discounting are methods of providing working capital, commonly available in mature markets. In the case of factoring, the financing party may take control of the sales ledger and chases customers for settlement, whilst when using invoice discounting, it is usually on a case-by-case agreement, whether discount is with or without recourse on the customer.
The risk of open account trade is usually mitigated by credit insurance. Many companies are offloading part of the risk through credit insurance, as cover for the possibility of default payment by the buyer. It is also common practice between a small number of banks to share the risk of a particular borrower by way of a syndication with other banks (i.e. a group of banks each assuming a percentage of the overall risk) or through Club Deals arrangements by leading banks to share risk.
When goods are purchased by way of advance payment, risk is usually diluted by putting in place.’Frustration Contract Insurance Policy’ or by asking the supplier to issue guarantees, in the form of an ‘Advance Payment’ or ‘Performance Guarantee’. Advance payments are usually a way in which the buyer finances a supplier in return of a bank guarantee, issued on behalf of the supplier, and under which one can claim in case the supplier does not supply the goods.
Compliance and Regulatory Requirements
‘Know Your Customer’ protocols and regulatory requirements imposed on banks and financial institutions are changing the way counterparties interact between one another. The reputational risk associated with non-compliance, and the financial exposure that might arise, has resulted in a contraction of bank correspondent relationships, with most financial institutions reducing their correspondent network drastically. Correspondent relationships are entered into by a bank to service transactions that originate or are completed in foreign countries, thus acting as the bank’s agent abroad. This is mainly due to high compliance costs and the desire to avoid unnecessary reputational risk – in fact the term used to describe this phenomenon is ‘de-risking’. The African continent and a number of CIS counties were the ones most impacted by the loss of bank correspondent networks, particularly in relation to US banks. This has made the trading of commodities, which is primarily denominated in USD, more difficult.
Market Trends and Developments
A growing de-risking scenario is resulting in substantial, growing levels of unmet demand for trade finance. Financial Technology (FinTech) companies, is a new class of companies that are using technology to improve financial activities. Many of these companies are in start-up phase, which have identified an opportunity and are ready to move in and fill this gap. As these are private companies, the level of regulation applicable may be somewhat lower than that imposed on banks and financial institutions. This allow them to be creative and to devise innovative products to meet the ever-changing trends in trade finance.
Trade Finance Funds are also becoming an alternative source of trade financing. These funds are offering direct competition to banks, and are a prime source of financing for small and/or newly established trading companies.
Meanhwhile, large European and American banks are dedicating substantial resources to be at the forefront of ‘Blockchain’ technology. Blockchain can reduce the costs of managing trade finance through automated processes, offer a secure platform in handling cross-border deals and drastically reduce fraud.
Other interesting developments which deserve to be followed concern peer-to-peer lending and the ever-increasing use of cryptocurrencies. Although these are not yet considered mainstream, world trade is changing. Old trade corridors are drying up, while new stream flows are emerging. Trade finance is evolving and changing to a more globalised but regulated environment.
Trade finance goes hand-in-hand with international trade, and it is impossible to separate the two. Trade finance is a mosaic made up of different components: exporters, buyers, manufacturers, traders, logistics and shipping companies, insurance companies and banks. Once all the pieces fall in place the real picture emerges, a picture which we witness every day through millions of transactions, and which affects the way we live.