Importers and exporters normally require intermediaries such as banks or alternative financiers to guarantee payment and also the delivery of goods. Cash advances or trade credits on open accounts usually develop after the buyer and seller develop a trusted relationship; therefore trade finance requires financing mechanisms to help support these transactions.
Support for trade finance includes facilitating payment in a secure and timely manner (e.g. SWIFT), mitigating possible risks through credit insurance, and tracking the shipment of goods when they are in transit.
Payments have varying types of risk: for the importer and the exporter. Here we cover 4 types of payment methods: cash advances, letters of credit, documentary collections and open accounts. 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.
The importer assumes the risk as a cash advance requires payment to the exporter before the goods have been shipped. Cash advances are common with internet businesses, and low value orders.
As an exporter, a cash advance is by far the least risky payment method; it provides them with up front working capital to produce and/ or ship the goods, and security (no risk of no or late payments). Conversely, as an importer, a cash advance can cause cash flow problems for the business, and can be problematic if the goods aren’t up to standard, faulty, or not delivered on time.
Letters of Credit (LCs)
Letters of credit (LCs), also known as documentary credits are financial, legally binding instruments, issued by banks or specialist trade finance institutions, which pay the exporter 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 a confirming (or advising) bank respectively. The financiers and their creditworthiness are crucial for this type of trade finance: it is called credit enhancement – the issuing and confirming bank replace the guarantee of payment from the importer and exporter. In this section, and in most cases, we may consider the importer as the buyer and the exporter as the seller.
An LC transaction generally happens as follows
An importer agrees to buy goods from an exporter – a purchase order (PO) is issued
The importer will approach an issuing bank (trade financier) who will issue an LC if it fulfils their criteria (e.g. they are creditworthy)
The exporter will work with a confirming bank who will request the LC documents to be shipped from the issuing bank of the importer
The confirming bank will then check the LC and if the terms are correct, the exporter can then ship the goods
The exporter then sends the relevant shipping documents to the confirming bank
Once the confirming bank has examined the shipping documents in strict compliance against the LC terms from the issuing bank, they will forward these documents on to the issuing bank
Payment is made according to the agreed terms; guaranteed by the issuing bank
The issuing bank then releases the shipping documents so that the importer can claim the goods that were shipped
Depending on the terms agreed, the issuing bank then transfers money to the confirming bank who will then transfer this money to the exporter
LCs are flexible and versatile instruments (we will talk about the different types of LC below). The 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).
Demystifying the Letter of Credit
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. We’ve put together a quick summary of terms that are common in LCs.
The LC can be cancelled or changed at any time by the buyer or the issuing bank without notification. It is important to note that in the latest version of the UCP 600, revocable LCs have been removed for any transaction undertaken under their jurisdiction.
The LC cannot be unilaterally reversed, unless all parties (the issuing bank, confirming bank, buyer and seller agree).
The status of an LC is ‘confirmed’ once the confirming bank (of the exporter) has added its obligation to the issuing bank. The obligation could be a guarantee or assurance of payment.
An unconfirmed LC is guaranteed only by the issuing bank (i.e., there is no confirmation by the advising bank). This type of confirmation is the most common in LCs, although where a jurisdiction has economic instability or political unrest, payment could be at risk.
If the beneficiary is an intermediary for the real suppliers of goods or services, the payment will need to be transferred to the actual suppliers.
An un-transferrable LC disallows payments from being transferred to third parties.
Here, the issuing bank has to pay the beneficiary.
The issuing bank is obligated to pay the beneficiary or any bank nominated by the beneficiary.
Only one advising bank can purchase a bill of exchange from the seller in the case of a restricted LC.
The confirmation bank is not specified, which means that the exporter can show the bill of exchange to any bank and receive a payment on an unrestricted LC.
Payment can be deferred in the case of a usuance LC which gives time for the buyer to inspect or even sell the goods.
If an LC is at sight, it is payable as soon as the documents have been verified and presented.
In the case of DC, the exporter will request payment by presenting its shipping and collection documents to their remitting bank. The remitting bank then forwards 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 risks, nor do they guarantee payment; banks just control the flow of the documents.
With documentary collections, the bank does not cover credit and country risk, however, they are more convenient and more cost-effective than Letters of Credit and can be useful if the exporter and importer have a good relationship, and if the importer is situated in a politically and economically stable market.
An open account is a transaction whereby the importer pays the exporter 30 – 90 days after the goods have arrived from the exporter. This is obviously advantageous to the importer and carries substantial risk for the exporter – it often occurs if the relationship and trust between the two parties is strong.
Open accounts help increase competitiveness in export markets, and buyers often push for exporters and sellers to trade on open account terms. As a result, exporters may seek export finance to fund working capital whilst waiting for the payment.