Trade Finance

GENERAL PROBLEMS

One important aspect of global markets is, of course, international trade. If we

consider the various problems which will arise in the export/import business, there
are many ways in which banks can provide assistance:

1 Payment services The basic question of money transfers

2 Collection of debts The heart of the matter – how to ensure that we get
paid
3 Extension of credit This involves ensuring that we get paid and the ques-
tion of extending credit using, say, the bill of exchange
4 Finance This may be for the exporter to fund completion of the contract
or for the importer to help pay for goods
5 Foreign exchange Sales/purchases of foreign currency spot, forward and
by way of options, which are discussed in Chapter 8
6 Trading guarantees This covers many questions – quality of goods al-
ready paid for (importer), failure of chosen supplier to perform on award of
a tender (importer), insurance against political risk, sudden withdrawal of
export licences (exporter)
7 Miscellaneous This involves market intelligence, letters of introduction,
correspondent banking facilities and similar services.

PAYMENT SERVICES

There are various ways in which the banks may arrange to remit funds:

❏ Mail transfer (MT) – instruction by letter

❏ Telegraphic transfer (TT)
❏ SWIFT – the Society for Worldwide Interbank Financial Telecommunication,
is the bank-owned cooperative supplying secure messaging services and
interface software to 7800 financial institutions in 202 countries. SWIFT
helps its customers reduce costs, improve automation and manage risk. In
addition to its 2292 member banks, SWIFT users include brokers, invest-
ment managers, securities deposit and clearing organisations and stock
exchanges.
❏ International money transfer (IMT) or Express IMT – modern terms for the
mail transfer and telegraphic transfer
❏ International money order (IMO) – A UK bank, for example, may issue a
cheque drawn on their New York office

254
 Trade Finance 255

❏ Bank draft – This will be drawn on a bank’s home account or on their nostro
account at a correspondent bank.
The last two documents are usually sent by the customer and not their bank.

SWIFT reported its network traffic grew 11% in 2004 to 2.3 billion messages,
compared with, say, 812 million in 1997. On an average basis SWIFT is handling
more than 9 million messages per day.
Securities traffic grew 9% in 2004. The securities sector represents 32% of
SWIFT’s total message volume. Securities messages are the second largest category
of messages used by SWIFT’s customers.
There are four message categories for which the share of business at end of 2004
is shown in Table 1.

Table 1 SWIFT message categories and share of business, 2004

Market Traffic Share

(millions) %

Payments 1355 58.9

Securities 737 32.1
Treasury 148 6.4
Trade services 47 2.0
System 12 0.6

Source: SWIFT.

COLLECTION OF DEBTS

There are methods which may not involve extension of credit:

❏ Advance payment This seems ideal but there are still problems. Suppose
the advance payment is not received? What if the order is cancelled prior
to sending the payment? Time must be allowed to clear the cheque/draft
anyway. From the importer’s point of view, the goods may not be shipped,
or the wrong goods may be shipped, or the shipping documents may be
wrong.
❏ Payment on shipment The exporter emails notice of shipment and awaits
payment. The exporter could find themselves having shipped goods and yet
the payment does not arrive. The bill of lading may give the importer title
to the goods. From the importer’s point of view, the goods may be found to
be faulty or the wrong goods.
256 An Introduction to Global Financial Markets

❏ Open account trading We despatch the goods and send an invoice marked
‘payment within 7 days’ (for example). Full of risk but quite suitable for
circumstances where a valuable trading relationship has been set up and
trust exists. This is very common in the US.

EXTENSION OF CREDIT

We now consider methods which involve extension of credit or cash on delivery

but where we ask for a bank’s help in collecting the money and guaranteeing ar-
rangements to a certain extent.

Bill of Exchange
This is drawn by the exporter on the importer, with the latter agreeing to pay on
demand or at a determinable future time the value of the goods to a specified person
or bearer of the bill. This is explained fully in Chapter 5.
❏ Sight bill or demand draft Immediate payment upon presentation of the
bill and documents, with no required acceptance of the bill by the importer,
as part of a documentary credit.
❏ Usance, tenor or term bill Payable in a number of days or months, usually
‘accepted’ by a bank, the exporter then sells to a bill broker who holds to
maturity or trades.
❏ Documentary bill With documents (bill of lading, invoice, insurance cover
and similar documents) attached.
❏ Clean bill Without documents.

Documentary Letter of Credit

A bill of exchange is drawn by the exporter. A documentary letter of credit is opened
by the importer.
There is an international code of practice for documentary credits set out in the
International Chamber of Commerce’s Uniform Customs & Practices for Docu-
mentary Credits.
(The International Chamber of Commerce was set up in 1919 to define the rules
and norms by which trade is carried out. Sixty national commissions make up its
federal structure.)
The importer opens a documentary credit with his bank (issuing bank). This
arranges for the issuing bank, upon instructions from the importer, to:

(a) make payment to the exporter (the beneficiary); or

(b) pay on or accept a bill of exchange drawn by the exporter; or
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(c) authorise another bank (probably its correspondent bank in the exporter’s
country) to be the advising bank, which makes payment to the exporter or
accepts his bill of exchange (thus becoming a ‘documentary acceptance
credit’). The advising bank may also be asked to be the confirming bank, to
add its guarantee that the exporter will get paid if the issuing bank does not.
(However, some countries, for example Iran, prohibit banks from opening
credits on terms that require an advising bank to add its confirmation.)

All the above have to be backed by stipulated documents. These documents

include:

❏ Transport documents Usually by sea under a bill of lading, which gives

evidence that the goods have been dispatched, purport to be of the type and
quality ordered and be properly transported. A copy of the bill of lading is
the buyer’s claim to possession of the goods when they arrive.
With container traffic these days there may be a forwarder’s bill of lading
– not necessarily a document of title.
If by air there is an air waybill, not however a document of title, merely
acknowledgement of acceptance for delivery.
If by road or rail there is a carrier’s receipt or railway receipt and this
is also not a document of title.
❏ Commercial invoice Specifying quality, quantity and unit and total price.
❏ Insurance documents
❏ SAD document Simplified customs form for the EU.
❏ Other documents Certificate of origin; certificate of quality; health cer-
tificate; veterinary certificate; weight note.

There are potential problems with documents – documents missing, incorrectly

completed or showing an invoice value different from that on the documentary
letter of credit. The bank’s staff check these and should see, for example, ‘freight
paid’ on the bill of lading and insurance certificate if goods are sent CIF (including
cost, insurance and freight). Incorrect documents can cause delays at the port on
landing and incur costs such as local storage.

Types of Documentary Credit

❏ Confirmed credit – when the advising bank also guarantees payment.
❏ Revocable/Irrevocable credit – revocable may be amended/cancelled by the
issuing bank if the importer is not satisfied. This is obviously not usually
acceptable to the exporter but may be suitable for selling to overseas sub-
sidiaries where letters of credit must be used by local regulation. Irrevocable
can only be amended/cancelled with agreement of the confirming bank and
the beneficiary.
258 An Introduction to Global Financial Markets

❏ Sight credit, term or acceptance credit

Sight – the exporter draws a demand draft (bill) and presents it to the cor-
respondent bank for payment.
Term/acceptance – the exporter draws a draft for a period of time (30, 60,
90 days) on the issuing or confirming bank.
❏ Negotiation credit – the confirming bank is instructed by the advising bank
(if they are not one and the same) to negotiate the bill which is drawn on the
advising bank. Or the bill may be drawn on the confirming bank who will
accept it, making it a bank bill and therefore ‘discountable’.
❏ Standby credit – to fall back upon if payment has not been made to the
beneficiary by the other arranged methods.
❏ Deferred payment credit – payment made later.

Typically, in the Western world, all questions of import licences, exchange

controls, insurance and documentation have been settled prior to issuing the letter
of credit.
From the point of view of the exporter there are these advantages:

❏ Assurance of a payment or acceptance on shipping the goods.

❏ If an acceptance, then it will be a banker’s acceptance and at best discount
rates. Who pays the discount is a matter for negotiation!
❏ Generally, the reassurance of a bank (or banks) rather than just the importer’s
promises.

The importer, too, has advantages:

❏ No money will be paid until the goods are shipped and the required docu-
ments lodged.
❏ There may be time to pay, if a bill of exchange is involved. Again, accept-
ance will not be made until the goods are shipped.
❏ All formalities are complete before authorising the letter of credit.

There is, finally, the question of the relationship of the bank and the bank’s cli-
ent wanting to issue a letter of credit. The request to the bank for a letter of credit
must be signed by someone in authority as it incurs obligations for the client (the
‘accountee’). Links with the bank in this day and age may be electronic. The whole
trade deal must conform with local import regulations and EU rules if the client is
a member of that community.
From the bank’s point of view, this is a contingent liability and affects existing
credit agreements and limits. It is also an off-balance sheet transaction which needs
capital under BIS capital ratio rules. The bank will probably charge the client a
deposit and needs authority to debit expenses and charges. If a bill of lading is not
used, the bank may require the goods to be at the disposal of the bank or consigned
to the bank.
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If the bank is the advising bank, it is responsible for seeing that the proposed
credit is authentic.

Documentary Collection
The exporter ships the goods and presents the documents through a bank. The bank
may be requested either to collect the payment in return for the documents or to see
that a bill of exchange is accepted in return for handing over the documents.
The bank, however, is only using its ‘best efforts’ to collect the money or accept-
ance. The importer may still refuse the documents. If the goods have been shipped
and the documents are not documents of title, the importer might even be able to
collect the goods anyway. We may request the collecting bank to protect our interest
in the event of default. If the importer doesn’t pay or refuses the transaction, the
goods (having been despatched) may have to be stored locally.

Effect of 1997 Asian Crisis

Prior to the Asian crisis in mid-1997 (see 'Insurance'), much international trade had
moved to an open account basis or was transacted through payment on documentary
collection. The demand for confirmed letters of credit naturally increased after the
crisis. Although this is more expensive for the exporter, it provided more secure
cover for sales to countries like South Korea, Thailand and Malaysia. The bank
issuing the confirmation would look at it on a case-by-case basis.

FINANCE FOR THE EXPORTER

The exporter may need finance while waiting to be paid other than that provided
by, say, discounting the bill of exchange. Two possibilities are forfaiting and fac-
toring.
Forfaiting This is traditionally associated with longer-term high value capital
goods and construction projects. In the UK, London Forfaiting has a high concen-
tration of deals in excess of £50 million in value. However, others have also done
a lot of 60 day business with £250 000 probably a minimum figure.
A bill of exchange or promissory note is bought ‘à forfait’, meaning without
recourse to the exporter: that is, the purchaser forfaits all recourse to other parties.
They look to the importer’s bank to sign the bill or promissory note to guarantee
payment and the bill/note will be unconditional. They can then sell the note/bill
in an active secondary market. The major currencies are dollars, Swiss francs and
deutschmarks.
For the exporter, forfaiting has the advantage that the finance is without recourse
and has no effect on credit limits with their bank or any other. It is useful where
export credit guarantees (or private insurance) are not available and, where it is
260 An Introduction to Global Financial Markets

available, avoids cash flow problems while waiting for a claim to be met. However,
the forfaiter needs to be satisfied about client, country and political risk and the
discount may be expensive. Also, they may not finance 100% of the value.
Factoring Factoring companies purchase trade debts of clients and usually pay
80% of the full value of debts due to be paid in less than six months. Normally, this
is used for continuous rather than ad hoc business. The remaining 20% is passed to
the client after all the debt has been collected. The factor runs the sales ledger and
collects the money. Factoring can be with or without recourse. The latter can be
very convenient, especially for export business, but is, naturally, more expensive.
Frequently ‘open account’ terms are used. As well as a charge for providing finance,
there is also a service fee for running the sales ledger and collecting the debt. This
service fee varies from 1⁄2% to 2%. A variation on the theme is invoice discounting,
in which the factor provides finance against invoices as before but the client runs
the sales ledger and collects the debt. In the UK, invoice discounting is 85% of the
market and factoring 15%. This is because it is cheaper, companies like to keep
control of the sales ledger and it is more confidential.
The overseas agent of a factor will investigate credit status so that a quick report
can be made to the factor, and the agent will usually underwrite the debt and deal
with any queries locally. Factors may have their own offices abroad or be part of a
network of independent factoring organisations. The largest such network is Factors
Chain International (FCI), founded in 1968. It has 150 members in 50 countries and
factoring/invoice discount business of €760 billion in 2004. In the UK, the Factors
and Discounters Association reported that 40 000 businesses used the services of
38 full members and 8 group members in 2004. At the end of the second quarter
in 2005, turnover for the year to date was £70.9 billion of which domestic invoice
discounting was £59.0 billion. Factoring companies are often subsidiaries of banks
– for example, in the UK, Barclays Sales Financing, HSBC Invoice Finance and
Lloyds TSB Commercial Finance. The exporter has the advantages of dealing with
a bank subsidiary, funding working capital on normal finance terms, not having
to run the sales ledger and collect the debt and (in the case of non-recourse) peace
of mind.
As stated, factoring is only provided for short-term debts and continuous sales
of consumer items. In principle, it is similar to an overdraft.
While most factoring is domestic, international factoring is on the increase. The
biggest markets using international factoring are the Netherlands, Germany, Italy,
the UK, France, Belgium and the US.
Other finance The exporter may require more general financial help than that
merely required to bridge the gap while waiting to be paid – finance to produce
capital goods, for example, that may take up to a year to deliver. Most large banks
have departments which specialise in export finance and have ‘packaged’ schemes
available. Sometimes some form of government aid or support may be available
and the most important of these is insurance from a government export credit
guarantee body (discussed later). If it is a large international project, then the term
 Trade Finance 261

used may be ‘project finance’ with a syndicate of banks involved, and recourse is
available only to the stream of funds from the project. The exporter, in some cases,
may be interested in the question of aid to the importer to help purchase the goods.
In a small number of cases, where factors are involved, the factor’s overseas agent
may get involved with providing finance to the importer also. On many occasions,
however, a key component will be official sources of finance.
There are programmes from donors such as the World Bank, the EU and the
African Development Bank. It is estimated that more than one third of sub-Saharan
African imports are aid-financed. Assistance is focused on countries implementing
the economic reform programmes of the IMF and the World Bank. The paperwork
and bureaucracy are formidable but payments are guaranteed and there is no cur-
rency risk.
In other cases, banks provide ‘buyer credits’ in conjunction with export credit
guarantee insurance.

FOREIGN EXCHANGE

This subject was dealt with in Chapter 10.

TRADING GUARANTEES

The question of guarantees has been mentioned and the concerns of both exporters
(political and currency risk) and importers (faulty goods or general non-performance
of contracts). There is a series of schemes for trading guarantees other than export
credit guarantees. These refer to guarantees backed by banks.
Bid or tender bond This is required to support an exporter’s offer to supply
goods or a contractor’s offer to carry out a service.
The bond safeguards a buyer against loss if the tender is awarded but the seller
fails to proceed by signing the contract or submitting a performance bond.
A bid bond is guaranteed by the seller’s bank and is usually 2%–5% of the value
of the contract.
Performance bond When the seller’s bid is accepted, the bid bond is replaced
by a performance bond, usually 10% of the value of the contract.
It is issued by the seller’s bank, guaranteeing that he will supply goods (to the
standard required by the buyer) or perform a service. If the buyer does not accept
that goods are up to standard then they can claim under the performance bond.
Advance payment guarantee The buyer pays the seller an agreed percentage
of the contract price as an advance payment, which can be claimed back if goods/
services provided are not satisfactory.
Retention monies guarantees / progress payment bonds Part of the contract
price (usually 5%) can be held back by the buyer for a certain period to give time
262 An Introduction to Global Financial Markets

to assure themselves that the goods or services supplied are satisfactory, or stage
payments may be made on a similar basis.
These may be conditional or unconditional – for example, conditional on the
seller admitting the fault or having won an arbitration proceeding or legal case.
The bank must have a counterindemnity with their client, authorising debit of the
said sum if money is paid under the guarantee. ‘Unconditional’ means that the bank
will pay up simply on the signed statement by the buyer that the seller has failed
in their obligation.
The bank guarantee may have to be paid even if the bank’s client goes into
liquidation.
Export credit guarantees Government departments often provide exporters
with facilities for insuring their shipments of goods against default by foreign
importers and most other risks, except for normal marine insurance. Premiums are
charged but the service is generally provided on a non-profit making basis. Such
government departments do not themselves extend export finance but in providing
insurance against risk encourage the banks to do so.
There are, however, also private insurers that will quote premiums for trade
risk; for example, in the UK, Trade Indemnity. The UK’s Export Credit Guarantee
Department was founded in 1919. There is a distinction drawn between short-term
projects, up to two years, and longer-term risks. The short-term end was located in
Cardiff and called the Insurance Services Group (ISG). However, the government
sold this in December 1991 to the Dutch insurer NCM. The new name is ‘NCM
Credit Insurance’. NCM also took control of the short-term export insurance in
Sweden following the collapse of Svenska Credit.
The insurance protection is against non-payment, insolvency, withdrawal of im-
port licences, problems due to foreign government decree and war and earthquake.
Cover is typically up to 90%. The element of risk can be noted when we see from
a report in 2003 that the UK’s ECGD had run up debts of £9 billion, dating back
three decades, much of it to poor countries. It was estimated that only £2 billion
was recoverable.
Given export credit guarantees, the banks are obviously happier to provide export
finance and may arrange and administer the policy as part of the deal.
Other export credit guarantee organisations are:

❏ Euler Hermes Germany (private sector)

❏ NCM Holland (private sector)
❏ COFACE France (state majority holding)
❏ SACE Italy (state majority holding).

An example of international cooperation here is seen in the case of the financing

of the two A340 and three A320 Airbus passenger jets for China Eastern Airlines.
Export credit finance of $363 million has been organised by BNP Paribas with the
 Trade Finance 263

assistance of the US Export-Import Bank, ECGD (UK), Coface (France) and Euler
Hermes (Germany).
The biggest names in international trade finance are ABN Amro, Citigroup and
Deutsche Bank.

MISCELLANEOUS SERVICES

Export houses These are market experts who know about shipping, insurance,
quotas, licences, exchange terms and local conditions. They may:

❏ Handle all the paperwork and even promote sales abroad but the exporter is
still the principal although the export house carries the risk
❏ Act for an overseas buyer – find a supplier, arrange shipment and insurance
and confirm the contract on the buyer’s behalf
❏ Act as an agent and buy goods and resell them but only against firm or-
ders.

Confirming houses Similar to export houses but will place an order for a buyer
as a principal and will pay the exporter when the goods are despatched. May ar-
range credit for the buyer.
International credit unions Finance houses and some banks have entered into
reciprocal arrangements to arrange local finance to help an importer to import goods
from a fellow member. An exporter, for example, may be asked by the importer of
capital goods for instalment terms of payment. The bank may be able to arrange
this through the partner in the credit union in the foreign company. The local
bank/finance house will investigate and arrange finance – typically for machinery
and capital goods generally. Examples are European Credit Union, Amstel Club,
Export Finance International.
Barter/Countertrade These arrangements are common where currencies are not
convertible or subject to any restrictions preventing normal issue of export licences.
Barter is a simple exchange of goods; countertrade is a wider term including things
like counterpurchase and buy-back. Under these arrangements, exporters may agree
to buy back goods from the importing companies, for example, the exporter of tex-
tile machinery must agree to buy back textiles. Alternatively, the exporter agrees to
buy back goods in a more general way to a given percentage value of the exports.
For many years, Russia dealt with Finland on the basis that Russian oil purchased
by Finland accumulated credits that could only be used to buy Russian goods.
Other examples: car imports into Tunisia (Peugeot, VW) were only permitted on
the basis that spare parts were purchased from Tunisian companies to a value of
50% of the cost of the car; Balfour Beatty in the UK won a contract for £2 million
in Malaysia on the basis that Balfour Beatty had to find buyers for tin, palm oil
and rubber goods.
264 An Introduction to Global Financial Markets

Barter and countertrade have now become a very big international business, with
specialist companies like ICON International and Attwood Richards. For example,
Keebler, a US biscuit company, was left with $1 million of unusable packaging.
Attwood Richards asked Keebler UK to fill the packaging with biscuits worth
$14 milion for sale in markets where Keebler had no presence – Russia, Ukraine
and the Baltic States. Keebler was paid in trade credits, eventually exchanged for
packaging and shipping services. Attwood Richards also arrange barter for surplus
seasonal goods – swimwear, beach umbrellas and golf clubs. Trade credits have
also been used to buy office furniture, computers, cleaning services, hotel rooms
and airline seats.
General Banks also provide a host of other services in connection with export/
import business – market intelligence, credit status enquiries, letters of introduction,
correspondent banking, translation, legal and accountancy facilities.

SUMMARY

Banks facilitate international trade with cross-border payment systems. The SWIFT
system is the most important.
Simply sending an invoice to the importer and awaiting payment is open ac-
count trading.
Credit may be extended by the use of a bill of exchange which may be a sight,
tenor, documentary or clean bill.
A promise by the importer’s bank either to pay for the goods or to sign a bill of
exchange on despatch is a documentary letter of credit, which may be revocable
or irrevocable. The importer’s bank is the issuing bank in this connection and the
exporter’s bank is the advising bank.
The exporter is the beneficiary. If the exporter’s bank agrees to pay for the
goods, even if the importer or the importer’s bank doesn’t, it is a confirmed letter
of credit.
With documentary collection, the exporter’s bank attempts to obtain payment
by offering the shipping documents to the importer’s bank.
Finance for export might be based on forfaiting or factoring. There may also be
official help from development banks. Export credit guarantees, offered by gov-
ernments or the private sector, insure against non-payment. The banks offer other
guarantees such as bid or tender bonds, performance bonds, advance payment
guarantees and progress payment bonds.
Miscellaneous services offered by banks include acting as export and confirming
houses and assisting with barter and countertrade.