Open Account Trade and the Changing Nature of Risk in the Supply Chain

Globalisation continues to offer corporates access to new trade markets, leading to the emergence of more sophisticated risk management techniques and physical supply chain practices. Furthermore, traditional finance instruments, such as letters of credit (LCs) have played an important role in developing world trade but corporates are now asking if these instruments, which are based on centuries-old practices, remain appropriate in the modern business world.

A Closer Look at Letters of Credit

The introduction of LCs and their subsequent standardisation over the years (e.g. UCP rules) provided major benefits to trading parties as a means of promoting global trade. The main advantages associated with LCs include:

• Guaranteed payment once the underlying conditions, which are documentation based, have been met. Early on this created an important principle of separating credit risk from business performance risk (i.e. financial standing versus quality of goods or compliance with contract).
• For the supplier, a LC transfers credit risk from the buyer to a trusted third party, typically the buyer’s own bank, although the ability to receive funds is still contingent on the performance of third parties, such as freight forwarders, to produce LC compliant documentation.
• LCs allow the transfer or assignment of trade proceeds through several layers of supply chain and also allow for early payment or financing mechanisms to be built in, i.e. in the form of a bill of exchange, which can then be discounted at preferential financing rates by the ultimate holder.

LCs still have a role as financing instruments and their use has been aided by improvements in the regulatory environment with initiatives such as UCP 600 and also better technology platforms to ease their administration. However, LCs imply that a transfer of risk from the buyer (i.e. corporate) to the local bank represents the most suitable approach for raising finance. In fact many banks mitigate their risk to corporate obligations by re-selling it through a variety of instruments, such as collateralised debt obligations (CDOs).

In addition, when discounting LCs there are two risks to consider – the risk of the issuing company and the risk of the issuing bank. In some cases, the risk of the bank is greater than that of the corporate on whose behalf they have issued the LC.

There are other institutions that are happy to assume corporate risk, including hedge funds and insurance companies as well as capital market instruments, such as asset-backed commercial paper to finance receivables. However, while these methodologies are highly effective in terms of financing costs, the structures commonly used fail to separate business performance from credit risk.

A New Approach in Open Account Trading

One approach to supply chain financing is based on the separation of business performance from credit risk, a principle established by LCs, but in a manner which benefits multiple layers of the supply chain based on the creditworthiness of the end-buyer.

An example of this is an industry procurement utility, which enables the separation of risk and credit enhancement of the underlying receivable. This, in turn, can be financed to facilitate synthetic early payment programmes through multiple layers of the supply chain. These programmes allow corporates to take advantage of supplier early payment discounts and therefore enhance earnings growth as well as improving required working capital.

Furthermore, the risk to intermediate layers can also be reduced through ‘toll manufacturing’ and ‘toll distribution’ programmes, which achieve the ‘netting’ of trade exposures without the need for traditional sell/back back arrangements for components or finished goods while reducing transaction taxes.

Separation of credit risk and the resulting supply chain transparency also allows for optimal risk transfer and financing mechanisms, which include insurance products (credit insurance and/or monoline wraps) and facilitates sales to banks and hedge funds, issuance of asset-backed commercial paper conduits, or other methods.

Financing structures can be designed to be in strict compliance with off-balance sheet treatment under various accounting standards and optimise tax structures.

An Industry Supply Chain Example

The paper and printing industry is a good example to demonstrate the benefits of an industry procurement utility for each participant in the multi-layered supply chain. The challenges currently faced in this industry as a result of conducting business in the traditional method are:

• Printers in the middle of supply chain are the weakest link in this chain due to their small size and financial weakness, which makes it difficult to underwrite sufficient credit limits.
• Credit constraints significantly reduce velocity of the system causing low capacity utilisation in printers with resulting negative impact on profit margins.
• Market ‘overcrowding’ is putting pressure on margins.
• Costs are increasing while margins are decreasing.
• Credit insurance is often at maximum capacity, which creates significant delay in delivery of goods.

Substantial outsourcing activity by large end buyers to print managers, who are creditworthy and against which sufficient credit limits can be underwritten. At the same time, there is substantial outsourcing activity by large end buyers to print managers who are creditworthy and against whom sufficient credit limits can be underwritten.

The use of a procurement utility provides significant improvements in working capital and profitability for all participants. The latter is crucial since traditional methods for working capital improvement have tended to ignore the impact on profitability.

Additional benefits at each layer of the supply chain can be described as follows:

Print managers:

• Improves their choice of printers as the paper component is consigned through the printers and therefore allows for credit limits to be freed up.
• Increased competitiveness: ability to win new business and retain existing clients.
• Outsourced procurement with increased visibility and provides full transparency on volume rebates.

Printers:

• Reduces capacity issues with paper merchants.
• Strengthens relationships with print managers.
• Reduces idle time for printing equipment.
• Early payment of receivables without recourse at lower cost
• Supports any turnaround plan for financially distressed printers.
• Opens up opportunities for new business

Paper merchants:

• Improves choice of printers through removal of credit limit constraints.
• Outsourced procurement with increased visibility that provides full transparency on volume rebates.
• Increased competitiveness: ability to win new business and retain existing clients.

Conclusion

The supply chain is emerging as the next frontier that companies are focusing on to drive financial advantage over their competitors. Companies in industries undergoing power shifts or with financially weaker tiers should evaluate supply chain finance opportunities to drive working capital and earnings improvements. An industry procurement utility approach is the next evolution in the new frontier of the financial supply chain.