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.
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:
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.
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.
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:
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:
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.