Trade Finance: The New Value Proposition
With the growing trend of globalisation, corporates are increasingly sourcing from suppliers and selling to customers far away from their traditional home markets. This is driven by a concept know as lowest cost country sourcing, a willingness to go greater distances in order to purchase goods or services at the lowest possible cost. The Internet, advanced communications and ease of travel have opened up new opportunities for importers and exporters to identify and do business with distant counterparties. In this new global environment, trade finance banks are re-defining their value proposition to meet the evolving needs of their corporate customers.
Today’s leading trade banks have a valuable role to play in helping their customers to mitigate risk and cut costs with competitive financing structures, while migrating business processes away from paper-based trade towards lower cost electronic document exchange and processing. In this evolution, new financing techniques are emerging for the benefit of exporters and importers. This article explores the important steps being taken by trade banks to deliver value to their customers through the increasing use of the web for the provision of trade finance solutions that ensure transactional control and risk mitigation. We will also define a practical road map for migrating from documentary trade finance structures towards open account trading solutions, to suit the needs of different markets and business relationships, combined with efficient working capital financing solutions.
With the globalisation of trade, banks recognise the growing importance of their customers’ global supply chains and they wish to become more involved in these activities. This article assesses how supply chain finance fits with more conventional trade finance and shows how these two disciplines interlink and complement each other, at a time when the perceived division between them is becoming increasingly blurred.
In order to compete successfully, trade finance banks now need to offer a comprehensive range of pre-shipment, in-transit and post shipment finance solutions. To achieve this, banks are using a blend of traditional trade instruments, together with a growing suite of open account finance solutions. Similarly, banks are deploying a range of foreign exchange, bulk payment and collection, reporting and liquidity management solutions to support their customers’ international trading activities. This combination of product delivery is increasingly leveraging web-based technologies for the benefit of buyers and suppliers.
Trade finance can be defined as the provision of bank credit facilities and services to meet a corporate’s needs in relation to their export and import activities. The key elements of trade finance are:
Transactional control is one of the principal advantages of trade finance instruments. For example, by requiring a full set of bills of lading in a documentary collection, the importer will not be able to take possession of goods until he accepts or pays a bill of exchange, hence giving the exporter a high level of confidence that this trade debt will be settled. Similarly, an importer using a letter of credit (LC) knows that the bank will only pay away funds if the exporter presents specified documents, which demonstrate that the required goods have been shipped, hence raising the degree of certainty that the correct goods will be received.
International terms of trade are generally agreed by the exporter and importer when a sales contract is negotiated. But the importer and exporter have naturally opposing views of risk, so that terms of trade that are totally satisfactory to one party will involve high risk for the other party. For example, an exporter working on open account loses control of the goods if he sends shipping documents to the importer who can decide whether and when he settles the invoice. Such an act on the exporter’s part requires a high level of trust in the importer’s willingness and ability to settle the trade debt.
This natural tension between buyer and supplier objectives can be illustrated as a ‘risk ladder’, which shows the varying degrees of transactional control or protection for the exporter and the importer that are diametrically opposed.
Terms of trade will depend on negotiations between the exporter and importer before the sales contract is signed. On the one hand, an importer very keen to obtain goods may have to accept an exporter’s request for certain types of protective trade terms. On the other hand, an exporter very keen to win a contract may be obliged to accept an importer’s preferred terms of trade. Commercial practice in the countries involved will also play an important role in determining the terms of trade adopted, e.g. open account is normal practice in the EU and US whereas in Asia, Middle East, Africa and Latin America LCs are more widely used.
One of the marked trade trends identified in recent years is that there is a movement towards open account and away from usage of LCs and documentary collections, which now account for less than 20% of global cross-border trade. However, the overall use of LCs is still widespread, with over US$1 trillion per year of cross-border trade being settled by LC. Furthermore, growth in emerging markets’ business means that traditional LC services and collections will continue to have an important role to play. LCs are particularly suitable in the early phases of new buyer/supplier relationships. In some situations, these LC trade terms continue for years while, in other cases, as trading partners get to know each other better, there is a tendency to move to open account trade terms. Furthermore, LCs are still widely used in a number of emerging markets, but less so between OECD countries. In parts of Asia, for example, exporters use LCs to obtain local finance to fund the sourcing or production of goods. It is also noteworthy that LCs are still mandatory in certain countries where Foreign Exchange Controls prevail. In this global environment, it can be reassuring to work with trade banks with large international branch networks, combining local expertise with global reach. This international footprint often enables the bank to know both the importer and exporter, even though they might be situated on opposite sides of the earth.
Transactional control is a key benefit of trade finance products compared to conventional banking products, as they give increased comfort to the exporter and importer. Transactional control helps the exporter to retain control of documents of title (hence goods themselves) until the importer has accepted a bill of exchange or paid a bill (e.g. under a documentary export collection) or, indeed, under an LC, guarantees the exporter that he will be paid provided he can present documents to a local bank demonstrating that the requisite goods have been shipped. Transactional control also helps an importer to delay paying until he knows he has received the goods he has ordered (e.g. under an import LC).
Over the last 12 months, supply chain finance has received a tremendous amount of attention from CFOs and procurement specialists, as well as their bankers and consultants. This focus has been driven by a desire to develop open account financing techniques to make supply chains more competitive. This in turn has seen the emergence of web-based buyer-backed reverse factoring solutions, which enable suppliers to obtain competitive supplier finance. Pricing generally reflects the credit quality of the buyer at the top of the supply chain. (This type of financing is discussed in more detail below).
In some extreme cases, the level of market attention devoted to this type of financing solution has led a few banks to re-bundle all their trade activities as supply chain solutions. We would not be inclined to take this approach since, in international terms; buyer-backed supply chain finance is more accurately a sub-set, albeit of great added value, within the wider subject of global trade finance. The long-standing product set of trade finance spans a richer range of solutions, both importer and exporter centric, short term and medium term, ranging from transactional control to off balance sheet non-recourse finance. As a further distinction, unlike trade finance, which generally relates only to cross-border commerce, supply chain finance has an extremely important domestic dimension, since buyer-backed reverse factoring can benefit both domestic and international supply chains.
Thus, we do not see supply chain finance taking over from trade finance, but actually complementing traditional trade finance instruments that will continue to have an important role for years to come, meeting the needs of specific markets and specific phases in a business relationship. Similarly, we recognise the need for a trade bank to be able to offer the full range of traditional trade finance and open account supply chain finance solutions.
A growing number of OECD importers are realising that in certain situations, such as well-established supplier relationships, there are cost effective alternatives to LCs and they are pressurising their suppliers to move to open account trade terms. Similarly, from the point of view of exporters, the goal of any business is to increase sales, which can be accomplished by offering their customers attractive payment terms. These improved trade terms make it easier for the importer to purchase goods. Non-OECD exporters realise that if they refuse this move to open account they may well find themselves missing out on business opportunities. They have learned that to be competitive it is sometimes necessary to sell on open account, with extended payment terms.
Importers’ reasons for seeking a move to open account are entirely logical: they wish to cut costs, reduce the need for bank credit lines and improve efficiency. On the other hand, open account terms of trade can be bad news for suppliers: they take on increasing risk and lose access to local finance backed by LCs, resulting in a reduction in valuable funding. Often a supplier’s size and geographical location (e.g. in an emerging market) mean that local financing is very expensive in terms of underlying interest rates, margins and fees.
Capital constrained small and medium sized enterprises (SMEs) find themselves obliged to raise finance through traditional accounts receivable factoring or local bank finance, which can prove expensive. With the globalisation of trade, a growing percentage of receivables are now based on exports to remote markets. These receivables can be harder to finance, since the trade creditors are less well known to the exporter’s local bank. Some banks remain reluctant to include these cross-border receivables as the eligible base for conventional domestic lending. Furthermore, the invoices also carry longer payment terms than domestic receivables. Understandably, these factors can have a negative impact on an exporter’s days sales outstanding (DSO) and working capital.
The growth of cross-border open account business is driving demand for new financing solutions, both pre-shipment and post shipment instruments. Buyers wish to extend payment terms for as long as possible in order to improve their days payable outstanding (DPO), which in turn helps reduce their working capital position. Unfortunately, in normal circumstances, the suppliers’ high cost of finance means that extending payment terms will be prohibitive, placing upward pressure on the suppliers’ end pricing, which may well make the whole buyer initiative self-defeating.
A solution being deployed by a few leading trade finance banks is buyer-backed supplier finance, which creates a win-win for the buyer and supplier. This supply chain optimisation technique provides the buyer with longer payment terms or lower cost of goods, whereas the supplier gets lower cost and reliable finance. This can be structured as non-recourse funds by banks that are experienced in these solutions. It is noteworthy that it is Spanish banks which have pioneered this reverse factoring financing technique, initially in their domestic Iberian markets and more recently in Latin America where they have a dominant market share. These solutions are now also being made available to large buyers in other regions, such as Northern and Western Europe, for the benefit of their extended international supply chains. (Read also The Best Kept Secrets in Supply Chain Finance.)
This reverse factoring structure meets the objectives of large OECD importers sourcing from emerging markets that want to strengthen their core supplier relationships by providing competitive supply chain finance. The key achievement here is less about just reducing the cost of finance for the buyer and more about reducing the cost of finance for suppliers. Market focus is currently around post shipment finance, when goods have been shipped and invoices have been presented and approved by the buyer. The finance made available is generally based on the credit risk of the large buyer at the head of the supply chain, although there are some other variations in the SME market.
Despite the considerable advantage of payer centric reverse factoring, this supply chain finance structure will not always fit with particular characteristics of a corporate or supply chain. Payer centric reverse factoring solutions rely heavily on the large buyer using his strong credit rating to support his supply chain. Given this reliance on the buyer, reverse factoring can only be used where creditworthy buyers are willing to lend such financial support.
In contrast to the buyers described above who want to extend DPO and retain cash flow as long as possible, large exporters want to accelerate the conversion of international receivables into cash, hence improving their own DSO. Banks are therefore deploying other web-based solutions for this second important requirement. Indeed, in some cases, the customers with these receivables financing requirements are the accounts receivables units of the very same organisations whose accounts payable units are beginning to benefit from reverse factoring, as described above. Both aspects, namely efficient payables financing and receivables financing, help to drive improved working capital in a business, improving profitability and shareholder value on both sides of the balance sheet.
Handling receivables from vendors, however, rather than approved invoices from buyers, can be more complex. Instead of one debtor, there are now many debtors, with varying conditions and payment terms to take into account. For these requirements, banks are providing a growing range of web-based invoice discounting services (typically backed by credit insurance), or export factoring, with or without recourse to the supplier. One fundamental difference between supplier-backed receivables financing and buyer-backed reverse factoring is that, while the latter benefits from buyer data (i.e. knowledge that invoices to be financed have been approved), factors and invoice discounters are generally reliant on information solely from the supplier at the point when funds are advanced. A bank with a large branch network, with a deep knowledge of businesses of all sizes operating in its geographical footprint gives the bank a significant advantage in assessing the credit risk of debtors in such transactions.
Some pioneering corporates are already extremely advanced in automating their processes and reducing the volumes of paper-based and manual processes in their international trade activities. On the other hand, many corporates are barely setting out on this journey. Banks closely involved in this space recognise that a phased approach is suitable for this migration from paper to electronic processing. They also recognise that they have a tremendous opportunity to assist in this migration, as a valuable complement to existing trade finance as well as payment and collection services.
A number of innovative banks are beginning to partner with e-invoicing solution providers (or launch their own proprietary solutions) in order to streamline electronic purchase order (PO) distribution, invoice receipt and matching of these documents for buyers and suppliers. This matching is sometimes achieved through a device known as PO flip, whereby the original PO is used as the basis to create a new invoice. The more flexible services being offered by banks include the ability to handle multiple formats of PO’s and invoices, with reformatting, so that each user of the network can continue to create and process documents in the format most easily handled by their own ERP systems. Furthermore, the most sophisticated solutions produce and exchange invoices that are fully compliant with VAT requirements in a wide range of countries.
Recognising that their corporate customers are at varying points along the migration towards e-invoicing, banks realise that they need to provide a combination of paper and electronic solutions that will meet the needs of their customers wherever they are situated on the road towards straight through processing (STP). One of the key advantages of a bank working with an e-invoicing network is that accelerated and automated approval of invoices (which have been matched against POs) are ready to be financed and paid early to suppliers, under a reverse factoring solution, hence improving working capital in the supply chain.
An interesting new development in trade finance is combining financing decisions with logistics information. Logistics companies can track the movement of goods, warehousing, goods inspection and customs clearance, among other key milestones. A few leading banks are now looking at incorporating this valuable transport tracking information into their financing solutions, using web-based solutions. One of the exciting aspects of the merging of the physical and financial supply chains is the ability to deliver finance against a series of milestone events in the trade cycle.
Improved visibility in the supply chain is helping banks to develop a new type of streamlined finance. They are exploring using key milestones in the trade cycle as triggers for the release of finance. Credit can be made available at a decreasing cost of finance as successive transport data is provided showing that the goods are progressing satisfactorily towards their destination and that the contract is more likely to be fulfilled. From a banker’s point of view, this information demonstrates that the risk of default on the transaction is steadily reducing.
Key milestones in the trade cycle which can potentially serve as triggers for finance include:
Of all these possible milestones, the two most popular finance triggers are undoubtedly:
Finance against confirmed POs is where at PO issuance the importer confirms his commitment to pay the face value of the contract. This enables the bank to advance a percentage of the PO value to the supplier. The latter will use these funds to purchase or manufacture the goods that are the subject of the PO. In some markets, the availability of this kind of pre-shipment finance can be a pre-condition for exporters’ acceptance of a move to open account, thereby replacing LCs against which exporters are accustomed to obtaining local finance.
A further development of this event driven finance is in-transit finance. A logistics company has control over goods and can track where the goods are located, for example in a distribution centre or in transit using the logistics company’s transportation capabilities. In these circumstances, a financing partner can mitigate risk in making available finance for these goods. This transactional control can be used to provide competitive financing.
As the next big development in global trade finance, banks are merging their multiple and disparate solutions to create integrated working capital solutions, accessible by exporters and importers, as well as domestic buyers and suppliers. The web has become the key communication medium for a new generation of solutions to make it easier for corporates to access bank solutions to meet their trade finance needs. These platforms combine the best of traditional trade finance products as well as open account solutions, in order to address the challenges of the financial and physical supply chains. They also incorporate cash and liquidity management capabilities, thus consolidating cash and trade solutions.
All these solutions are delivered with the latest technology, which is indeed increasingly becoming a key differentiator, as great efforts are being made to improve efficiency in the front office and middle office. Being web-based and hosted by banks, there is no lengthy set-up or integration to access these platforms. Hence, large trade banks, with the ability to invest in technology and handle large volumes of transactions, have a growing competitive advantage over smaller banks.
The kind of documentary trade finance and open account solutions now being delivered by trade banks include:
Examples of these trade finance and open account capabilities are summarised in the table at the end of this article.
Trade finance banks are working hard to re-define their role in a changing world. While there is undoubtedly a shift towards open account in certain markets and verticals, there is a valuable role for traditional documentary trade finance solutions in many geographical markets and situations, at the early stages of a new business relationship between distant trading partners, for example. Banks can deliver enormous value to their clients in risk mitigation and the provision of finance which in some cases can create off balance sheet solutions and provide credit beyond the capabilities of conventional bank lending. Today’s leading trade finance banks now need to offer a full range of pre-shipment, in-transit and post shipment finance solutions.
There is undoubtedly a merging of trade and cash activities within banks, reflecting our customers’ own activities. Furthermore, there is recognition of the need to adapt solutions to meet the current demands of customers for open account solutions, such as e-invoicing, as well as related financing techniques, in particular reverse factoring. The successful banks will continue to be those that offer a full range of trade finance and open account products, as well as liquidity management and payment capabilities, with the ability to provide holistic solutions to meet the varying needs of their customers in whichever markets they operate, bringing bottom line success to both buyers and suppliers.
|Letter of credit||Documentary collection||Open account|
|Post shipment finance|
|Confirmed acceptance LC: Exporter receives non-recourse payment on presentation of compliant documents.||Discounting accepted bill of exchange: Exporter receives early payment.||Payer centric reverse factoring: Based on buyer-approved invoices, supplier sells receivables to bank without recourse.|
|Deferred payment LC: Exporter receives non-recourse payment on presentation of compliant documents.||Advance against collections: Exporter receives with recourse advance of a percentage of collection.||Supplier centric receivables finance: Bank discounts receivables, often backed by credit insurance.|
|Negotiating bill under unconfirmed LC: Exporter receives advance on presentation of compliant documents.||Discounting bank avalised bill: Exporter receives non-recourse payment.||Export factoring: Exporter outsources collection process to bank/factor and receives advances against a percentage of sales turnover.|
|Bill discounting under sight LC: Exporter is paid at sight using proceeds from bill drawn by importer on his bank.||Forfaiting: Exporter of capital goods receives up-front non-recourse payment against promissory notes or bills avalised by importer’s bank.||Dealer finance: Exporter is paid on shipment, while dealers pay local bank direct from sales proceeds. Significant local bank presence advantageous.|
|Red clause LC: Exporter receives advance for a percentage of LC against specified documents.||Confirmed purchase order finance: Exporter receives advance for a percentage of PO.|
|Receipt & undertaking LC: Exporter receives advance against receipt and undertaking.|
|Import loan (at back end of sight LC) backed by warehouse warrants or trust receipts in favour of bank: Importer obtains advance to pay exporter pending receipt of sales proceeds.||Event triggered finance: Logistics companies can control goods in transit to the order of the bank as security for finance.|
|Risk mitigation/Transactional control|
|Import LC: Importer only required to pay if compliant documents received by bank proving goods shipped.||Documents against payment: Documents only released to importer on payment of bill of exchange.||Matching: POs, invoices and goods received notes.|
|Confirmed export LC: Exporter receives guarantee of payment from local bank against compliant documents proving goods shipped.||Documents against acceptance: Documents only released to importer on acceptance of bill of exchange.||Tracking and control of goods: movement by logistics companies:|
|Transferable LC: Beneficiary can transfer LC to one or more new beneficiaries. Used when first beneficiary acts as middleman/does not supply goods himself.||Advanced Payment Guarantee and or Progress Payment Guarantee: protect importer who makes advance payment before completion of contract.|
|Back-to-back LCs: Two separate LCs where first LC acts as ‘security’ for second LC as potential source of repayment. Used by traders who buy and on-sell goods|
|Standby LC: Enables open account trade, under bank guarantee to pay against specified documents.|
|Upload of electronic POs to create import LCs; on-line amendments.||Electronic advice, review and acceptance of documents.||E-invoicing, electronic PO distribution, PO flip; document matching.|
|Electronic advice and review of export LCs.||Document scanning and electronic archiving.|