Corporate TreasuryFinancial Supply ChainLetters of Credit/Open AccountA Comparison of International Trade Payment Methods

A Comparison of International Trade Payment Methods

In international trade, both the buyer and seller are concerned with the completion of the deal. Having contracted with the seller, the buyer wants to be sure that he receives the goods of the quantity and quality agreed. On the other hand, the seller is eager to receive payments on time and in the currency required once he has sent the goods. In order to meet these demands, various methods of payment have been developed: advance payment, documentary collection, open account, bank guarantee and documentary credits. These methods are discussed and examined in this article.

Advance Payment

This method is beneficial to the seller because he receives payment in advance, even before the goods are dispatched. As a result, he has money in his account even before parting with the goods and he can use it for arranging production and delivery of the goods. The seller, therefore, is has the advantage and need not worry about receipt of the money.

The buyer, on the other hand, faces the following risks using this system:

  • Local regulations might not allow advance payment to a seller.
  • The risk that the seller might not be able to fulfill the contract.
  • Regulations in the seller’s country that might prohibit the sending of the goods.

For these reason, a large number of exporters welcome advance payment rather than documentary credits or bills for collection.

Bills for Collection

While advance payment is more beneficial for the seller, bills for collection are more beneficial to the buyer. Using this method, a bank acts as an intermediary and hence the seller does not have to depend on the buyer only. But the bank’s role is only in the process of routing the documents of transport/title along with other documents. (Collections can either be Clean or Documentary collections, which are covered by the Uniform Rules for Collection, ICC Document 522.)

The seller draws documents in terms of the contract it has entered into with the buyer, hands over those documents to the bank with clear instructions as to the mode of collection, i.e. whether goods are to be delivered against payment or against acceptance of documents (a bill of exchange). If that bill is not paid for some reason, the seller can take action against the buyer under the Negotiable Instruments Act to get payment.

Under this system, the buyer does not have to pay until he has received documents proving transport of the goods from the seller. The seller has a reasonable expectation of getting paid for the goods. Documents will be handed over to the buyer only if one of the above two factors happens. The seller, however, has no guarantee of the bank assuring payments even if he has complied with the terms and conditions. From the seller’s point of view, this is not a satisfactory system of payment – not only because he has no bank guarantee – but because he cannot negotiate these documents and get bank finance.

Bills for collection are becoming more and more popular because of the high cost of letters of credits – not just from the importer’s point of view but also from the exporter’s point if view. They are open to lack of security in obtaining payment though.

Open Account

From the seller’s point of view, open account is the most risky payment system. Under this system, the buyer pays at the end of an agreed period. The seller consigns the goods directly to the buyer or to his order, and documents pertaining to the goods are sent directly to the buyer enabling him to take delivery of the goods. Under this system, the seller is at the mercy of the buyer having sent the goods.

This type of payment is normal in trading arrangements requiring:

  • A high degree or trust between the buyer and the seller.
  • A regular and continuous business relationship between the two parties.

The benefit of this system is that since there is no bank involvement, there is less paper work and consequently lower costs. This system is more beneficial to a large number of exporters and importers and is based on full and undoubted trust between the two parties. Certainly, from the exporter’s point of view, if you are going to release goods and also give your buyer documents to accompany them, you must have a high element of trust; otherwise, you would be out of business.

The letter of credit as a means of payment for international trade between countries is declining. Buyers and sellers are now choosing bills for collection or open account for settlement of their international trade transactions.

Bank Guarantee

When the buyer and seller do not have confidence in each other, they seek the participation of an intermediary who will protect the interest of both parties – this is usually a bank. A bank guarantee is one such method of payment in which the buyer’s bank guarantees to pay the seller in case the buyer fails to pay for the goods supplied by the seller. The following example explains how this method works where Company A in the US is the exporter, Company B in the UK is the importer and ABC Bank is the bank of Company B.

Company A and Company B enter into a contract for the sale of 100 bicycles from Company A to Company B valued at US$10,000. As a result, Company B has to pay US$10,000 to Company A within a period of three months from the date of shipment of the bicycles. In the contract, Company A states that to secure its payment, it wants a guarantee issued in its favour by Company B’s bank.

Company B approaches ABC Bank and requests them to issue a guarantee on its behalf in favour of Company A. If the bank is satisfied with the creditworthiness of Company B, then the bank will issue the guarantee. The wording of the guarantee issued in favour of Company A would be something like: “Having supplied 100 bicycles to Company B, in case of default on the part of Company B in making the payment of US$10,000 to you within a period of three months from the date of shipment, we guarantee to pay you the said amount, upon receipt of your claim that Company B has not made the payment, supported by documentary evidence of shipment of 100 bicycles.”

In reality, if Company A does not receive the payment from Company B within a period of three months from the date of shipment, then Company A will lodge a claim with ABC Bank. This is called as invocation of bank guarantee. On receipt of the claim, ABC Bank will pay US$10,000 to Company A and subsequently recover the amount from Company B. This is an example of a direct guarantee.
However, if Company A does not have confidence in the standing of ABC Bank, then they will demand a guarantee to be issued by a local bank in the US (e.g. Bank of America) in whom they have confidence. In such a scenario, ABC Bank will issue a counter guarantee in favour of Bank of America and request it to issue a local guarantee in favour of Company A.
There are two guarantees in this case: the main guarantee, which is issued by Bank of America in favour of the beneficiary and the counter-guarantee, which ABC Bank issues in favour of Bank of America.

Figure 1: Example of a Bank Guarantee

Conclusion

We can see from the different methods of payment discussed above that each has it pros and cons. Choosing the appropriate method will depend on a number of factors, the most important being:

  • Trust between the buyer and the seller.
  • Convenience.
  • Time, money and energy involved in each of these methods.
  • Availability of finance from the bank.
  • Past track record of the buyer.

Comments are closed.

Subscribe to get your daily business insights

Whitepapers & Resources

2021 Transaction Banking Services Survey
Banking

2021 Transaction Banking Services Survey

2y
CGI Transaction Banking Survey 2020

CGI Transaction Banking Survey 2020

4y
TIS Sanction Screening Survey Report
Payments

TIS Sanction Screening Survey Report

5y
Enhancing your strategic position: Digitalization in Treasury
Payments

Enhancing your strategic position: Digitalization in Treasury

5y
Netting: An Immersive Guide to Global Reconciliation

Netting: An Immersive Guide to Global Reconciliation

5y