Open Account Transactions: A Death Knell for Traditional Trade Finance?
Manufacturing companies, retailers and wholesalers are major participants in the trade supply chain. These companies and others, as buyers and sellers within the supply chain, need funding to keep the markets moving. Though banks provide trade finance for buyers and sellers to create liquidity in the supply chain, open account transactions have become more common over the past few years. Open account transactions are those trading relationships in which the buyer pays the supplier upon receipt of the goods with no backing other than the buyer’s reputation.
Use of open account transactions in lieu of financed trade is rising, as large corporations demand open account trading terms from their smaller suppliers. Even middle-market companies are embracing open account transactions. Generally, the banks’ role in open account transactions is minor or non-existent. Therefore, banks’ trade finance revenues are likely to decline as open account transactions take hold. In this article, we explore the degree to which middle-market companies embrace open account transactions and reject trade finance. Further, we look at ways that banks can mitigate their trade finance revenue losses against the impact of open account transactions.
Aite Group conducted a survey of senior financial and accounting managers at 40 US and 25 Canadian middle-market companies in April and May 2008, in order to gauge the use of bank provided traditional trade finance mechanisms. Among the most interesting findings are that traditional trade finance remains a staple for nearly 80% of middle-market companies1, the dollar value of financed transactions is nearly the same as the dollar value of open account transactions, and trade banks have the expertise to assist middle-market clients with open account transactions.
A staggering 94% of US and Canadian middle-market respondents report using open account transactions today. Even as open account transactions gain momentum among middle-market companies, however, traditional bank-provided trade finance still has its role. Seventy-nine per cent of survey participants continue to use traditional trade finance, with 74% of respondents using both open account transactions and traditional trade finance, and 5% using only traditional trade finance (see Figure 1 below). The final holdouts from open account transactions may not have trading partners that they trust enough for open account transactions or may have long-standing trade agreements that require financed trade.
Traditional trade finance, as defined by Aite Group’s survey, includes:
Banks’ revenues from traditional trade finance are dependent on the number of trade finance transactions and the dollar amount of those transactions. Significant movement to open account transactions by middle-market companies can have a negative impact on bank trade-finance revenues in two ways. First, banks charge fees on the number of trade finance transactions, which are declining. Second, banks charge a percentage of the dollar value of individual transactions so lower dollar value trade financed transactions mean less revenue for banks.
According to Canadian and US middle-market survey respondents, 14% of their financed transactions are much higher in dollar value than their open account transactions, 6% are somewhat higher in dollar value, and 8% say the two represent about the same dollar value, for a combined 28%. Nearly the same percentage (27%), indicate financed transactions are of a somewhat to much lower dollar value than open account transactions. Twenty per cent of respondents do not know the relative value of financed to open account transactions.
Banks seem to retain much of the dollar value of financed trade from middle-market companies. Therefore, the greatest negative impact on bank trade finance revenues is fewer per transaction fees due to a lower number of financed transactions.
Of those companies with banks that offer traditional trade finance services, 75% of respondents use documentary credits and 66% of participants use standby letters of credit. Use of documentary credits and standby letters of credit are fairly high, especially given the death knell for trade finance sounded by the adoption of open account transactions. However, only 36% of survey respondents use guarantees and bonds.
Among middle-market respondents that use traditional trade finance, 52% report that it is very to extremely important that their bank supports documentary credits, while 21% say that it is moderately important. Similar percentages apply for standby LCs, with 48% saying it is very to extremely important for their bank to provide support, and 17% indicating that it is moderately important. Bank support is less important for guarantees and bonds than for documentary credits and standby LCs – only 17% of respondents choose very to extremely important and 14% choose moderately important (see Figure 2).
Overall, middle-market companies that use trade finance consider bank-supported traditional trade finance for documentary credits and standby LCs important.
According to Aite Group’s survey, 78% (51 companies) of Canadian and US middle- market companies have enterprise resource planning (ERP) systems. These systems tend to support operational functions at companies, but companies are beginning to use them for finance and treasury functions, as well. The percentage of respondent middle-market companies’ ERP systems that integrate with their banks is low. For trade finance initiation, it is 18%, document sharing is 24%, and exceptions resolution for payments and/or trade documents is 18% (see Figure 3).
Lack of bank integration is ‘not a problem at all’ to ‘a very little problem’ for the Canadian and US middle-market companies using ERP systems without integration. For trade finance initiation, 81% of respondents indicate that lack of ERP systems integration with their bank is not a problem at all or a very little problem. For document sharing, 79% of respondents say that lack of integration is not a problem at all or a very little problem. When it comes to exceptions resolution of payments and/or trade documents, 78% of Canadian and US middle-market companies report it is not a problem at all or a very little problem. Among middle-market companies with existing ERP systems, not integrating exceptions resolution online with their bank is a big to very big problem for 10% of respondents.
While a low percentage, the lack of bank integration for exceptions resolution represents the highest relative percentage of responses of a big to very big problem from middle-market companies. Based on the feedback from Canadian and US middle-market companies, banks need to consider raising their focus on providing automated workflow to resolve exceptions. Banks should consider automating exceptions resolution more than initiation of trade.
Interestingly, among the 14 Canadian and US middle-market companies that have not implemented an ERP system, respondents indicate a much stronger importance for integrating an ERP system for trade finance initiation than those companies with ERP systems. Fifty per cent of participants indicate that it would be extremely important for trade finance initiation. For document sharing, 43% indicate very to extremely important, and 43% indicate very to extremely important for exceptions resolution for payments and/or trade documents (see Figure 4).
Potentially, companies without ERP systems are able to view the possibilities more broadly and consider greater integration benefits than those companies that implemented ERP systems for specific functions.
Traditional trade finance remains a viable offering for banks that support Canadian and US middle-market companies. Although these companies use open account transactions, many of them also need traditional trade finance – especially documentary credits and standby LCs. Banks that have a strong middle market focus for clients and prospects should continue to support traditional trade finance while moving to develop services for open account transactions. Banks can leverage their trade finance expertise in document review and knowledge of legal requirements by country to assist their clients with purchase order and invoice management for open account transactions. By entering into non-financed transactions, banks retain their client relationships and apply their staff capabilities effectively. This approach provides broad-based financial support for banks’ middle-market clients and assists banks in the transition toward open account transactions.
The current economic climate demands risk management. It is likely that the move to open account transactions will be slower than in a thriving economy, although the trend will not reverse. Traditional trade finance is a substantial solution to limit the risks of international trade – non-payment or insolvency of purchaser, non-delivery or late delivery of goods, and incorrect quantity or poor quality of goods – for both the purchaser and the supplier. Banks should use this opportunity to provide consultative services to their middle-market clients by providing guidance on alternative risk mitigating solutions, including the many forms of traditional trade finance that middle-market companies may not have considered in the past, such as guarantees and bonds.
1It is important to note that for this survey, middle-market companies were defined as those companies with annual revenues between US/CA$50m and US/CA$500m. Given the close exchange rate between the United States and Canadian dollars at the time of the survey (US$1 to CA$1.0006 in May 2008), Aite Group did not distinguish between Canadian and US dollars for qualifying respondents.