Open Account Trading: a Question of 'Adapt or Die'?
The patterns of global trade have radically changed over the past 20 years – with Organisation for Economic Co-operation and Development (OECD) countries moving away from being producer/exporter economies to being buyer/importer economies, largely from non-OECD emerging markets. It is a shift that has had a profound impact on the way trading partners deal with each other – especially with respect to risk and finance.
The changes are most obviously seen in the terms of trade. According to SWIFT, open account trading – that is, trades that are not protected by a bank-issued Letter of Credits (LC) guaranteeing payment – now accounts for 80% of cross-border trade, some US$12.6 trillion in value. It also accounts for virtually all the growth in world trade over the past 10 years – spurred on by European and US multi-national companies moving their Asian manufacturing units towards open account trading.
Such figures add up to a wholesale shift in the terms of world trade – and a rapid one at that. Some surveys report that, just in the past 10 years, the 80:20 ratio has been inverted – with 80% of trade now undertaken on open account, where once 80% would have been supported by documentary credits such as LCs. Exporters, it seems, need to adapt to the paradigm shift, or die.
Most attribute this seismic shift to changes in trade flows, with a greater proportion of manufacturing located in emerging markets with less bargaining power than their purchasers in OECD markets. Yet significant increases in technology have also encouraged open account trading through increasing visibility of the physical and financial supply chain, which increases comfort levels throughout the supply chain.
But there is an argument that, even without the changes in trade flows and technology, the LC would still be viewed as an old-fashioned instrument. While still largely viewed as safe and reliable, a key problem is that LCs – the traditional form of risk mitigation against cross-border credit risk – are increasingly seen as slow, expensive and prone to errors. This is an image not discouraged by self-interested parties such as credit insurers, factoring houses and forfaiters – keen to promote their own alternative trade funding solutions – as well as buyers keen to promote open account as the least-cost method of procurement, with optimal cash flow benefits (at least for the buyer) and speed.
Indeed, as an idea, open account trading has many merits. It enables the financial supply chain to move more in sync with the physical supply chain. It also provides greatly improved visibility and transparency and helps generate liquidity in the purchasing cycle.
Yet, on implementation, open account generates some key issues, especially for the supplier. Chief among these is funding for the supplier. Minus an LC, suppliers are without strong security to offer their banks in exchange for working capital funding. And as the exporters are often located in jurisdictions with restricted funding, exporters may face a funding gap with respect to financing production. Traditionally emerging market exporters look to their local banks for help, but they offer LCs on such transactions – rarely do they offer funding without the security of an external LC.
Meanwhile, the buyers that insist on open account terms also insist on deferred payment terms, stretching the working capital needs of the exporter. In addition, they also insist on ‘just in time’ delivery, which further increases the financial pressure on sellers.
Given these constraints, many sellers – especially in the Asian manufacturing countries – find it difficult to accept the additional risks involved with open account trading, while remaining open to the idea of making themselves more competitive. Yet how can they reconcile the opportunities of open account trading while guarding against the additional risks?
Another way is to work with trade services companies, who buy the goods being produced or extracted and pay immediately. The trade services company then sells the goods to the clients on deferred payment terms. As far as the seller is concerned the goods are sold, with the trade services company creating structures that deal with the credit risk and, if applicable, the foreign exchange risk. The only risk retained by the specialist is performance risk on the seller – i.e. the producer’s ability to produce, and even this can be offset by imaginative structuring if needs be.
Trade services companies understand the risks on particular trades through their structuring and credit assessment teams, and can generate solutions on either a transactional or comprehensive basis. They can be more creative than local banks, as well as more competitive-unconstrained, as they are, against country, credit or product limits.
It is also important not to write off the LC. In terms of volume, documentary credits are still increasing and they remain a primary tool for south-south trading and for trading between OECD countries and Africa, the Middle East, and south/southeast Asia. In higher risk trades, LCs are still seen as superior to credit insurance because of the contract assurances within LC documentation. LCs are also tailored to each transaction – a great advantage when trading with more difficult markets.
And moving to open account does nothing to streamline customs clearance – the cause of the bulk of documentation in trade. Indeed, open account trading does not decrease documentation on a transaction at all. Many open account trades often have to replicate features inherent in an LC, such as how to dispute invoices that do not reconcile, how to ensure proper documentation at customs, how to reconcile vendor payments and how to conduct financial conditions management. This means that open account trading has a hidden cost, often borne by the seller.
Despite the current economic concerns it is clear that globalisation is here to stay, as is the attendant growth in cross-border trade. It is also clear that, given the patterns of trade, open account trading will remain the dominant terms under which this continued growth in trade will take place. Yet it is also important to note that, for producers, open account trading does not necessarily mean trading on permanently disadvantageous terms.