- Trade Finance Definition
- The Documentary Draft and the Bank Collection Process
- The Use of Time Drafts and Acceptances
- Banker’s Acceptances and Acceptance Financing
- Credit Risk in Trade Finance Programs
- Credit Risk in Acceptance Financing Rights of the Holder in Due Course
- Credit Risks in Factoring Accounts Receivable
Trade Finance Definition
Banks involved in commercial lending provide a wide range of financing packages for international trade, commonly called trade finance. Trade finance not only assists the buyer in financing its purchase but also provides immediate cash to the seller for the sale. This type of financing is profitable for the lending institution. This mechanism is an important financing or credit device, providing the seller and buyer with a mechanism for financing the international sale.
The Documentary Draft and the Bank Collection Process
A draft that is to be paid upon presentation or demand is known as a sight draft because it is payable “on sight”. The sight draft is prepared by the seller and is sent to the buyer along with shipping documents. The draft is sent “for collection,” know as a documentary collection. The draft and documents are accompanied by a collection letter that provides instructions from the seller on such matters are who is responsible for bank charges, what to do in the event the buyer dishonors the draft, and how the proceeds are to be remitted to the seller.
Essentially, documentary collections function like a cash-on-delivery transaction. When the sight draft is presented to the buyer at its bank or place of business, it is paid, and the buyer’s bank remits the payment to the seller. Only then does the bank turn over the shipping documents with which the buyer can claim its cargo from the carrier. If a sales contract between buyer and seller calls for payment upon presentation of a sight draft, the contract terms commonly call for cash against documents. There is no guarantee the buyer will pay when presented with the documents.
The Use of Time Drafts and Acceptances
The use of a documentary draft in trade finance works like this: A seller agrees to issue a draft that is due, say, sixty days after shipment of goods. The draft states that it is due in sixty days or on a future date specified on the instrument. A draft due at a future date or after a specified period is known as a time draft.
The time draft is sent to the buyer for its acceptance; this is typically done by stamping “accepted” across the face of the draft. Under the UCC, the acceptance “may consist of the drawee’s signature alone.” The buyer has thus created a trade acceptance. The buyer’s acceptance indicates the buyer’s unconditional obligation to pay the draft on the date due.
- A draft payable at “sixty days after date” is payable by the drawee sixty days after the original date of the instrument.
- A draft payable at “sixty days sight” is payable sixty days after the date of acceptance.
As with a sight draft, a seller usually sends the time draft together with the shipping documents to the buyer through banking channels with instructions to the banks that the shipping documents should be handed over to the buyer only upon acceptance of the draft. The sales contract would have indicated the parties’ agreement to this arrangement by calling for “documents against acceptance.”
After acceptance, the bank returns the draft to the seller through banking channels. The seller can then hold the draft to maturity or sell it at a discount to a local ban or commercial lending institution for immediate cash. The commercial lender takes the acceptance by negotiation. The greater the creditworthiness of the buyer, the greater the marketability of the trade acceptance.
Banker’s Acceptances and Acceptance Financing
A banker’s acceptance is a negotiable instrument and short-term financing device widely used to finance international and domestic sales. The purpose of an acceptance is to substitute a bank’s credit for that of the buyer to finance the sale. It is a time draft drawn on and accepted by a commercial bank. The bank stamps its name, date, and signature on the face of the draft to create the acceptance and thereby becomes obligated to pay the amount stated to the holder of the instrument on the date specified.
Importing buyers can use a banker’s acceptance for short-term borrowing until they can resell and liquidate the goods they are purchasing. Sellers and export markets can use a banker’s acceptance for short-term, pre-export financing of raw materials and production costs until the products are sold to the foreign customer, and the payment is received. Banker’s acceptances are short-term instruments because they must be for six months or less.
An eligible banker’s acceptance is one that qualifies for discount at the U.S. Federal Reserve Bank, which will buy it if it is not sold privately.
Credit Risk in Trade Finance Programs
Institutions prearrange financing terms by agreeing in advance to purchase the trade acceptances of the foreign buyer. This done through an evaluation of the buyer’s financial position, however to reduce credit risk and lower the cost of trade finance, several government agencies provide credit guarantees to back trade finances. These include Eximbank and the Agency for International Development.
Credit Risk in Acceptance Financing Rights of the Holder in Due Course
One of the primary reasons for the popularity of the acceptance as a financing device is the protection it provides to the financial institution or other party who purchases it, provided that party is a holder in due course. A holder in due course is a holder in possession of a negotiable instrument (ex: a draft or an acceptance) that has been taken:
- For value
- In good faith
- Without notice that it is overdue or has been dishonored
- Without notice that the instrument contains an unauthorized signature or has been altered
According to the holder in due course rule, the purchaser of an acceptance takes it free from most disputes that might arise between the drawer and the drawee – the original parties to the underlying transaction. The most common type of dispute is a breach of contract.
Example: Assume that DownPillow sells pillows to a Japanese buyer and forwards documents and a draft for acceptance. DownPillow discounts the trade acceptance to a U.S. bank, which then discounts the instrument to the credit markets. If the pillows turn out to be moldy and worthless, the Japanese buyer must still honor and pay the acceptance upon presentation in Japan. It may then assert its separate claim for breach of contract against DownPillow. This rule ensures the free transferability of commercial paper in international commerce.
Credit Risks in Factoring Accounts Receivable
An account receivable is no more than a representation of a contract right belonging to the seller – the right to collect money owed by the buyer under the contract for goods shipped. Contract rights can be assigned to another party. In a typical financing arrangement, the seller assigns its rights to collect the account to the financial institution. This is also called factoring, and the assignee is sometimes called the factor.
For Example: Assume DownPillow ships an ocean container of pillows to Japan and factors the account receivable with a U.S. bank. DownPillow now has its money, and the bank is awaiting payment directly from Japan. If a dispute breaks out over the quality of the pillows, the Japanese buyer may legally assert any claims and defenses against the collection by the bank.
The buyer can then argue it doesn’t have to pay the bank because of a breach of warranty by DownPillow. DownPillow will have to repay the bank for money received and resolve the breach of contract suit with the buyer. For this reason, banker’s acceptance financing offers some advantages over accounts receivable financing because of the holder in due course rule. Some insurance companies offer commercial credit insurance to protect credit risks in factoring accounts receivable that become uncollectible bad debts.