This issue is further complicated by the credit standing of the buyer. If it is a multinational with unimpeachable references, it is probable that they hold the “whip-hand”. However, in the case of a start-up or a business that has had issues in the past, the supplier will often require some additional security over the goods before they become part of a bigger machine and unrecoverable in the case of an issue with the payment.
Irrevocable Letter of Credit – Providing Security for Commercial Transactions
The most secure method for both sides in any commercial transaction is a confirmed irrevocable letter of credit. That is all well and good as far as security is concerned, but it doesn’t always satisfy the issue of payment terms.
Banks are not always willing to issue a letter of credit on a customer’s behalf that includes a usance period since it means that they take on something of an uncovered risk.
In the case of a sight L/C, under which payment is made upon receipt by the confirming bank of compliant documents, the issuing bank can retain the documents until he has been paid by the buyer. In case of any difficulty, in theory, the bank has control of the goods and can sell them to another buyer in the case of non-payment.
In the case of a usance letter of credit, the bank doesn’t have that luxury, as the goods will be “long gone” before the payment becomes due.
Under usance letters of credit, one of the documents generally required is a bill of exchange often referred to a Negotiable instrument.
Once the compliant documents are presented to the confirming bank, or in the case of an unconfirmed L/C to the issuing bank, they “accept the bill”. That means that the bank accepts that it is liable to make the payment on the due date and that document becomes a Bankers Acceptance.
This can alleviate the issue mentioned earlier of the shipper wanting to be paid as soon as possible and the buyer wanting to defer payment as long as he can.
Once the bill of exchange has been accepted, the buyer (beneficiary of the L/C) can ask the bank to discount it and provide them with the “current value” of the funds. For example, if the bill of exchange is for £10,000 and payable in 90 days, the current value of the bill is the future value discounted at the banks’ lending rate for the usance period. Once the bill is discounted, the seller has been paid, the buyer is able to defer payment and the bank has fulfilled its primary function of standing in the middle of the transaction and facilitating the trade. A bank acceptance draft can be offered for discount by the bank to any financier he desires. There are several specialist trade finance companies who are now offering this facility. They offer use of their own banking facilities to clients and this new fintech model is attacking traditional banking products in a similar manner to corporate foreign exchange.
Documents Against Acceptance
This whole scenario is also available when the two parties decide that they feel sufficiently confident to deal with each other without a letter of credit. In this case, there are two possible scenarios:
- The documents are presented by the seller to his bank who forwards them on a little more than a post office to the buyer’s bank. The draft which is due at a future date will be accepted by the buyer. The seller then receives the draft back from the buyer’s bank via his own bank. It may be that the seller may ask his bank to discount the draft accepted by the buyer, if the buyer is sufficiently well known.
- Alternatively, when the documents are sent by the seller’s bank to the buyer’s bank the seller may ask for the buyers bank’s acceptance to be added once the buyer has added its own acceptance to the bill of exchange once they have accepted the documents.
Each of these scenarios are called documents against acceptance.
A seller may have several clients who buy his goods and therefore have several different obligors who owe him funds and have accepted bills of exchange. They can present a list of names to their bank who will review the list and confirm that they will advance funds to the seller using the accepted bills of exchange as collateral. There will generally be a “haircut” attached where the bank lends, say, 90% of the value of outstanding acceptances at any one time. This acceptance finance is a useful addition to a company’s own overdraft facilities and aids cash flow enormously.
These types of transaction bear the generic name “Trade Acceptance” and are a common form of “oiling the wheels on commerce since they satisfy a sellers desire for immediate payment and a buyer’s need for credit terms.
About Alan Hill
Alan has been involved in the FX market for more than 25 years and brings a wealth of experience to his content. His knowledge has been gained while trading through some of the most volatile periods of recent history. His commentary relies on an understanding of past events and how they will affect future market performance.”