TRADE FINANCE PRODUCTS

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1 TRADE FINANCE PRODUCTS Thriving international trade is a sign of a healthy global economy. Exports and imports combined drive a huge amount of growth and development in the world, but especially in emerging or developing economies. The most common Trade Finance Products used in International Trade are Documentary Collections, Documentary Credits and Guarantees or Standby Letters of Credit and Trade Loans. Trade Finance Products provided by a bank involve two key elements, risk coverage and provision of finance, or simply put, money to support trade activities. In this section we will look in greater detail at each product, identifying the benefits and risks to both the exporter and the importer and the product cycle from application to payment. Trade Finance Products> Documentary Collections > This section outlines how Documentary Collections are used to facilitate international trade transactions. This will be achieved by becoming familiar with: A simple definition of Documentary Collections The parties involved The applicable international rules for bank Documentary Collections The workflow for a Documentary Collections or how it works? The benefits EBRD TFP e-learning Introduction to Trade Finance TRADE FINANCE PRODUCTS Page 1

2 Here is a simple but complete definition of a Documentary Collection as used in the context of international trade and finance. There are basically two ways in which collections may be used to collect payment from an importer in another country. These two means are known as Export Documentary Collections and Export Clean Collections. When using documentary collections the commercial and transport documents sent for collection may also be accompanied by financial documents such as a Bill of Exchange or a Promissory Note. Documentary Collection Documentary collections are a service provided by a bank whereby the bank will use its correspondent bank relationships as a network to collect the proceeds of export shipments using the documentary collection product operating under internationally accepted rules known as the URC 522. Export Documentary Collection In the case of Export Documentary Collections a bank will remit export documents which result from the sales contract between the seller and the buyer to a nominated correspondent bank in the importer's country. Instructions will be provided to the bank to release the documents to the buyer (importer) either against sight payment or against acceptance of a Bill of Exchange (Draft). Upon release of the documents to the importer, the importer can take delivery of the goods. Export Clean Collection In the case of Export Clean Collections the bank will only remit a financial document (Bill of Exchange/Promissory Note) to a nominated correspondent bank in the importer's country. Instructions will be provided to the collecting bank to present the financial document to the buyer (importer) for payment at sight or at some specified future date or term. As the commercial documents are not involved in a clean collection, the clean collection cannot provide any constructive control over the goods, it merely facilitates collection of payment. EBRD TFP e-learning Introduction to Trade Finance TRADE FINANCE PRODUCTS Page 2

3 Bill of Exchange A Bill of Exchange is drawn up by the seller and can be defined as An unconditional order in writing drawn by the drawer requesting another party to pay on demand or on a future determinable date a sum certain in money to, or to the order of, the drawer A Promissory Note A Promissory Note is similar to a Bill of Exchange except that the promissory note is drawn by the buyer and can be defined as An unconditional promise to pay a sum certain in money on demand or on a future determinable date to, or to the order of, another party. Documentary Collections follow a particular cycle or workflow with various roles filled by the parties involved: The primary parties involved in a documentary collection are: the Principal the Remitting Bank the Collecting Bank sometimes a Presenting Bank and the Drawee Like other international trade finance instruments used to facilitate international trade Documentary Collections also operate subject to international rules developed by the ICC Banking Commission. The Principal The Principal is the party that initiates the collection and is often referred to as the Exporter, Seller or Drawer. The Remitting Bank The Remitting Bank is the exporter's bank which remits the collection document to the collecting bank in the importer's country. The Collecting Bank The Collecting Bank is often referred to as the correspondent bank or agent of the EBRD TFP e-learning Introduction to Trade Finance TRADE FINANCE PRODUCTS Page 3

4 remitting bank and its role is to endeavour to collect the proceeds of the collection and remit the collected funds. A Presenting Bank The Presenting Bank is often the same bank as the collecting bank or it can be the bank of the drawee or importer but in any event in the context of collections it is acting under the collection instruction received from the Remitting Bank. The Drawee The Drawee is the importer, otherwise known as the Buyer. ICC Banking Commission The ICC Banking Commission is the largest commission of the International Chamber of Commerce (ICC), the World Business Organization. The ICC Banking Commission has more than 600 members in more than 100 countries. The ICC Banking Commission is the rule making body for trade finance instruments such as Documentary Credits (UCP), Demand Guarantees (URDG), Standby Letters of Credit (ISP) and Documentary Collections (URC). The rules, known as the Uniform Rules for Collections (URC) first came into force on 1 January 1968 and have been updated and modified with the most recent update being the Uniform Rules for Collections, 1995 Revision, ICC Publication No. 522, or URC 522 for short. URC 522 The URC 522 rules provide a set of clear standardised procedures and regulations for all parties involved in a collection, the exporter or drawer; the remitting bank; the collecting bank; the presenting bank; and EBRD TFP e-learning Introduction to Trade Finance TRADE FINANCE PRODUCTS Page 4

5 the importer or drawee. The purpose of the URC 522 is to provide a standardised set of international rules for collections, both clean and documentary, and to establish strict workable guidelines for all parties that are involved in any stage of a collection operation. The rules state that any collection can be subject to the URC 522 and that all parties to the collection must adhere to the URC 522 unless it has been expressly agreed otherwise, and unless the rules run contrary to the provision of a national, state or local law and/or regulation which supersede the URC 522. The Collection Order When the remitting bank acting of behalf of the exporter sends a documentary collection to a collecting bank it will use a standardized documentary collection instruction order which will state that the collection is to be handled subject to the URC 522 rules. Every collection order will contain the following information: The name of the Collecting Bank. The number and type of documents included for collection. Whether the collection is Sight or Term. The methods by which to remit proceeds. Procedure in the case of dishonor or non payment. EBRD TFP e-learning Introduction to Trade Finance TRADE FINANCE PRODUCTS Page 5

6 SHOW ME HOW IT WORKS Five steps of the Documentary Collection Life Cycle: Step 1: The Exporter and the Importer agree that settlement of the agreed contract of sale will be by way of a documentary collection. Step 2: The Exporter ships the goods and sends the shipping and commercial documents to their bank which is known as the Remitting Bank because it remits the collection documents to the Collecting Bank in the Importer s Country. The Exporter is now known as the Principal. Step 3: The Remitting Bank sends the documents to the Collecting Bank along with the Collection Instruction to deliver the documents to the Importer either against payment (Documents against Payment D/P or Sight collection) or against acceptance of a bill of exchange (Documents against Acceptance D/A or Term collection). Step 4: The Collecting or Advising Bank will only release the shipping and commercial documents to the buyer provided the buyer pays or accepts as specified in the documentary collection instructions. Step 5: When the collection payment is collected it is sent back to the Remitting Bank for credit of account of the Exporter. EBRD TFP e-learning Introduction to Trade Finance TRADE FINANCE PRODUCTS Page 6

7 There are 2 primary ways in which collection of payment and transfer of documents can take place: Documents against Payment (D/P), also called a Sight Collection and Documents against Acceptance (D/A), also called a Term Collection Another method for the operation of documentary collection is "D/A + Bank Aval". Documents against Payment (D/P) With D/P or a Sight Collection, the collecting bank receives the Bill from the remitting bank and presents it on to the importer, if necessary using the service of another bank (the presenting bank). The payment instrument is accompanied by the commercial documents as specified in the collection order. On sight of this bill, the drawee (importer) is requested to pay the amount due in exchange for release of the documents. When payment is effected the importer receives the documents to collect the goods. The proceeds are sent by the collecting bank to the remitting bank and then paid to the seller. Documents against Acceptance (D/A) Documents against Acceptance, or term collections, also known as usance collections are used when payment is to be made on a future date and they provide the drawee or buyer with time to pay (period of credit). The buyer on whom the Bill is drawn is known as the drawee. The drawee is expected to ACCEPT the term bill, which is an undertaking by the drawee to pay the amount due at a specified future date (maturity date). If the Bill is accepted then the documents are released to the drawee/importer to collect the goods. D/A + Bank Aval In this case the collection order will specify that the Bill of Exchange must be accepted by the drawee and also guaranteed or "avalised" by the importer's bank prior to release of the documents. EBRD TFP e-learning Introduction to Trade Finance TRADE FINANCE PRODUCTS Page 7

8 Documentary Collections - The Benefits for the Exporter By using documentary collections I have a local bank in the importer's country working to collect the proceeds of the collection. Documentary collections are simpler for me to operate and not as expensive as documentary credits. Of course they do not provide the same level of security. I have the protection of international rules setting out the obligations of the parties involved. I can obtain trade finance if my bank will discount an accepted draft or bill of exchange that is for payment at a future date. I have the security of guaranteed payment when the collection order is avalised or guaranteed by a bank. Documentary collections may enable the collecting bank to retain control over the goods until either "payment" or "acceptance". Documentary Collections - The Benefits for the Importer I can avoid making payment in advance before the goods are shipped. Documentary collections are simpler for me to operate and not as expensive as documentary credits. I have the protection of international rules setting out the obligations of the parties involved. Under a term or usance documentary collection I do not have to pay until the maturity date. This reduces the amount of local financing that I need. I am happy that my exporter trusts me to deliver under a documentary collection. EBRD TFP e-learning Introduction to Trade Finance TRADE FINANCE PRODUCTS Page 8

9 Trade Finance Products> Documentary Credits > This section outlines how a Documentary Credit is used to settle international trade transactions. We will look at: A simple definition of a Documentary Credit The parties involved The workflow for a documentary credit or how it works? The methods of honour or settlement of a documentary credit The benefits for the parties involved EBRD TFP e-learning Introduction to Trade Finance TRADE FINANCE PRODUCTS Page 9

10 A documentary credit is an undertaking by a bank that payment will be made when the seller presents documents specified in the documentary credit. The documents should provide evidence that the seller has performed under the international contract of sale. A documentary credit is also referred to as a letter of credit or LC. A documentary credit can be payable at sight (on presentation of documents) or at a future date. Documentary credits operate globally under a very important set of international banking rules developed by the ICC known as The Uniform Customs and Practice for Documentary Credits, 2007 Revision, ICC Publication no. 600 ( UCP ). Documentary Credit A documentary letter of credit is an undertaking by a bank, on behalf of an importer (buyer), to pay a certain amount of money to an exporter (seller) within a specified period of time, provided that the exporter presents documents specified in the letter of credit, which comply with the terms and conditions set out in the letter of credit. Future Date Payment at a Future Date is (usually shown as 'X days from shipment date'). Where payment is at a future date the payment instrument is known as an acceptance, deferred payment or usance letter of credit. The International Chamber of Commerce The International Chamber of Commerce (ICC) developed the Uniform Customs and Practice for Documentary Credits to provide importers and exporters with a set of common rules to govern the operation of documentary credits. When a documentary credit is issued that expressly states the application of UCP 600 rules, the rules are binding on all parties. Application of UCP 600 Rules: The Uniform Customs and Practice for Documentary Credits, EBRD TFP e-learning Introduction to Trade Finance TRADE FINANCE PRODUCTS Page 10

11 2007 Revision, ICC Publication no. 600 ( UCP ) are rules that apply to any documentary credit ( credit ) (including, to the extent to which they may be applicable, any standby letter of credit) when the text of the credit expressly indicates that it is subject to these rules. They are binding on all parties thereto unless expressly modified or excluded by the credit. The effective date of the latest version UCP 600 rules was 1 July The parties involved in a documentary credit transaction are: the buyer or importer known as the Applicant, the importer s bank known as the Issuing Bank, and the exporter known as the Beneficiary. The banks that interact with the exporter (usually in the exporter s country) are: the Advising Bank, the Confirming Bank and the Nominated Bank The Applicant The buyer or importer is known as the Applicant because this party applies to its bank to issue a documentary credit to facilitate the shipment of the goods. The Issuing Bank The Issuing Bank issues the letter of credit on the instructions of the applicant. The issuing bank takes a credit risk decision on the importer before agreeing to open the letter of credit and must take adequate collateral and get approval for a credit line as once issued the letter of credit is an irrevocable financial commitment of the bank. The Beneficiary The Beneficiary is the party in whose favour the documentary credit is issued and who EBRD TFP e-learning Introduction to Trade Finance TRADE FINANCE PRODUCTS Page 11

12 will benefit by means of obtaining payment for complying documents presented under the documentary credit. The Advising Bank The Advising Bank is the bank, usually in the exporter's country, which verifies the apparent authenticity of the letter of credit received from the issuing bank and which subsequently forwards or advises it to the exporter. The Confirming Bank The Confirming Bank is the bank, usually located in the exporter's country which if requested and if it agrees provides an additional independent undertaking to pay the exporter, provided that a complying presentation of documents is made by or on behalf of the exporter. It is very often the case that the Advising Bank and the Confirming Bank are the same bank. The Nominated Bank The Nominated Bank is the bank, again usually located in the exporter's country, with which the documentary credit is available for drawing. In simple terms the nominated bank can be said to be the bank authorised, within the letter of credit, to make settlement to the exporter and to whom documents are normally presented. It is very often the case that the Advising Bank and the Confirming Bank and the Nominated are one and the same bank. EBRD TFP e-learning Introduction to Trade Finance TRADE FINANCE PRODUCTS Page 12

13 Before the Documentary Credit cycle begins, an agreement is reached between the exporter and the importer based on the price, quantity and description of the goods and the insurance and transport details. The exporter provides this information in the pro-forma invoice. The importer issues a purchase order and the two parties will enter into a contractual agreement to trade with each other. If the parties agree that settlement is to be made by documentary credit the documentary credit cycle begins. SHOW ME HOW THE CYCLE WORKS Ten steps of the Documentary Collection Life Cycle: Step 1: The importer applies to the issuing bank to issue a documentary credit. Step 2: The issuing bank checks that the application is complete and precise and satisfies internal credit approval. Step 3: The issuing bank issues the documentary credit subject to UCP 600. Step 4: The advising bank advises the documentary credit. Step 5: The beneficiary examines the terms and conditions of the documentary credit. Step 6: The beneficiary ships the goods and presents the documents to the nominated bank. Step 7: The nominated bank checks that the documents comply. If they do comply settlement may be made. Documents are then sent to the issuing bank. Step 8: The issuing bank checks that the documents comply with the credit. Step 9: If the documents comply, the issuing bank reimburses the nominated bank. The nominated bank makes settlement to the beneficiary if it has not already done so. Step 10: The issuing bank releases the documents to the applicant against payment. The applicant can now collect the goods. EBRD TFP e-learning Introduction to Trade Finance TRADE FINANCE PRODUCTS Page 13

14 When an exporter ships the goods and presents the documents required under the letter of credit the method of settlement will depend on how the credit was made available. The documentary credit must state where it is available and how it is made available for drawing or settlement to the beneficiary exporter. Where and how a documentary credit may be made available to the exporter beneficiary is covered by UCP 600 Article 6. In simple terms we can say that a documentary credit can be made available by: sight payment deferred payment acceptance or negotiation Where a documentary credit is made available to an exporter: A credit must state the bank with which it is available or whether it is available with any bank. A credit available with a nominated bank is also available with the issuing bank. How a documentary credit is made available to an exporter: A credit must state whether it is available by sight payment, deferred payment, acceptance or negotiation. UCP 600 Article 6: a) A credit must state the bank with which it is available or whether it is available with any bank. A credit available with a nominated bank is also available with the issuing bank. b) A credit must state whether it is available by sight payment, deferred payment, acceptance or negotiation. c) A credit must not be issued available by a draft drawn on the applicant. d) i. A credit must state an expiry date for presentation. An expiry date stated for honour or negotiation will be deemed to be an expiry date for presentation. ii. The place of the bank with which the credit is available is the place for presentation. EBRD TFP e-learning Introduction to Trade Finance TRADE FINANCE PRODUCTS Page 14

15 The place for presentation under a credit available with any bank is that of any bank. A place for presentation other than that of the issuing bank is in addition to the place of the issuing bank. e) Except as provided in sub-article 29 (a), a presentation by or on behalf of the beneficiary must be made on or before the expiry date. Sight Payment The letter of credit may provide for immediate payment of the sum due. This is known as available by sight payment. The paying bank will either be the issuing bank, the confirming bank, or another nominated bank in the exporter s country. The exporter will present the required documents to the bank. If the documents are in order, payment is authorised to be made at sight. Deferred Payment: In this case the issuing bank/confirming bank will simply incur a deferred payment undertaking for payment on a future date. It is possible for the exporter to request the bank to discount or provide finance under the deferred payment documentary credit. If the bank provides finance this is known as the bank making a prepayment or purchasing before the actual maturity date for payment. Acceptance: This method of settlement involves the acceptance of a bill of exchange drawn by the exporter on the bank where the credit is available. These credits are known as acceptance, term or usance credits and payment is due at the maturity of the bill of exchange. However, if the exporter requires cash immediately, he can request the accepting bank or another bank to discount the accepted bill of exchange. Negotiation: If the issuing bank authorises a nominated bank in the exporter s country to negotiate, then the nominated bank may advance its own money to the exporter or beneficiary of the letter of credit in advance of the maturity date, by purchasing the documents and/or drafts that have been presented in compliance with the terms and conditions EBRD TFP e-learning Introduction to Trade Finance TRADE FINANCE PRODUCTS Page 15

16 of the credit. The negotiating bank will charge a negotiation fee which basically represents interest on the advance of funds from the date of advance to the date that the negotiating bank receives final settlement by the issuing bank. Documentary Credits - The Benefits for the Exporter I have an independent bank undertaking before I ship my goods. I can agree the specified documentary conditions in advance that suit my needs. With a confirmed documentary credit when I can comply with the terms and conditions then even the country risk can be removed. Documentary credits enable me to offer extended credit to my import customers and this increases my business volumes. I can on occasion obtain pre-shipment finance when I can show my bank I have been advised a documentary credit from a reputable bank. In emerging markets where interest rates are higher than in my country the documentary credit helps me offer better contract terms to my customers. Documentary credits are irrevocable so once in place the undertaking to pay cannot be cancelled or amended unless I agree. EBRD TFP e-learning Introduction to Trade Finance TRADE FINANCE PRODUCTS Page 16

17 Documentary Credits - The Benefits for the Importer I can avoid having to pay in advance for goods ordered. I can agree terms and conditions in the credit which will require documents that will evidence that the supplier has performed under the contract. By providing a documentary credit to the exporters it is possible to get extended payment terms. With extended payment terms I can sell the imported goods with the profit margin before the payment is due to be made. Documentary credits in most instances cost a lot less then borrowing in local currency to import goods. My local bank can be more amenable to issue a letter of credit than to give me an import loan as they can on occasion take the goods as collateral. Banks also like to finance imports by documentary credit as they are certain as to the purpose of the documentary credit finance facility. EBRD TFP e-learning Introduction to Trade Finance TRADE FINANCE PRODUCTS Page 17

18 Trade Finance Products> Guarantees/Standby Letters of Credit > In this section I will outline how Bank Guarantees and Standby Letters of Credit are used to secure and facilitate international trade transactions. This will be achieved by becoming familiar with: A simple definition of a Bank Guarantee The use of Direct and Indirect Guarantees The applicable international rules for bank guarantees The workflow for a Bank Guarantee or how it works? The fundamentals of Standby Letters of Credit and the applicable rules. The benefits Here is a simple but complete definition of a bank guarantee which in the context of international trade is often referred to as a demand guarantee. Guarantees can be issued by parties other than banks but in the context of international trade most guarantees are issued by banks. For instance Guarantees can be issued by Insurance Companies, Corporate bodies or other financial institutions. In the context of securing international trade and finance transactions guarantees are issued by banks and are typically payable on demand. In common with Documentary Credits guarantees are used to secure a payment obligation relating to an underlying contract but in the context of guarantees this is referred to an underlying relationship. Bank Guarantee A bank guarantee is an irrevocable undertaking issued by a bank on behalf of an instructing party, usually the Applicant, to another party that the bank will pay a sum of money against a written demand for payment or against submission of a document (or documents) stipulated in the guarantee document itself. EBRD TFP e-learning Introduction to Trade Finance TRADE FINANCE PRODUCTS Page 18

19 Demand Guarantee When a bank issues a demand guarantee that bank has an obligation to pay on demand without contestation provided that bank receives a demand that is a complying demand under the demand guarantee Underlying Relationship The parties to the underlying contract or agreement are understood to be the parties to the underlying relationship. The party with the obligation under the underlying relationship, which is secured by the Guarantee, is known as the Applicant whereas the party in whose favour the guarantee is issued is known as the Beneficiary. Historically bank demand guarantees tended to be issued subject to the local law of a particular country but in the evolution of modern international guarantee practice there has been a dramatic increase in the use the international rules of the ICC. In day to day international guarantee practice the international rules for demand guarantees are known as the URDG. The benefits of using standardised international rules which have been agreed by the international trade banking community is that the rules supplement the local law and clearly establishes the payment must be made on presentation by the beneficiary of a complying demand and furthermore defines what is the nature of a demand guarantee issued subject to the URDG. Simply put, the bank must pay on demand against a complying demand which under the URDG rules must meet the requirements of a complying presentation. EBRD TFP e-learning Introduction to Trade Finance TRADE FINANCE PRODUCTS Page 19

20 There are two general categories of demand guarantees used to secure international trade and finance these are Direct Guarantees and Indirect Guarantees. Both categories are used in international trade transactions but with transactions between parties located in different countries the use of Indirect Guarantees is more common. In common with Documentary Credits, guarantees whether they are Direct Guarantees or Indirect Guarantees are used to secure a payment obligation relating to an underlying contract or agreement. In the context of bank demand guarantees this relationship is typically referred to an underlying relationship. Direct Guarantees Direct Guarantees are used when the beneficiary of the guarantee is willing to accept the guarantee issued directly by the foreign bank in favour of the beneficiary. Indirect Guarantees Indirect Guarantees are when the beneficiary of the guarantee will typically only accept a guarantee issued by a local bank in the country of the beneficiary. Underlying Relationship The parties to the underlying contract or agreement are understood to be the parties to the underlying relationship. The party with the obligation under the underlying relationship, which is secured by the Guarantee, is known as the Applicant whereas the party in whose favour the guarantee is issued is known as the Beneficiary. EBRD TFP e-learning Introduction to Trade Finance TRADE FINANCE PRODUCTS Page 20

21 DIRECT GUARANTEES Five steps of the Direct Guarantee Cycle in this example: Step 1: The applicant establishes an underlying relationship or contract with the beneficiary whereby it is agreed that the contract performance be secured by way of a demand guarantee. The party to perform under the underlying relationship is the seller or exporter so the seller or exporter will be the applicant or instructing party. Step 2: The applicant instructs his bank (Guarantor) to issue a demand guarantee by completing a guarantee application form in favour of the guarantor bank. Step 3: The guarantor issues a demand guarantee in favour of the beneficiary which in our case is the exporter to cover the risk of non-payment by the importer. Step 4: In the event that the applicant is in default or breach of the underlying relationship or contract the beneficiary presents a written demand for payment to the guarantor bank. The guarantor pays the beneficiary provided that the demand is a complying demand. Step 5: The guarantor claims reimbursement from the applicant account based on the agreement usually included as part of the demand guarantee application form. EBRD TFP e-learning Introduction to Trade Finance TRADE FINANCE PRODUCTS Page 21

22 INDIRECT GUARANTEES Six steps of the Indirect Guarantee Cycle in this example: Step 1: The applicant establishes an underlying contract or commercial relationship with the beneficiary whereby it is agreed that the contract performance be secured by way of a demand guarantee. The party to make payment under the underlying relationship is the buyer or exporter so they will be the applicant or instructing party. Step 2: The applicant instructs her bank (counter guarantor) to facilitate the issuance of a local demand guarantee in the country of the beneficiary by completing the bank s guarantee application form. Step 3: The counter guarantor issues a counter guarantee in favour of a local bank (the guarantor) in the beneficiary s country which in turn issues its local guarantee in favour of the beneficiary. Step 4: The local guarantor, on the strength of the counter guarantee, issues the local demand guarantee in favour of the beneficiary. Step 5: In the event that the applicant is in default or in breach of the underlying relationship or contract, the beneficiary presents a written demand for payment to the guarantor bank. The guarantor pays the beneficiary provided that the demand is a complying demand. Step 6: The guarantor bank claims payment from the counter guarantor bank who in turn claims from the applicant account based on the agreement, usually included as part of the demand guarantee application form. EBRD TFP e-learning Introduction to Trade Finance TRADE FINANCE PRODUCTS Page 22

23 Depending on the contractual relationship between the parties involved there are various forms of demand guarantees that fulfil important functions in supporting : Delivery of Goods between Exporters and Importers Completion of major construction, infrastructure or development contracts between contracting parties. Here are some common various forms of demand guarantees that are used to support secure international trade and contracts. Payment Guarantee: The payment guarantee provides security for a contractual payment obligation, such as in connection with a contract of sale, a construction contract, loan or any other financial commitment. A payment guarantee can be issued for the full amount of the contract or, where part of the amount has been paid in advance, for the remaining amount due under an underlying relationship. Tender Guarantee (Bid Bond): The tender guarantee covers the risk that the company submitting the tender under the underlying relationship: - Withdraws its offer prior to the actual awarding of the tender; - Fails to sign the contract, if awarded the tender under the underlying relationship - Fails to submit the required performance guarantee, if required. These guarantees are normally issued for a specified percentage (usually 1%-5%) of the contract value Performance Guarantee: A performance guarantee is issued for a specified percentage (usually 10%-15%) of the contract sum under the underlying relationship. The performance guarantee may be issued as a single guarantee to cover all phases of the contract or issued to cover distinct segments of the contract. The performance guarantee will provide that the beneficiary may make an on demand claim in the event of non or delayed performance by the applicant in respect of the underlying relationship or contract. Warranty Guarantee: The purpose of the warranty guarantee is to cover the applicant s obligations after it has delivered the goods or completed its work during the contractual warranty period. In the event that there is a breach of warranty or, for example, machinery breaks down, the beneficiary may demand payment under the warranty guarantee. EBRD TFP e-learning Introduction to Trade Finance TRADE FINANCE PRODUCTS Page 23

24 Advance Payment Guarantee: The contractor (applicant) may receive a pre-payment (the advance payment amount) on the contract value. The aim of this pre-payment is usually to purchase raw material or hire machinery related to the contract. This demand guarantee is used to secure the beneficiary s right to recover the advance payment received by the applicant in the event of the applicant s failure to perform the contractual obligations relating to the advance payment. The amount in such guarantee is usually agreed between the contracting parties. The use of Standby Letters of credit to support and secure international trade and finance is growing rapidly. At a basic level the Standby Letter of Credit has many features similar to a demand guarantee. Standby Letters of Credit are most often used as a Standby Security which stand-by in the event that the buyer of a contractor fails to perform under an underlying contract or agreement or fails to pay an amount of money due. In common with Documentary Credits and Demand Guarantees, Standby Letters of Credit are issued subject to international rules of the ICC. A Standby Letter of Credit can be issued subject the UCP 600 rules or another set of rules developed specifically for use with Standby Letters of Credits. These specific rules are known as the ISP or International Standby Practices and the version currently in effect is ISP98. A Standby Letter of Credit can be issued subject to the UCP 600 rules, or the ISP98 rules. The ICC The International Chamber of Commerce (ICC) developed the Uniform Customs and Practice for Documentary Credits to provide importers and exporters with a set of common rules to govern the operation of documentary credits. The ISP98 Rules International Standby Practices (ICC Publication No. 590, 1998 Edition) are rules developed and designed specifically for use with Standby Letters of Credit. EBRD TFP e-learning Introduction to Trade Finance TRADE FINANCE PRODUCTS Page 24

25 Guarantees/Standby Letters of Credit - The Benefits for the Exporter With one bank demand guarantee or a Standby Letter of Credit in my favour I can cover the risk of non payment for many exports to my regular import customers. As an exporter I can tender or bid for large contracts when my bank will support my tender with a tender guarantee. The independent nature of a demand guarantee provides a lot of security for the parties involved as it is independent of the underlying contract or relationship. I can offer greater amount of credit and extended credit to my customers when their payment obligations are supported by a bank guarantee. There is significant comfort for my business when there is a bank guarantee or standby letter of credit standing by in the event of a default. By getting my bank to issue an advance payment guarantee in favour of my customers I often receive an advance payment on the contract amount which is much more cost effective than borrowing in local currency. Guarantees/Standby Letters of Credit - The Benefits for the Importer My customers provide me with greater credit and extended credit when I can get my bank to issue guarantees in their favour. Some of my suppliers provide me with performance and warranty guarantees which cover the risk of non performance of the seller or poor quality of goods supplied. I can comfortably and securely provide an advance payment to the supplier when I receive an advance payment guarantee as if the supplier does not perform I can claim the return of the advance payment on demand. Guarantees generally cost a lot less than borrowing in local currency. With one bank guarantee issued by my bank in favour of my regular suppliers I can do many repeat transactions. Guarantees are issued subject to international rules and while this is very good for me it is also good for my supplier as we know the specific obligations of the banks involved. EBRD TFP e-learning Introduction to Trade Finance TRADE FINANCE PRODUCTS Page 25

26 Trade Finance Products> Trade Loans > This section outlines how Trade Finance Loans Trade Loans are used to finance international trade transactions. This will be achieved by becoming familiar with: A simple definition of Trade Loans Examples of where trade finance loans are suitable for export and import business The workflow for a Trade Loan or how it works? Bank-to-Bank Trade Loans The benefits The term Trade Finance includes the traditional trade finance instruments covered in this section such as Documentary Credits, Documentary Collections, Guarantees and Standby Letters of Credit but it also includes Trade Finance Loans. Trade Finance Loans are loans granted for the specific purpose of financing international trade transactions, commonly known as cross border trade finance. These trade related loans are directly linked to the asset conversion cycle or trade cycle of the underlying goods being traded between the seller and the buyer. Trade Finance Loans are typically denominated in the currency of the underlying transaction and can mean reduced levels of Foreign Exchange Risk and also reductions in costs of financing. Documentary Credits A documentary letter of credit is an undertaking by a bank, on behalf of an importer (buyer), to pay a certain amount of money to an exporter (seller) within a specified period of time, provided that the exporter presents documents specified in the letter of credit, which comply with the terms and conditions set out in the letter of credit. Documentary Collections Documentary collections are a service provided by a bank whereby the bank will use its correspondent bank relationships as a network to collect the proceeds of export EBRD TFP e-learning Introduction to Trade Finance TRADE FINANCE PRODUCTS Page 26

27 shipments using the documentary collection product operating under internationally accepted rules known as the URC 522. Guarantees A bank guarantee is an irrevocable undertaking issued by a bank on behalf of an instructing party to another party that the bank will pay a sum of money against a written demand for payment or against submission of a document (or documents) stipulated in the guarantee document itself. Standby Letters of Credit A Standby Letter of Credit is a guarantee of payment issued by a bank on behalf of a client that is used as "standby payment of last resort" should the client fail to fulfill a contractual commitment with a third party. Cross Border Trade Finance This means that the finance provided is used for export, import or distribution trade contracts where goods or services actually cross the border of at least one of the countries involved. Asset Conversion Cycle The Asset Conversion Cycle represents the number of days it takes a company to purchase raw materials, convert them into finished goods, sell the finished product to a customer and receive payment from the customer/account debtor for the product, goods or services. Exchange Rate Risk The Exchange Rate Risk is that one currency either depreciates or increases in value with another currency over a period of time. For example, if the currency expected for settlement of goods exported depreciates this is an exchange rate risk that can result in an exchange rate loss as the currency amount received will convert into a smaller amount of local currency. EBRD TFP e-learning Introduction to Trade Finance TRADE FINANCE PRODUCTS Page 27

28 SHOW ME THIS IN SIMPLE TERMS CONSIDERATIONS The key question for an SME Importer or Exporter is where to source the funds needed to finance their international trade transactions. The SME Company may use their own funds or capital to finance the transaction but in practice SME companies rarely have surplus funds available to fund or finance trade finance transactions. The SME Company will most often finance their international trade transactions by means of a local loan or overdraft from their local bank in their local currency. The SME Company will usually not have their trade finance needs separated from general banking or working capital facilities with their local bank. By organising finance in these typical methods the SME Company is: Restricting its access to finance. Most often paying higher costs for finance than necessary. Incurring exchange rate risks that can often be avoided. EBRD TFP e-learning Introduction to Trade Finance TRADE FINANCE PRODUCTS Page 28

29 Here are the steps involved: 1. The Exporter/Importer approaches their local bank for a trade finance loan in the currency of the contract, for example in EURO. 2. The Exporter/Importer outlines the asset conversion cycle or trade cycle to their local bank. 3. The trade cycle outlines for the local bank the period of time for which trade finance is required and the final repayment source for the goods. 4. Provided the local bank is satisfied that the trade cycle is realistic (and is satisfied with the credit risk) the bank grants a trade finance loan to the Exporter/Importer to cover the trade cycle time period. Note: The bank will often add an extra days to the trade cycle to cover minor operational delays that commonly arise. SHOW ME HOW THIS WORKS FOR THE EXPORTER ❶ Viktor the Carpet Manufacturer normally borrows in his local currency Alds from his local bank in Aldastan to pay the local farmers who supply him with wool to produce carpets for export. The cost of local finance for an SME Company is 18% per annum. ❷ If Viktor starts paying the farmers and his other costs on 1 May and then produces the carpets ready for shipment by 30 June and gives his customer Anna the importer from Qumran 60 days credit from the shipment date then we can say that Viktor s Asset Conversion Cycle is approximately 120 days. EBRD TFP e-learning Introduction to Trade Finance TRADE FINANCE PRODUCTS Page 29

30 ❸ Viktor will incur an interest cost of 18% on the local currency for approximately 120 days or longer if there is a delay receiving payment from Anna. As Viktor has borrowed the money in local currency Alds but exports to Anna in EURO he also carries an exchange rate risk as the currency he is paying out is different from the currency he will receive in payment. If the EURO depreciates before Anna s payment into local currency ALDS then Viktor will receive less local currency than he expected. This will result in a local currency loss. If on the other hand, the EURO appreciates then Viktor will receive more ALDS than expected i.e. a local currency gain. Viktor needs to avoid foreign exchange risk and should know in advance: The date and currency of the anticipated payment The profit he can expect upon receipt of payment Features Viktor is borrowing in EURO so when the goods are exported and sold he will be paid in EURO so there is no foreign exchange risk. As Viktor is borrowing in EURO he may pay interest at 6% which is far cheaper than paying interest on his local currency at 18%. By clearly defining the asset conversion cycle Viktor is able to increase his access to finance by way of the trade finance loan or trade loan. Summary By using a trade finance loan Viktor has: Avoided the Foreign Exchange Risk Obtained financing at a reduced cost Gained access to financing that may not normally be available from his local bank for international trade activities. EBRD TFP e-learning Introduction to Trade Finance TRADE FINANCE PRODUCTS Page 30

31 SHOW ME HOW THIS WORKS FOR THE IMPORTER ❶ Anna, the Importer from Qumran, banks with her local bank and normally borrows in local currency Qams at the high local interest rate of 20% per annum. Anna needs to borrow money from her local bank to pay Viktor for the supply of goods she wishes to import. ❷ If Anna pays Viktor on 2 April for the goods ordered and if the goods arrive at her import warehouse on 10 July and it takes between days to sell the goods locally market then we can say that Anna s Asset Conversion Cycle is approximately 160 days. Consequences Anna will incur interest costs of 20% on the amount of money borrowed from her local bank in the local currency for approximately 160 days or longer if there is any delay in the delivery and sale of the goods in the local market. As this transaction is clearly an international trade transaction then it makes sense to finance it with a trade finance loan or trade loan denominated in the currency of the international contract which is EURO. Summary By using a trade finance loan Anna has: Obtained financing cheaper than borrowing in her local currency Gained access to financing that may not normally be available from her local bank for international trade activities. However, in this instance there was a foreign exchange risk which should be taken into consideration. EBRD TFP e-learning Introduction to Trade Finance TRADE FINANCE PRODUCTS Page 31

32 BANK TO BANK TRADE FINANCE LOANS In the context of international trade banking, trade finance is generally considered to be lower risk than conventional lending or working capital finance. As a result international banks: are often able to provide short term bank-to-bank trade finance loans on favourable terms to local banks provided the loans are used to fund trade finance activities of customers of the local bank. where the international bank will provide a trade finance loan or funding to a local bank and that local bank will then on lend the funds to its customers for the purpose of financing international trade transactions of their customers. International banks providing bank-to-bank loans will also be concerned with the credit risk, the bank risk and the country risk. The funding bank also needs to understand the underlying trade transaction and the applicable asset conversion cycle in advance of providing funds for on-lending to the local customer. It would also be common practice for international funding banks to occasionally check that the funds provided by way of trade finance loan are actually being used to finance international trade activity which as we have seen has a lower risk profile than conventional or working capital lending. The Credit Risk (Counterparty Risk) This is the risk of non-payment by the purchaser of goods or services. The risk of nonpayment is possibly greater in international trade than in domestic trade because the exporter may not be able to accurately assess the creditworthiness of a customer located in another country. Bank Risk Sometimes an exporter will insist that the importer s bank guarantees the payment for goods being shipped. Bank risk is the risk that the bank fails to honour such a payment obligation. Such a payment obligation could be by way of a bank guarantee, a documentary credit or a Standby LC. Country Risk Country risk arises when a foreign buyer is prevented from making payment due to: exchange control regulations other government restrictions political uncertainty EBRD TFP e-learning Introduction to Trade Finance TRADE FINANCE PRODUCTS Page 32

33 or in extreme situations, such as the breakout of war Asset Conversion Cycle The Asset Conversion Cycle represents the number of days it takes a company to purchase raw materials, convert them into finished goods, sell the finished product to a customer and to receive payment from the customer/account debtor for the product, goods or services. EBRD TFP e-learning Introduction to Trade Finance TRADE FINANCE PRODUCTS Page 33

34 Trade Loans - The Benefits for the Exporter I can obtain greater levels of finance when I can demonstrate that the trade loan is to finance my international trade activity. The trade finance loan can be denominated in the currency of the international contract of sale which can mean that I can achieve a reduction in the cost of financing. Provided the currency of the trade finance loan matches the currency in which I sell my goods then foreign exchange risks can be avoided. By understanding the asset conversion cycle and explaining it to my bank I can obtain financing that will fluctuate in accordance with my trading operations and match my financing needs. The documentation for trade finance loans is not complicated so it is much easier to provide for my bank. Trade Loans - The Benefits for the Importer By using trade finance loans I can obtain better terms from my suppliers as by paying them in advance or early they will often give me a discount on the cost of the goods. Trade finance loans can be packaged to match my asset conversion or trade cycle which gives me greater flexibility in managing my trade finance needs. By obtaining a trade finance loan in the international currency of my supplier I can often get my financing at a much cheaper cost than financing in local currency. Once my bank understands that the repayment source for the trade finance loan is from the sale of the underlying goods for which there is demand I can achieve greater levels of trade financing which will help me expand my business. The documentation to be provided to the bank to organise trade finance loans is comparatively simple and pretty much standardised. EBRD TFP e-learning Introduction to Trade Finance TRADE FINANCE PRODUCTS Page 34

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