Friday, March 20, 2015

Trade Finance Instruments – Let the terminology battle begin!


Assume you are 18 years old and you want to buy a car.

  • Usually, at that age, you don't have the money to buy a car. This is why you need financing. If you have at least some money, short-term financing may be enough. However, if you have nothing, long-term financing is needed. (Scenario 1)
  • But perhaps, by chance, your are already rich at that age. But even then, the car seller normally will not trust you. This is why you need some form of guarantee, usually from your parents. (Scenario 2)

Now assume, you start a company to build an electric car. As you don't have a specific buyer yet, you need financing to bridge the time until you have build and sold your car. (Scenario 3)

The three scenarios are all you need to understand trade finance instruments:

  • Scenario 1: If you finance short-term, we call that factoring. If you finance long-term, we call that a buyer-credit, leasing, or forfaiting.
  • Scenario 2: A letter of credit, demand bond, guarantee, indemnity, or comfort letter can reassure your seller of your creditworthiness.
  • Scenario 3: In trade finance speak, we talk about a pre-financing agreement.





Factoring

Factoring means transferring an exporter’s short-term account receivable to a factor. The transfer price is lowered by a margin that remunerates the factor for the recovery of the claim. At international level, factoring can, depending on the countries involved, be governed by the Ottawa Convention on International Factoring dated May 28, 1988.


Buyer Credit

A buyer credit grants financing to a foreign buyer, even though it is disbursed directly to the exporter. A buyer credit can benefit of an ECA cover, ECA refinancing, or ECA interest rate stabilization.


Leasing

Leasing means that a financial institution buys the good or machine (through a special purpose vehicle) and lends it to the buyer. The buyer then doesn’t pay a purchase price or interest thereon but only a rental fee. At international level, leasing can, depending on the countries involved, be governed by the Ottawa Convention on International Financial Leasing dated May 28, 1988.


Forfaiting

Forfaiting designates factoring for mid- and long-term receivables.


Letter of credit (= documentary credit)

The letter of credit is a contract under which a bank agrees to pay the seller, in connection with the export of specific goods, against the presentation of specified documents, relating to those goods. Despite its name, the letter of credit constitutes a payment instrument and only guarantees such payment. However, it is usually not a credit as such. In other words, the commercial contract will provide for a payment through letter of credit.

A letter of credit is an independent obligation of the Issuing Bank; however, this obligation is closely linked to the underlying claim through the documents which shall be presented.





  • The Issuing Bank grants a letter of credit, upon the buyer’s request, to the seller. In a cross-border context, the Issuing Bank usually comes from the buyer’s country.
  • Oftentimes, a Confirming Bank, Nominated Bank, or Advising Bank in the seller’s country doubles the Issuing Bank’s engagement to satisfy the seller. However, where a Confirming Bank must pay upon presentation of the documents, the Nominated Bank only can pay but has no obligation to do so. Finally, the Advising Bank has no payment obligation whatsoever; it only confirms the authenticity of the credit vis-à-vis the Beneficiary.
  • Obviously, exporter and importer are involved in the underlying sale of goods.

Contrary to a demand bond, guarantee, or indemnity, the letter of credit constitutes a bilateral engagement. Upon specific reference, a letter of credit may be governed by the ICC Uniform Customs and Practice for Documentary Credits (UCP 600) and the ICC International Standard Banking Practice for the Examination of Documents under Documentary Credits (ISBP).


Demand bond

The issuer of a demand bond has to fulfill of a contractual obligation owed by one person to another if the first person defaults. The demand bond constitutes a primary obligation on the issuer without requiring the other party to sue the defaulting party.

Four types of demand bonds exist:

  • A bid bond covers the risk of a prospective seller submitting a tender which he withdraws prior to entering into a binding contract.
  • An advance payment bond covers the buyer who has made advance payments, in case the seller fails to deliver.
  • A performance bond ensures the risk of the seller not performing the contract.
  • If the buyer is entitled to retain part of the purchase price during a maintenance period, a (maintenance) retention bond ensures the seller against non-payment of such retention.

The parties may choose to incorporate the ICC Uniform Rules for Contract Bonds of 1993 in their demand bond.


Guarantee

The guarantor is responsible to fulfill of a contractual obligation owed by one person to another if the first person defaults. The obligation to pay under a guarantee is dependent on the creditor establishing his claim in respect of the underlying contract.

In parallel to demand bonds, four types of guarantees exist:

  • A tender guarantee covers the risk of a prospective seller submitting a tender which he withdraws prior to entering into a binding contract.
  • An advance payment guarantee covers the buyer who has made advance payments, in case the seller fails to deliver.
  • A performance guarantee ensures the risk of the seller not performing the contract.
  • If the buyer is entitled to retain part of the purchase price during a maintenance period, a (maintenance) retention guarantee ensures the seller against non-payment of such retention.

The parties may choose to incorporate the ICC Uniform Rules for Demand Guarantees (URDG) of 2010 in their demand guarantee. Another source of law can, depending on the countries involved, be the United Nations Commission on International Trade Law (UNCITRAL) Convention.


Indemnity

An indemnity is a promise to be responsible for another’s loss. Unlike a guarantee, it is a primary obligation in favor of the beneficiary. It is independent to, and not contingent on, the obligations of the debtor. Therefore, an indemnity is more robust than a guarantee which constitutes only a secondary obligation.


Comfort Letter

The issuer of a comfort letter does not intend it to be legally binding. He simply offers some comfort to the buyer as to the seller’s ability or willingness to perform his obligations.


Pre-financing agreement

The financing benefits the seller and covers the time of manufacturing. It includes either an individual transaction or a set of transactions.


This post was essentially about terminology. However, especially in trade finance, people don't always mean the same when they use the same words. So you better check twice with your peer that you are really talking about the same thing.