Trade finance tools help importers and exporters structure contracts in a way to minimize cash flow risk while helping build relationships with counter-parties. There are a variety of payment mechanisms representing the most basic and common forms of settlement in international trade transactions.
The FITTskills International Trade Finance course offers a comprehensive list of three finance tools available to international trade professionals. The payment types described are flexible, adaptable, and enduring due to their numerous features, variations, and options.
1. Open Account
Open account payments are essentially transfers of funds to the account of the exporter.
Historically, open account payments have been used in trade between very stable and secure markets, such as the United States and Canada, or in intra-EU trade, and in cases where the trading relationship is established and trusted. Open account payment terms are those under which the seller extends credit to the buyer, finances the whole sale, and sends a standard invoice demanding payment within 30 to 60 days of receiving the goods. In addition, terms are suitable for a very strong buyer-seller relationship with a creditworthy client. Much of the trade between Canada and the United States is done on an open account basis.
Trade on open account is also increasingly the preferred mode of payment across much of the globe, even in markets once considered sufficiently risky to warrant the use of documentary credits. This shift, driven by large global importers, introduces additional risk for exporters in that payment is effected after the delivery of goods and/or services, sometimes for as long as ninety days after delivery.
This method has some potential risks as the importer could, for example, become insolvent, or the country of import could experience political turmoil, preventing payment. In such cases, the exporter loses control, and usually title, to the goods and/or services and has limited recourse to recover payment.
From a documentation standpoint, aside from the commercial invoice being issued by the exporter in an open account transaction, this transaction normally also involves an ocean bill of lading (i.e. if ocean shipping was part of the agreed-upon terms and a shipping container of goods has been sent). In these instances, the exporter will usually send all original copies of the ocean bill of lading (i.e. those issued by the shipper as receipt for the goods) to the buyer. The ocean bill of lading serves as the title to the goods so, upon receipt, the buyer (or the buyer’s designate) can present an original copy of the ocean bill of lading at the receiving port to get the shipment released.
2. Payment in Advance
In contrast, advanced payment options present the highest risk to the importer, given that the exporter could easily receive the funds and not carry through with the promised shipment.
Advanced payment is payment made ahead of its normal schedule, such as paying for a good or service before receiving the good or service.
Exporters sometimes require advance payments by importers as protection against non-payment or to purchase supplies to fulfill the order. Higher advance payments may be required for specialized products as a hedge against buyer default when it may be more difficult or impossible to sell the products to a secondary buyer.
Even with the best intentions and good faith, factors could prevent a willing and well-intentioned exporter from completing a payment as promised, such as political turmoil, exchange controls, and other unforeseen events.
As a result, payment in advance is rarely used for transactions that are structured on a recurring basis. However, advance payment is frequently used when the reputation of the exporter is well-established and the importer sees little risk in an advance payment. This establishes the importer’s credibility and is often seen as a show of good faith. In these situations, the initial payment in advance transaction is used to gain the confidence of the exporter, and it is often accompanied by negotiations that are intended to lead to better payment terms on subsequent transactions, such as open account, as described above, or documentary collections, which is explained next.
3. Documentary Collections: Sight and Term Drafts
Documentary collections provide some level of security but, like advance payments, are typically used in established trading relationships where stable and lower-risk markets are involved.
Documentary collections are types of financial transactions where banks acts as intermediaries between the importer (buyer) and exporter (seller), in effect, agreeing to facilitate payment to the exporter only once a set of shipping documents have been prepared and presented to an intermediary bank.
In a documentary collection, the exporter ships goods to an importer and mails the shipping documents, through its own bank, to a collecting bank in the importing country, which obtains payment from the importer in exchange for the documents. By using a bank as an intermediary, the exporter keeps title to the goods until payment is received in a sight draft transaction or until the importer issues a formalized promise to pay by way of an acceptance in a term draft transaction. Documentary collections are usually subject to a set of rules and practices called the Uniform Rules for Collections (URC), which is published by the International Chamber of Commerce (ICC). The importer and exporter will negotiate specific terms based on factors, including:
- Timing of payments and disbursement based on each party’s respective needs
- Negotiating leverage
- Prevailing competitive environment
- Cost of financing in one jurisdiction versus the other
In addition, payments via documentary collections may be considered as Documents Against Payment (D/P), also known as a sight draft, or may be considered as Document Against Acceptance (D/A), also known as a term draft. The key difference between these two types of documentary collections involves the timing of payment to the exporter, as explained in the following.
Documents Against Payment
Documents Against Payment (D/P), or sight draft, is a type of documentary collection where the exporter instructs the presenting/collecting bank to hand over shipping and title documents for the goods to the importer, only if the importer makes the full payment.
Documents Against Acceptance
Documents Against Acceptance (D/A), or a term draft, is a type of documentary collection where the payment due date can be determined based on the date of the receipt and acceptance of documents from the exporter (payable at 60 days’ sight) or based on the shipment date reflected on the transport documentation (payable at 90 days after the on-board date shown on the ocean billing of lading).
Even under D/A, which gives the importer additional time to pay, an exporter may choose to receive funds immediately by selling the accepted payment undertaking at a discount – usually to a bank. This allows the exporter to receive funds immediately in exchange for applicable fees and interest, while permitting the importer to pay at the original, deferred due date.
Documentary Collection Cycle
Documentary collections afford some degree of incremental protection to both parties in comparison to open account payments. The importer will not authorize payment to the exporter without receipt of a set of shipping documents through a neutral third-party, and the exporter has the assurance that shipping and other commercial documents required to claim the good shipped will not be released to the importer unless payment is authorized or a draft for future payment is accepted.
Will you use these payment tools on your next international trade deal? Let us know in the comments down below.