While there are many risks inherent in international trade finance, there are also numerous methods of settlement in international trade available to exporters and importers to manage and mitigate risks.
In most developed countries, an organization can draw on a wealth of free or inexpensive expert opinions to assist with risk mitigation for financial transactions.
Major banks typically have large portfolios of international loan assets and maintain extensive international financial networks. To safeguard their interests and those of their customers, banks employ large staffs of political analysts and international economists, and are often willing to share their expert opinions and written reports.
Embassies and consulates abroad, as well as commercial officers, are valuable sources of political and economic risk information, and can refer their clients to local service providers abroad that can assist in obtaining more detailed information on commercial risks.
These resources can often provide information on a target country’s current business environment, as well as credit and business information about potential customers.
An organization should select the financial instruments that best address its needs and identified risks, as well as those that respond to the underlying dynamics of a commercial contract.
In general, importers and exporters must agree on terms and methods of payment based, in part, on the risks associated with planned transactions. Below you will find 4 methods of settlement in international trade you can use to reduce your risk.
Want to learn more about methods of settlement in international trade and other risk mitigation options? Check out the FITTskills International Trade Finance online course.
Businesses that engage in international trade can mitigate commercial risk and protect its interests through various forms of insurance, including:
- Political risk insurance
- Foreign accounts receivable insurance
Indeed, insurance options are available to address nearly every category of risk that suppliers and buyers could possibly encounter while conducting international commerce.
Political risk insurance (PRI) and accounts receivable insurance (ACI) are particularly common, and can be obtained from specialist private sector providers or, depending on the market, from public and private entities such as export credit agencies (ECAs).
Most ECAs were originally established as public sector entities that promoted exports by providing various financing and risk mitigation products and solutions.
In recent years, however, some of these organizations have been fully or partially privatized and have mandates that extend beyond their original public sector focus. In fact, just before the onset of the recent global financial crisis, many questioned the need for ECAs in international trade.
However, their critical value was demonstrated when the market collapsed and private sector providers retreated in panic. Variations on the ECA model continue to be numerous, with the approach and the scope of ECA-like organizations varying almost by country.
In any event, most ECAs continue to offer political risk insurance and foreign accounts receivable insurance, which are both important forms of coverage that can help exporters offset trade-related commercial risks. Some ECAs also offer medium-term buyer financing, which is another helpful tool for export promotion.
Many of the strategies mentioned in this section involve the transfer of risk from one party to another for a fee. Insurance, for example, transfers risk from an individual policyholder to a portfolio of clients managed by an insurer to disperse the risk among stakeholders whose premiums fund payouts against claims.
This usually occurs over time, as it is unlikely, under normal circumstances, that a material number of policyholders will present claims at the same time.
Another attribute of an organization that successfully mitigates and manages commercial risk includes the continual assessment of the relevant risks versus the associated costs of conducting global financial transactions.
For example, a very common loss suffered by exporters involves the commercial failure of the foreign importer, while, for importers, it is the failure or inability of the supplier to deliver the merchandise exactly as specified and when required. Sometimes, poor documentation will restrict or inhibit the export or import of merchandise.
Political and country risks account for a much smaller number of losses, but should also be considered when structuring a transaction.
The challenge for an organization trading internationally, whether importing or exporting, is to get to know and trust its foreign suppliers or importers and to balance this knowledge with the risk optimization tools available from a variety of sources.
An organization must then choose a form of settlement consistent with the assessed risk and its level of tolerance for that risk. The ongoing test will be to remain competitive—and commercially viable—while incorporating the risk of loss and the price of protection against such a loss, into the final price of the finished product.
Risk can also arise from factors beyond the good faith or control of the trading partners. If exchange controls are imposed by a government, the ability and willingness to pay is not sufficient to assure a successful conclusion to the transaction. The next section emphasizes the trade finance instruments which can be used to secure payment.
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 thirty to sixty 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.
This shift, driven by large global importers, introduces additional risk for exporters in that payment is affected after the delivery of goods and/or services, sometimes for as long as 90-120 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 that will be 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.
Note that, in certain circumstances, it is possible for the exporter to authorize a release of the goods without an original copy of the ocean bill of lading. However, many exporters still rely on the courier to deliver original copies of the ocean bill of lading to the importer to prevent an unintended and unsecure release of the goods.
Payment in Advance
One of the methods of settlement in international trade not yet mentioned is payment in advance. In contrast, payment in advance (advance payment) is a payment that is made before receiving the good or service, so it presents the highest risk to the importer (i.e. given that the exporter could easily receive the funds and not carry through with the promised shipment).
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 another buyer.
If an importer wanted to have a pre-shipment inspection when paying cash in advance, he/she could hire a 3rd-Party Inspection service to visit the manufacturer and file an inspection report.
However, the cost of such an inspection would also add to the investment being made by the importer. So the credibility of the exporter in this sort of a scenario would typically have to be very high.
Even with the best intentions and good faith, factors such as political turmoil and other unforeseen events could prevent a willing and well-intentioned exporter from completing a shipment as promised.
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.
Advance payment establishes the importer’s credibility when the exporter does not have sufficient confidence in the importer. 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.