Alternatives in trade finance tools

RMA Journal, The, Feb, 2005 by Jee Meng Chen

Letters of credit are no longer the only game in town, and commercial banks are examining and using alternative tools in their international trade financing. This article looks at the applications and risks of alternative structures.

Some 70% of business is transacted on an open-account basis, with only 30% still relying on traditional letters of credit (LCs). (1) Indeed, large importers prefer to trade on open-account terms instead of using the LC, which is seen as unduly cumber-some and costly. Large U.S. and European importers, especially those in the electronics and chemical sectors, now insist that their Asian suppliers sell goods on open-account terms. (2) J.C. Penney also announced its intention to dispense with LCs in favor of open-account deals supported by Internet-based trading platforms such as TradeCard. (3)

The decline of the traditional trade-financing model has two key implications for traders and commercial banks:

1. Exporters will have to reconsider their buyer risk exposure and funding requirements. No longer the beneficiaries of LCs, exporters not only lose the guarantee of payment, but they also have to source for alternative financing arrangements, balancing between inherent risks and costs of protection. Similarly, importers should not restrict themselves to LCs alone. Going forward, the successful consummation of trade deals may hinge critically on finding the right banking partner to come up with the appropriate trade solution.

2. Edward de Bono says, "An opportunity is as real an ingredient in business as raw material, labor, or finance, but it exists only when you see it." Commercial banks must remain responsive to the financing needs of their customers. The customer-retention rule is simple: If you don't do it, someone else will, and you will likely lose the customer forever.

Structured Flexible Financing

Notwithstanding the intricacies embedded within the UCP500 (4) rules, financial institutions using the documentary credit system know that as long as documentation is compliant, reimbursement is guaranteed. But open-account trading offers no tangible form of security beyond recourse to the exporter, and risks increase significantly for working-capital transactions that are poorly structured. The financer, then, is challenged to offer a competitive financing package to the exporter while mitigating potential financial default risk. Perhaps, it is time in revisit what has been referred to as the "F" word in many circles--factoring. Factoring continues to be a growth industry, and the turnover globally is estimated at US$700 billion a year--with 12% annual growth.

Under a factoring arrangement, the business firm sells its short-term account receivables to a factor or financial institution on a with- or without-recourse basis. The factor provides a comprehensive range of services, including collection, credit management service, credit risk protection, and more. Its perceived complexity comes from its flexibility. This facility can be broadly tailored along four dimensions: 1) payment, 2) advance or maturity, 3) recourse or nonrecourse, and 4) with or without notification to meet the specific needs of the trader.

While factoring is generally associated with the financing of consumer goods and services, it can be applied in international trading as well. International factoring is similar to domestic factoring except that it involves a two-factor system (see Figure 1). (5)

Commercial banks have shown increasing interest in providing factoring services, as financers are looking at alternative "securities" to support their lending. In fact, receivables with a good spread of debts may qualify nicely. However, the factoring business is not easy, as it involves more than just lending and debt collecting. In the words of Terry. Haydon (managing director, Commercial Factors Limited), "It's not an industry for the faint-hearted."

Long-tenored Financing in Emerging Markets

Competition and market saturation inevitably drive many companies to venture abroad--often to unfamiliar but potentially lucrative territories. Consider the dilemma of an exporter who is thinking about extending medium-term financing--say, five years--for the sale of heavy industry equipment to an importer domiciled in an emerging market. What's the best way to mitigate financial default risk considering the length of time involved? Issuing; usance documentary credits is an unlikely option, given that the conventional LC seldom caters to a financing period exceeding; 360 days except for structured financing. And unless the margins are sufficiently lucrative, the all-in costs of credit structuring (not to mention the legal fees) are likely to erode the trader's profit. A less complex option is forfaiting.

Forfaiting is a post-shipment finance instrument. It is the purchase of receivables (arising from an underlying export of goods and services), guaranteed (avalized) by the importer's bank, without recourse to the exporter. Figure 2 illustrates a simplified financing flowchart.