Trade Finance Instruments and Services

1. Trade Finance Instruments and Services Chapter 3 Instructor Shan A. Garib, Winter 2013

2. The Tools and How to Use Them Overview • Changing role of technology and increase in trade relations - traditional financing needing to adapt • This chapter a review of instruments: advantages/disadvantages, purpose, role of financial institutions and ECA

3. The Tools and How to Use Them Instruments: An Overview • Documentary Collections • Documents against payments • Documents against acceptance • Parties and processes under documentary collections • Documentary Letters of Credit • Parties and processes under DLC • Irrevocable, unconfirmed, confirmed, deferred payment and acceptances, transferable, back-to-back, revolving, red clause, corporate

4. The Tools and How to Use Them Instruments: An Overview • Bonds, guarantees and standby letters of credit • Bid bond • Performance bond • Advance payment and progress payment guarantee • Warranty and retention guarantee • Standby letters of credit versus guarantees • Bonds, guarantees and standby letters of credit: selected observations

5. The Tools and How to Use Them Documentary Collections • Exporter mails shipping docs to collecting bank which obtains payment from importer in exchange for documents • Exporter keeps title until PMT is received Documents against PMT • Docs representing title to the shipment are released to the importer only on receipt of PMT

6. The Tools and How to Use Them Documentary Collections Documents against ACCEPTANCE • Docs representing a promise to pay in the future • Importer receives documents once the acceptance is created Parties and processes under documentary collections • Applies to both DOP/DOA • Key difference is timing of PMT and risk involved

7. The Tools and How to Use Them Documentary Collections Parties and processes under documentary collections • Applies to both DOP/DOA • Key difference is timing of PMT and risk involved • Four parties: exporter, importer, exporter’s bank, importer’s (correspondents) bank • Duties outlined in a collections order provided by exporter • Collections order lists the documents enclosed and provides terms and conditions under which PMT is made

8. The Tools and How to Use Them Documentary Collections Parties and processes under documentary collections • The Principal (exporter) – ships goods and provides DOCs to remitting bank (exporters bank) • The remitting bank verifies DOCs against collection order and sends them to importer’s bank (collecting bank) • The collecting bank verifies DOCs against collection order and gives to importer for PMT

9. The Tools and How to Use Them Documentary Collections Parties and processes under documentary collections • The drawee (importer) gets DOCs through immediate PMT or term draft or bill of exchange (obligation to pay) • Other terms: • Drawer (exporter) draws up and signs bill of exchange • Acceptor (importer) signs acceptance of the bill of exchange • Presenting bank (importers bank) presents DOCs to importer

10. The Tools and How to Use Them Documentary Collections Parties and processes under documentary collections • Banks only deal with DOCs to ensure consistency • Role of banks set out in Uniform Rules for Collection (URC) – latest is URC 522 Direct Collection Systems • Some remitting banks allow exporters to prepare collection order themselves and remitt it and DOCs to collecting bank

11. The Tools and How to Use Them Documentary Collections The bill of exchange or draft • Written unconditional order signed by the exporter and drawn on the importer, demanding PMT of face value of draft • Legal DOC representing PMT obligation • Subject to Bill of Exchange Act – Canada • Represents and instrument of debt • Draft maybe payable on presentation (sight) or future date

12. The Tools and How to Use Them Documentary Collections The bill of exchange or draft • Exporter forwards the draft and DOCs to importer through remitting and collecting banks for acceptance and PMT • Choosing DOA, exporter keeps control until importer has incurred an enforceable obligation to pay in future • Remitting bank has no responsibility for the authentication of signature or creditworthiness of the importer

13. The Tools and How to Use Them Documentary Collections The bill of exchange or draft • A draft accepted by the importer does not guarantee PMT at maturity to • So, exporter may ask collecting bank or presenting bank to provide a guarantee of PMT • The is called “AVAL” - bank assume risk at a cost to either the exporter or importer • Draft is now avalized

14. The Tools and How to Use Them Documentary Collections The bill of exchange or draft • Exporter may arrange to have draft discounted for immediate PMT • If exporter’s bank is willing to assume of importer or importer’s bank when adding the aval • Exporter may discount draft with recourse in the event of non-PMT • Charges for discount are in the form of interest rate which includes risk premium

15. The Tools and How to Use Them Documentary Collections Protest for non-PMT • Legal procedure for exporter when importer refuses to accept bill of exchange or dose not pay at maturity Convenience and cost verses risk • A documentary collection is cheaper than LOC it does not provide the same level of protection to the exporter • Possible that importer refuse sight PMT or PMT at maturity – leading to delays

16. The Tools and How to Use Them Documentary Collections Convenience and cost verses risk • Suitable means of securing PMT if: • There is confidence in importers reputation • Political/economic and legal conditions in importing country are stable • Importing country places no restrictions on imports

17. The Tools and How to Use Them Documentary Letters of Credit Parties and Processes • Securing contractual commitments in a commercial contract • Provide security, protection for imp/exp • L/C effective in these situations: • Importer concerned that goods shipped in prescribed manner and time before being required to pay • Exporter concerned with security of PMT

18. The Tools and How to Use Them Documentary Letters of Credit Parties and Processes • Conditional written undertaking by issuing bank given to exporter (beneficiary) at the request of an importer (applicant) • L/C requires issuing bank to effect PMT within time limit against presentation of correct DOCs

19. The Tools and How to Use Them Documentary Letters of Credit Parties and Processes • L/C mechanics: • Exp/imp agree to contract in sale of goods and PMT be made by L/C • Importer instructs bank (issuing bank) to open a L/C • Once issued it is a PMT obligation of issuing bank • Independent of importer’s wiliness to pay • Issuing bank forward L/C to correspondent bank (advising bank) in the country of exporter • Issuing bank authorize advising bank to pay exporter

20. The Tools and How to Use Them Documentary Letters of Credit Parties and Processes • L/C mechanics: • If receipt of L/C exporter unwilling to comply, exporter contact importer and request amendment • Once issued L/C irrevocable • L/C may be confirmed where the advising bank adds their PMT undertaking to L/C • DOCs checked by advising bank and sent to issuing bank • PMT made to advising bank and importer’s account charged

21. The Tools and How to Use Them Documentary Letters of Credit Importer/buyer/applicant/account party • The party that contracted to buy goods • Applied to their bank to have L/C issued on their behalf • Gives importer assurance that exporter will be paid if comply with terms • Eg terms: shipment date, origin of goods, route

22. The Tools and How to Use Them Documentary Letters of Credit Issuing Bank • Issues L/C replaces the standing of importer ie. Credit enhancement Advising Bank • Issuing bank sends L/C to with instructions to notify the exporter Confirming Bank • If requested by issuing bank, the advising bank may add their confirmation to L/C • Provides assurance of PMT to exporter

23. The Tools and How to Use Them Documentary Letters of Credit Confirming Bank • Independent of willingness of issuing bank to pay • Concerns over risk from importers bank • Request to confirm only made by issuing bank • Variation of confirmation of L/C is silent or blind confirmation – when exporter asks own bank add its confirmation without request from importers bank • Discouraged by the international chamber of commerce

24. The Tools and How to Use Them Documentary Letters of Credit Exporter/Seller/Beneficiary Party • Party that has contracted to sell to importer Irrevocable documentary letters of credits • UPC 600 in July 2007 • New rules eliminated the revocable L/C • Only can be changed with agreement of parties

25. The Tools and How to Use Them Documentary Letters of Credit

26. The Tools and How to Use Them Documentary Letters of Credit Unconfirmed L/C • Bears the PMT undertaking of issuing bank only Confirmed L/C • Provide exporter with added assurance of PMT from a local bank other than the issuing bank and removes foreign bank and country risk • Commercial and country risk protection • Used: political/eco instability, issuing bank poor credit standing

27. The Tools and How to Use Them Documentary Letters of Credit Confirmed L/C • Request for confirmation originates from issuing bank and agreed with by advising bank • Exporter determines if confirmation is required before the L/C is issued • Then exporter asks importer to have their issuing bank make a request for the advising bank to add its confirmation • Cost born by exporter

28. The Tools and How to Use Them Sample Documentation • Importers can request documents to be prepared by the exporter: • Draft of bill of exchange • Commercial invoice • Packing list • Certificate of origin • Certificate of inspection • Insurance certificate • Bill of landing or other transport doc • Helath certificate

29. The Tools and How to Use Them Deferred PMT and Acceptances under Letters of Credit: • Exporter may agree to PMT at later date even after shipment –as much as 360 days • Reflected in letter of credit • Eg. Deferred PMTs, where issuing bank will make a PMT at future date and NO draft or bill of exchange is requested • Eg. Acceptance, where the LOC calls for a draft to be paid at a future date at a number of days AFTER sight (presentation) of shipment and drafts have to be drawn on the negotiation bank or issuing bank

30. The Tools and How to Use Them Transferable documentary Letters of Credit: • The exporter has the option to transfer the terms or conditions of a LOC to another company (a second beneficiary) • This allows the exporter to use the credit standing of the importer with their bank to secure an instrument in favour of the ultimate supplier (the second beneficiary) • Useful for an intermediary exporter or broker or when the exporter is unwilling to have a letter of credit issued by their bank

31. The Tools and How to Use Them Transferable documentary Letters of Credit: • This allows shipment to go from exporter to importer without the exporter or importer knowing each other • This way, the exporter and importer CAN’T CUT OUT MIDDLE MAN • Transferable credit can only be made a request of the applicant • Transferable credits allow changes to be made: • Broker can add a profit margin to price charged to the importer

32. The Tools and How to Use Them Transferable documentary Letters of Credit: • Transferable credits allow changes to be made: • The name and address of exporter (the first beneficiary) may be replaced by those of the applicant • The transferred portion of the letter may show a reduced amount and unit prices • The validity of the latter of credit, latest shipment date and latest date for presentation of documents may be compromised • The percentage of insurance coverage may be increased

33. The Tools and How to Use Them Transferable documentary Letters of Credit: • After shipment the second beneficiary is required to present correct documents as specified in the transferred LOC and the exporter (original beneficiary) will substitute their own invoices for the ones of the second beneficiary • The transferring bank (advising bank) will validate the docs before making PMT • Advantages of TLOC:

34. The Tools and How to Use Them Transferable documentary Letters of Credit: • Advantages of TLOC: • If exporter doesn’t have sufficient credit to have his/her bank open a LOC for him/her • Importer is assuming risk of extending credit to unknown third-party • Disadvantages of TLOC: • The importer might become award of secondary beneficiary and deal with them directly after • There is risk to exporter of his/her documents not being accepted (refused)

35. The Tools and How to Use Them Back-to-back documentary Letters of Credit: • Where one LOC is used as the basis for issuing a second LOC • The first LOC serves as collateral for second one • Used when exporter is acting like a broker (similar to TLOC) • B2B LOC are independent whereas TLOC are link to other documents • It is extremely risky for intermediary bank issuing a second LOC

36. The Tools and How to Use Them Revolving documentary Letters of Credit (cumulative and noncumulative): • Is an instrument that specifies terms that allow the amount or the period of the letter to automatically renew until an agreed final expiry date • It may also be confirmed • It may revolve in relation to time or to value or it may also be cumulative or non cumulative

37. The Tools and How to Use Them Revolving documentary Letters of Credit (cumulative and noncumulative): • Cumulative • Terms that allow for the value of any drawings not made in prior periods to carry over, or to be added to future claims • Non-cumulative • Do not allow for drawings to be combined and any unclaimed drawings in relation to the value or time cannot be claimed at a later period • Can be described as “use it or loose it”

38. The Tools and How to Use Them Revolving documentary Letters of Credit (cumulative and noncumulative): • Use to allow exporter to use the same LOC while making many shipments over time Red Clause documentary Letters of Credit: • Authorizing the advising bank to make advances to the exporter against the guarantee of the importer’s bank • Enables exporter to obtain or produce the goods that will be shipped to exporter

39. The Tools and How to Use Them Corporate documentary Letters of Credit: • LOC processed by banks for larger corporations • For importer it represents fewer bank fees and no usage of credit lines • For Exporter provides pre-export financing • BUT CLOC DON’T provide the independent PMT undertaking of a traditional bank LOC

40. The Tools and How to Use Them Bonds, guarantees and Standby Letters of Credit: • Performance bonds, and guarantees are promises issued by surety companies and banks to help ensure that the commercial parties will carry out their contractual agreements • They can also be used to secure a bank loan There are two types of Sureties: A bond – a guarantor (insurance company) will guarantee the execution of the exporter’s obligations - in order to benefit from the bond it has to be proven that the exporter defualted on his/her obligations

41. The Tools and How to Use Them Bonds, guarantees and Standby Letters of Credit: • They can also be used to secure a bank loan There are two types of Sureties: A guarantee – a guarantor (bank) will agree to pay some money if the exporter dose nto fulfil it’s obligations - in order to benefit from the bond it has to be proven that the exporter defaulted on his/her obligations -sometimes it is an unconditional instrument where the importer can get PMT on a simple demand!

42. The Tools and How to Use Them Bonds, guarantees and Standby Letters of Credit: • Issuers of bonds and Guarantees: • Surety companies – usually issue a performance bond in North America • Guaranteeing to importer that if exporter can’t fulfil obligations then the surety company will force it to • Banks – the banks performance bonds usually used to secure overseas contracts • It can be a simple irrevocable letter of guarantee or contain specific conditions

43. The Tools and How to Use Them Bonds, guarantees and Standby Letters of Credit: • Bid Bonds or guarantees: • A bidders must provide cash deposits or an irrevocable guarantee between 2 and 10% of the contract amount • The bond or guarantee is usually valid for the tender period –up to six months • For an international tender the bid bond can only be called if the exporter fails to follow through if they are awarded the contract • If that happens then the bond compensates the importer for the costs of having to find another company to complete the contract

44. The Tools and How to Use Them Bonds, guarantees and Standby Letters of Credit: • Bid Bonds or guarantees: • Usually issued by the local bank Performance Bond • For larger and longer term contracts • Usually posted at 10% up to 25% o the total contract cost • This instrument will undertake PMT if the exporter fails to follow through if they are awarded the contract • Usually issued by the local bank

45. The Tools and How to Use Them Bonds, guarantees and Standby Letters of Credit: Performance Bond • Unused guarantees are retuned to exporter Advance PMT and Progress PMT guarantee • Usually large contracts, PMTs made by importer to exporter to buy materials to start project • Advance PMT guarantee will refund all or part of the PMT if the seller (exporter) doesn’t produce or deliver on the goods

46. The Tools and How to Use Them Bonds, guarantees and Standby Letters of Credit: Performance Bond • Unused guarantees are retuned to exporter Advance PMT and Progress PMT guarantee • Usually large contracts, PMTs made by importer to exporter to buy materials to start project • Advance PMT guarantee will refund all or part of the PMT if the seller (exporter) doesn’t produce or deliver on the goods • The amount of the advanced PMT will be reduced, the more work the exporter does • Or exporters can be paid progress PMTS after each stage

47. The Tools and How to Use Them Bonds, guarantees and Standby Letters of Credit: • Warranty and Retention (hold back) guarantee • Provides financial compensation if goods bought do not perform as required or of low quality • Usually for a fixed period of time • Sometimes holdback 5-25% of the contract amount • To enable the exporter to receive cash upfront instead of waiting a bank may issue a hold back guaranteeto the importer forcing the importer to pay the exporter right away and not holdback

48. The Tools and How to Use Them Bonds, guarantees and Standby Letters of Credit: Other characteristics of these instruments: • Security for a loan or operating facility • A guarantee or standby credit will replace the financial standing of a borrower • Sometimes a couple of bank get together and offer a guarantee or standby credit • This shares the risk • These are known as “loan substitutes”

49. The Tools and How to Use Them Bonds, guarantees and Standby Letters of Credit: • Standby LOC versus guarantees • SLOC can be used as a guarantee • The exporter (beneficiary) presents docs in the form of an affidavit stating the nature of the default • “Standby LOC “ used as general term covering all types of guarantees either performance related or financial

50. The Tools and How to Use Them Bonds, guarantees and Standby Letters of Credit: • Uniform Rules of Contracts guarantees • The international Chamber of Commerce has published Uniform Rules for Demand Guarantees • URDG 458 • Provides definitions and achieves fair balance • Very often the rules governing LOC (ICC UCP600) are applied to standby credits and guarantees • Costs of Bonds and Gurantees • An exporter will pay comissions, premiums, fees and out of pocket charges to a surety company or bank issuing a bond or gurantee