Moving beyond Letters of Credit in international trade finance.

For over a century, the Letter of Credit (LC) has served as the primary international trade financing tool. The LC owes its remarkable success to the fact that is has so effectively fulfilled its dual mission of minimizing risk and facilitating smoother trade transactions.

However,

the LC was originally designed to address issues related to a global marketplace that, in many respects, have changed over time or no longer exist. A century ago, much slower methods of transportation and communication ensured that many exporters and importers rarely met, and the LC emerged as an optimal solution to their concerns about secure title transfer and payment.

Today, the emergence of new telecommunications tools has contributed to enhanced trust between global buyers and sellers and a genuine boom in international trade.

While the LC still has a valuable role to play in today's more diverse and complex global marketplace, it's no longer the best possible financing solution in every situation. In fact, banks and other financial services providers have developed a wide array of global trade financing tools and technologies, such as Documentary Collection and Trade Asset Distribution, that give importers and exporters increased flexibility in how they structure their trade transactions.

A New Era in Global Trade

In recent decades, the nature of international trade has changed dramatically. The telecommunications revolution has provided exporters and importers with the means to communicate more regularly, affordably and with such a sense of immediacy that it's far easier to develop a measure of trust with ones trading partner than was possible in the past.

In addition, many companies now support trading relationships that extend back at least 20 years, so their concern about the reliability of payment and title transfer has become a less pressing issue. Similarly, many firms have moved some of their operations overseas or have formed longstanding partnerships with overseas suppliers and, in the process, have gained a familiarity with overseas markets and financial institutions that has further enhanced trust between trading partners.

Also, as the volume of global trade has grown, so too has the level of competition, and that has led some exporters to drop their demand for LCs as a way to attract buyers for their goods. The result is that the LC has come to be viewed in certain types of transactions as more of a hindrance to efficient global trade than a facilitator of it.

Other LC Limitations

Recent changes in the way global trade is conducted have also underscored some of the inherent drawbacks of LCs. For example, the LC bears a higher cost than other payment mechanisms, and using it also necessitates considerable documentary paperwork.

In the past, when trading partners exchanged payment and goods several times a year, or perhaps even monthly, the cost of LCs and the required paperwork weren't particularly onerous. However, in today's era of just-in-time inventory management and substantially higher trade volumes, exporters may ship goods to a buyer on a weekly basis, and the costs in time and money of preparing so many LCs can become substantial.

Basically, while the LC may not have outlived its usefulness, it has clearly outlived its universality.

In response to this, banks and other financial services companies have developed an array of new international trade financing solutions designed to meet the more diverse needs of today's importers and exporters. These solutions aren't replacements for LCs. Instead, they complement the LC, providing additional financing resources in a more complex and demanding marketplace.

Documentary Collection Services

Documentary Collection is a method of payment in which a bank acts as an agent for an importer or exporter in order to facilitate the transfer of trade documents and payment.

In terms of document flow, Documentary Collection is similar to an LC transaction. However, there is one key difference. With an LC, a bank guarantees the payment, but in a Documentary Collection, a bank simply transfers the appropriate documents from seller to buyer without guaranteeing payment. The buyer must be willing to accept payment risk in these transactions.

In a typical Documentary Collection, the exporter sends title, invoice and other documents through its bank to an importer with instructions for collecting payment from that importer via a correspondent bank in the importer's home country. Often, the seller will instruct its bank to release the negotiable shipping documents to the buyer only when the buyer has either paid for the goods in question or has accepted them with the promise to pay at a future date. In some cases, the seller may opt to tier payment terms according to the value of the transaction.

Typically, Documentary Collection is used when two parties have developed a level of trust, either because the buyer is a reputable company, is an affiliate or subsidiary of the seller or has a favorable trading history with the seller. Documentary Collection also comes into play when there is intense competition for business and sellers have agreed to drop their request for LCs and accept more lenient payment terms.

Documentary Collection has emerged as a popular alternative to LCs because it is less expensive, requires less documentary paperwork yet still provides exporters with complete control over transaction documents until the buyer has paid or accepted a payment draft. For importers, Documentary Collection eliminates the need to rap into their credit facilities.

However, there are drawbacks associated with Documentary Collection of which both importers and exporters should be aware. Exporters may have to bear the cost of goods shipment, insurance and agent fees if the importer refuses the shipment and does not pay. Also, the U.S. International Chamber of Commerce's "Uniform Rules for Collection" only provide for the banks to act as agents, and not underwriters of commercial risk; therefore, an exporter may have to resolve matters directly with the importer.

Similarly, importers should know that because banks do not underwrite payment for Documentary Collection, they are not obliged to examine documents for discrepancies as they do with LCs. In these transactions, the importer is chiefly responsible for document review.

Still, in many situations, the benefits of using Documentary Collection more than outweigh its risks.

Export Receivables Insurance

As international trade has grown, so too has the competitive pressure on both buyers and sellers. This has created an environment in which large, powerful importers are often able to dictate payment terms to exporters, who in many cases may be much smaller and less well-funded.

As a result, it's not unusual for an importer to demand open account billing as a prerequisite for its business. Even though these companies may be reputable, long-established firms, smaller exporters may still have concerns about damage exposure from payment delays or even defaults.

Some insurance companies currently offer Export Receivables Insurance as a way to insure the value of receivables and minimize damage from payment delays and defaults. Export Receivables Insurance covers most of the risks (e.g., political, currency) that are typically covered by an LC.

Export Receivables Insurance enables exporters to use non-LC forms of international trade financing while still enjoying many of the risk protections LCs offer. With Export Receivables Insurance, exporters simply have an insurer underwrite transaction risk rather than a bank.

New International Trade-Related Technologies

Because LCs remain a valuable global trade financing tool in many situations, banks have also developed electronic enhancements to streamline and expedite LC processing. For example, some banks now offer Online LC Information Reporting, which enables importers to monitor the latest information on their LC transactions online through their banks' web sites. In the process, importers gain faster access to information, receive expanded self-service capabilities and can enjoy more accurate transaction reporting.

A number of banks offer another related tool known as Electronic LC Transaction Processing. Essentially, this tool enables importers to initiate LC transactions online using electronic documents that preserve repetitive, boilerplate information. As a result, this solution facilitates self-service, expedites LC processing and contributes to more accurate, error-free LC transactions.

Banks also have introduced new technologies for enhancing non-LC financing solutions. For example, a number of institutions now offer Automated Export Collection Processing.

As described earlier, in a Documentary Collection an exporter typically initiates the transaction by sending documents to its bank instructing it to accept payment from an importer via an overseas correspondent bank. However, exporters can expedite this process by employing Direct Collection, an alternative process in which the exporter sends documentation directly to the correspondent bank using reprinted letterhead from its (the exporter's) bank. Automated Export Collection is simply an electronic form of Direct Collection. Using it, an exporter fills out an electronic facsimile of its bank's letterhead with payment instructions and transmits it over the Internet directly to the correspondent bank. This allows exporters to pass information to importers more quickly. Exporters can also use Automated Export Collection to generate electronic reports on all transactions, which contribute to faster and more accurate transaction monitoring and processing.

Export Credit Agency Programs

Every developed nation engaged in international trade possesses some form of an export promotion agency whose mission is to promote and facilitate the export of its goods and services. In the U.S., that agency is the Export-Import Bank of the United States (Ex-Im Bank) (www.exim.gov). These agencies typically offer various types of financing programs dc-signed to assist exporters in addressing some of the common challenges of international trade.

For example, Ex-Im Bank offers Buyer Financing Programs that assist exporters in extending buyers more flexible forms of financing than are typically offered. Using this program, a U.S. manufacturer might be able to offer an overseas buyer more extended financing structures at lower interest rates than it could offer on its own. The ability to offer such financing can often be a key to securing a lucrative new contract.

Ex-Im Bank also offers Working Capital Guarantee Programs. These programs are designed for smaller exporters that have a market for their products yet are unable to finance the manufacturing volumes needed to meet market demand. Using the Working Capital Guarantee Program, a small manufacturer can arrange to have Ex-Im Bank guarantee 90 percent of the value of the line of credit the company needs from its bank to fund production of its exports. In effect, this program protects the lending bank while also ensuring that the manufacturer has access to the line of credit it needs to finance large, new business orders.

Trade Asset Distribution

Trade Asset Distribution, which is also known as Forfaiting, is another significant alternative to LCs. In a standard Trade Asset Distribution transaction, an importer agrees to purchase goods now but for various reasons seeks to defer payment for a stipulated period.

The importer then issues to the exporter a medium-term promissory note or a bill of exchange without recourse. In other words, the exporter accepts a debt obligation from the importer with no guarantee other than the importer's word that it will pay.

However, the exporter can sell that debt to institutional investors, who are willing to accept that risk and buy it at a discount. Forfaiting allows the importer to acquire necessary goods while also deferring payment to a more convenient time. It also enables an exporter to maintain its cash flow by shipping goods and receiving a prompt form of payment.

Forfaiting provides for trading partners a flexibly structured financing alternative to LCs that requires less paperwork and which doesn't exhaust a credit line. Obviously, this is an alternative suitable only for trading partners that have developed a considerable level of trust and for exporters willing to accept some risk.

Conclusion

There's no question that technology and new, far-reaching forms of international relations have radically reshaped the global trade environment over the past 50 years, and this change has facilitated an explosion in global trade activity. While LCs remain a reliable tool for financing that trade and minimizing its inherent risks, they no longer have universal application in a marketplace where flexibility is a must and trust has become far easier to establish.

Fortunately, banks and other financial services providers have been keeping up with this change and are bringing to market a new, expanded array of financing tools that address many of the issues faced by exporters and importers on the forefront of today's global marketplace. Naturally, matching the right tool to the right transaction has become a more complex and critically important issue, but trading partners can rest assured that the solutions they need are readily available.

Andrea Ratay is vice president in Trade Finance with The Bank of New York You can reach her at 516/294-2176 or via e-mail at aratay@bankofny.com.