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EBRD TFP e-Learning – Introduction to Trade Finance – TRADE FINANCE PRODUCTS Page 1
TRADE FINANCE PRODUCTS
Thriving international trade is a sign of a healthy global economy. Exports and imports
combined drive a huge amount of growth and development in the world, but especially in
emerging or developing economies.
The most common Trade Finance Products used in International Trade are Documentary
Collections, Documentary Credits and Guarantees or Standby Letters of Credit and Trade
Loans.
Trade Finance Products provided by a bank involve two key elements, risk coverage and
provision of finance, or simply put, money to support trade activities.
In this section we will look in greater detail at each product, identifying the benefits and
risks to both the exporter and the importer and the product cycle from application to
payment.
Trade Finance Products> Documentary Collections >
This section outlines how Documentary Collections are used to facilitate international
trade transactions.
This will be achieved by becoming familiar with:
A simple definition of Documentary Collections
The parties involved
The applicable international rules for bank Documentary Collections
The workflow for a Documentary Collections or ‘how it works’?
The benefits
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Here is a simple but complete definition of a Documentary Collection as used in the context of international trade and
finance.
There are basically two ways in which collections may be used to collect payment from an importer in another country.
These two means are known as Export Documentary Collections and Export Clean Collections.
When using documentary collections the commercial and transport documents sent for collection may also be
accompanied by financial documents such as a Bill of Exchange or a Promissory Note.
Documentary Collection
Documentary collections are a service provided by a bank whereby the bank will use its
correspondent bank relationships as a network to collect the proceeds of export shipments
using the documentary collection product operating under internationally accepted rules
known as the URC 522.
Export Documentary Collection
In the case of Export Documentary Collections a bank will remit export documents which
result from the sales contract between the seller and the buyer to a nominated
correspondent bank in the importer's country.
Instructions will be provided to the bank to release the documents to the buyer (importer)
either against ‘sight payment’ or against acceptance of a Bill of Exchange (Draft). Upon
release of the documents to the importer, the importer can take delivery of the goods.
Export Clean Collection
In the case of Export Clean Collections the bank will only remit a financial document (Bill of
Exchange/Promissory Note) to a nominated correspondent bank in the importer's country.
Instructions will be provided to the collecting bank to present the financial document to
the buyer (importer) for payment at ‘sight’ or at some specified future date or ‘term’. As
the commercial documents are not involved in a clean collection, the clean collection
cannot provide any constructive control over the goods, it merely facilitates collection of
payment.
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Bill of Exchange
A Bill of Exchange is drawn up by the seller and can be defined as ‘An unconditional order
in writing drawn by the drawer requesting another party to pay on demand or on a future
determinable date a sum certain in money to, or to the order of, the drawer’
A Promissory Note
A Promissory Note is similar to a Bill of Exchange except that the promissory note is drawn
by the buyer and can be defined as ‘An unconditional promise to pay a sum certain in
money on demand or on a future determinable date to, or to the order of, another party’.
Documentary Collections follow a particular cycle or workflow with various roles filled by the parties involved:
The primary parties involved in a documentary collection are:
the Principal
the Remitting Bank
the Collecting Bank
sometimes a Presenting Bank and the Drawee
Like other international trade finance instruments used to facilitate international trade Documentary Collections also
operate subject to international rules developed by the ICC Banking Commission.
The Principal
The Principal is the party that initiates the collection and is often referred to as the
Exporter, Seller or Drawer.
The Remitting Bank
The Remitting Bank is the exporter's bank which remits the collection document to
the collecting bank in the importer's country.
The Collecting Bank
The Collecting Bank is often referred to as the correspondent bank or agent of the
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remitting bank and its role is to endeavour to collect the proceeds of the collection
and remit the collected funds.
A Presenting Bank
The Presenting Bank is often the same bank as the collecting bank or it can be the
bank of the drawee or importer but in any event in the context of collections it is
acting under the collection instruction received from the Remitting Bank.
The Drawee
The Drawee is the importer, otherwise known as the Buyer.
ICC Banking Commission
The ICC Banking Commission is the largest commission of the International Chamber
of Commerce (ICC), the World Business Organization. The ICC Banking Commission has
more than 600 members in more than 100 countries.
The ICC Banking Commission is the rule making body for trade finance instruments
such as Documentary Credits (UCP), Demand Guarantees (URDG), Standby Letters of
Credit (ISP) and Documentary Collections (URC).
The rules, known as the Uniform Rules for Collections (URC) first came into force on 1 January 1968 and have been updated and modified with the most recent update being the Uniform Rules for Collections, 1995 Revision, ICC Publication No. 522, or URC 522 for short.
URC 522
The URC 522 rules provide a set of clear standardised procedures and regulations for all
parties involved in a collection,
the exporter or drawer;
the remitting bank;
the collecting bank;
the presenting bank; and
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the importer or drawee.
The purpose of the URC 522 is to provide a standardised set of international rules for
collections, both clean and documentary, and to establish strict workable guidelines for all
parties that are involved in any stage of a collection operation.
The rules state that any collection can be subject to the URC 522 and that all parties to the
collection must adhere to the URC 522 unless it has been expressly agreed otherwise, and
unless the rules run contrary to the provision of a national, state or local law and/or regulation
which supersede the URC 522.
The Collection Order
When the remitting bank acting of behalf of the exporter sends a documentary collection to a collecting bank it will use a
standardized documentary collection instruction order which will state that the collection is to be handled subject to the
URC 522 rules. Every collection order will contain the following information:
The name of the Collecting Bank.
The number and type of documents included for collection.
Whether the collection is ‘Sight’ or ‘Term’.
The methods by which to remit proceeds.
Procedure in the case of dishonor or non payment.
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SHOW ME HOW IT WORKS
Five steps of the Documentary Collection Life Cycle:
Step 1: The Exporter and the Importer agree that settlement of the agreed contract of sale will be by way of a
documentary collection.
Step 2: The Exporter ships the goods and sends the shipping and commercial documents to their bank which is
known as the Remitting Bank because it ‘remits’ the collection documents to the Collecting Bank in the Importer’s
Country. The Exporter is now known as the Principal.
Step 3: The Remitting Bank sends the documents to the Collecting Bank along with the Collection Instruction to
deliver the documents to the Importer either against payment (Documents against Payment D/P or Sight collection)
or against acceptance of a bill of exchange (Documents against Acceptance D/A or Term collection).
Step 4: The Collecting or Advising Bank will only release the shipping and commercial documents to the buyer
provided the buyer ‘pays’ or ‘accepts’ as specified in the documentary collection instructions.
Step 5: When the collection payment is collected it is sent back to the Remitting Bank for credit of account of the
Exporter.
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There are 2 primary ways in which collection of payment and transfer of documents can take place:
Documents against Payment (D/P), also called a Sight Collection
and
Documents against Acceptance (D/A), also called a Term Collection
Another method for the operation of documentary collection is "D/A + Bank Aval".
Documents against Payment (D/P)
With ‘D/P’ or a Sight Collection, the collecting bank receives the Bill from the remitting
bank and presents it on to the importer, if necessary using the service of another bank
(the presenting bank). The payment instrument is accompanied by the commercial
documents as specified in the collection order.
On sight of this bill, the drawee (importer) is requested to pay the amount due in
exchange for release of the documents. When payment is effected the importer
receives the documents to collect the goods. The proceeds are sent by the collecting
bank to the remitting bank and then paid to the seller.
Documents against Acceptance (D/A)
Documents against Acceptance, or term collections, also known as usance collections
are used when payment is to be made on a future date and they provide the drawee
or buyer with time to pay (period of credit).
The buyer on whom the Bill is drawn is known as the drawee. The drawee is expected
to ACCEPT the term bill, which is an undertaking by the drawee to pay the amount
due at a specified future date (maturity date).
If the Bill is accepted then the documents are released to the drawee/importer to
collect the goods.
D/A + ‘Bank Aval’
In this case the collection order will specify that the Bill of Exchange must be accepted
by the drawee and also guaranteed or "avalised" by the importer's bank prior to
release of the documents.
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Documentary Collections - The Benefits for the Exporter
By using documentary collections I have a local bank in the importer's
country working to collect the proceeds of the collection.
Documentary collections are simpler for me to operate and not as
expensive as documentary credits. Of course they do not provide the
same level of security.
I have the protection of international rules setting out the obligations of
the parties involved.
I can obtain trade finance if my bank will discount an accepted draft or
bill of exchange that is for payment at a future date.
I have the security of guaranteed payment when the collection order is
avalised or guaranteed by a bank.
Documentary collections may enable the collecting bank to retain control
over the goods until either "payment" or "acceptance".
Documentary Collections - The Benefits for the Importer
I can avoid making payment in advance before the goods are shipped.
Documentary collections are simpler for me to operate and not as expensive
as documentary credits.
I have the protection of international rules setting out the obligations of the
parties involved.
Under a term or usance documentary collection I do not have to pay until
the maturity date. This reduces the amount of local financing that I need.
I am happy that my exporter trusts me to deliver under a documentary
collection.
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Trade Finance Products> Documentary Credits >
This section outlines how a Documentary Credit is used to settle international trade
transactions.
We will look at:
A simple definition of a Documentary Credit
The parties involved
The workflow for a documentary credit or ‘how it works’?
The methods of honour or settlement of a documentary credit
The benefits for the parties involved
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A documentary credit is an undertaking by a bank that payment will be made when the seller presents documents
specified in the documentary credit. The documents should provide evidence that the seller has performed under
the international contract of sale.
A documentary credit is also referred to as a letter of credit or LC.
A documentary credit can be payable at sight (on presentation of documents) or at a future date. Documentary
credits operate globally under a very important set of international banking rules developed by the ICC known as
‘The Uniform Customs and Practice for Documentary Credits, 2007 Revision, ICC Publication no. 600 (“UCP”)’.
Documentary Credit
A documentary letter of credit is an undertaking by a bank, on behalf of an importer
(buyer), to pay a certain amount of money to an exporter (seller) within a specified
period of time, provided that the exporter presents documents specified in the letter
of credit, which comply with the terms and conditions set out in the letter of credit.
Future Date
Payment at a Future Date is (usually shown as 'X days from shipment date').
Where payment is at a future date the payment instrument is known as an
acceptance, deferred payment or usance letter of credit.
The International Chamber of Commerce
The International Chamber of Commerce (ICC) developed the ‘Uniform Customs and
Practice for Documentary Credits’ to provide importers and exporters with a set of
common rules to govern the operation of documentary credits.
When a documentary credit is issued that expressly states the
application of UCP 600 rules, the rules are binding on all parties.
Application of UCP 600 Rules:
The Uniform Customs and Practice for Documentary Credits,
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2007 Revision, ICC Publication no. 600 (“UCP”) are rules that
apply to any documentary credit (“credit”) (including, to the
extent to which they may be applicable, any standby letter of
credit) when the text of the credit expressly indicates that it is
subject to these rules. They are binding on all parties thereto
unless expressly modified or excluded by the credit.
The effective date of the latest version UCP 600 rules was 1 July
2007.
The parties involved in a documentary credit transaction are:
the buyer or importer known as the Applicant,
the importer’s bank known as the Issuing Bank, and
the exporter known as the Beneficiary.
The banks that interact with the exporter (usually in the exporter’s country) are:
the Advising Bank,
the Confirming Bank and
the Nominated Bank
The Applicant
The buyer or importer is known as the Applicant because this party applies to its bank to issue a documentary credit to facilitate the shipment of the goods.
The Issuing Bank
The Issuing Bank issues the letter of credit on the instructions of the applicant. The
issuing bank takes a credit risk decision on the importer before agreeing to open the
letter of credit and must take adequate collateral and get approval for a credit line as
once issued the letter of credit is an irrevocable financial commitment of the bank.
The Beneficiary
The Beneficiary is the party in whose favour the documentary credit is issued and who
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will benefit by means of obtaining payment for complying documents presented
under the documentary credit.
The Advising Bank
The Advising Bank is the bank, usually in the exporter's country, which verifies the
apparent authenticity of the letter of credit received from the issuing bank and which
subsequently forwards or advises it to the exporter.
The Confirming Bank
The Confirming Bank is the bank, usually located in the exporter's country which if
requested and if it agrees provides an additional independent undertaking to pay the
exporter, provided that a complying presentation of documents is made by or on
behalf of the exporter.
It is very often the case that the Advising Bank and the Confirming Bank are the same
bank.
The Nominated Bank
The Nominated Bank is the bank, again usually located in the exporter's country, with
which the documentary credit is available for drawing. In simple terms the
nominated bank can be said to be the bank authorised, within the letter of credit, to
make settlement to the exporter and to whom documents are normally presented.
It is very often the case that the Advising Bank and the Confirming Bank and the Nominated are one and the same bank.
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Before the Documentary Credit cycle begins, an agreement is reached between the exporter and the importer
based on the price, quantity and description of the goods and the insurance and transport details.
The exporter provides this information in the pro-forma invoice.
The importer issues a purchase order and the two parties will enter into a contractual agreement to trade with each
other. If the parties agree that settlement is to be made by documentary credit the documentary credit cycle begins.
SHOW ME HOW THE CYCLE WORKS
Ten steps of the Documentary Collection Life Cycle:
Step 1: The importer applies to the issuing bank to issue a documentary credit.
Step 2: The issuing bank checks that the application is complete and precise and satisfies internal credit approval.
Step 3: The issuing bank issues the documentary credit subject to UCP 600.
Step 4: The advising bank advises the documentary credit.
Step 5: The beneficiary examines the terms and conditions of the documentary credit.
Step 6: The beneficiary ships the goods and presents the documents to the nominated bank.
Step 7: The nominated bank checks that the documents comply. If they do comply settlement may be made.
Documents are then sent to the issuing bank.
Step 8: The issuing bank checks that the documents comply with the credit.
Step 9: If the documents comply, the issuing bank reimburses the nominated bank. The nominated bank makes
settlement to the beneficiary if it has not already done so.
Step 10: The issuing bank releases the documents to the applicant against payment. The applicant can now collect
the goods.
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When an exporter ships the goods and presents the documents required under the letter of credit the method of
settlement will depend on how the credit was made available.
The documentary credit must state where it is available and how it is made available for drawing or settlement to
the beneficiary exporter.
Where and how a documentary credit may be made available to the exporter beneficiary is covered by UCP 600
Article 6.
In simple terms we can say that a documentary credit can be made available by:
sight payment
deferred payment
acceptance or
negotiation
Where a documentary credit is made available to an exporter:
A credit must state the bank with which it is available or whether it is available with
any bank.
A credit available with a nominated bank is also available with the issuing bank.
How a documentary credit is made available to an exporter:
A credit must state whether it is available by sight payment, deferred payment,
acceptance or negotiation.
UCP 600 Article 6:
a) A credit must state the bank with which it is available or whether it is available with
any bank. A credit available with a nominated bank is also available with the issuing
bank.
b) A credit must state whether it is available by sight payment, deferred payment,
acceptance or negotiation.
c) A credit must not be issued available by a draft drawn on the applicant.
d)
i. A credit must state an expiry date for presentation. An expiry date stated for honour or
negotiation will be deemed to be an expiry date for presentation.
ii. The place of the bank with which the credit is available is the place for presentation.
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The place for presentation under a credit available with any bank is that of any bank. A
place for presentation other than that of the issuing bank is in addition to the place of
the issuing bank.
e) Except as provided in sub-article 29 (a), a presentation by or on behalf of the
beneficiary must be made on or before the expiry date.
Sight Payment
The letter of credit may provide for immediate payment of the sum due. This is known
as ‘available by sight payment’. The paying bank will either be the issuing bank, the
confirming bank, or another nominated bank in the exporter’s country. The exporter
will present the required documents to the bank. If the documents are in order,
payment is authorised to be made at sight.
Deferred Payment:
In this case the issuing bank/confirming bank will simply incur a deferred payment
undertaking for payment on a future date.
It is possible for the exporter to request the bank to discount or provide finance under
the deferred payment documentary credit. If the bank provides finance this is known
as the bank making a prepayment or purchasing before the actual maturity date for
payment.
Acceptance:
This method of settlement involves the acceptance of a bill of exchange drawn by the
exporter on the bank where the credit is available.
These credits are known as acceptance, term or usance credits and payment is due at
the maturity of the bill of exchange. However, if the exporter requires cash
immediately, he can request the accepting bank or another bank to discount the
accepted bill of exchange.
Negotiation:
If the issuing bank authorises a nominated bank in the exporter’s country to negotiate,
then the nominated bank may advance its own money to the exporter or beneficiary
of the letter of credit in advance of the maturity date, by purchasing the documents
and/or drafts that have been presented in compliance with the terms and conditions
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of the credit.
The negotiating bank will charge a negotiation fee which basically represents interest
on the advance of funds from the date of advance to the date that the negotiating
bank receives final settlement by the issuing bank.
Documentary Credits - The Benefits for the Exporter
I have an independent bank undertaking before I ship my goods.
I can agree the specified documentary conditions in advance that suit my needs.
With a confirmed documentary credit when I can comply with the terms and
conditions then even the country risk can be removed.
Documentary credits enable me to offer extended credit to my import
customers and this increases my business volumes.
I can on occasion obtain pre-shipment finance when I can show my bank I have
been advised a documentary credit from a reputable bank.
In emerging markets where interest rates are higher than in my country the
documentary credit helps me offer better contract terms to my customers.
Documentary credits are irrevocable so once in place the undertaking to pay
cannot be cancelled or amended unless I agree.
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Documentary Credits - The Benefits for the Importer
I can avoid having to pay in advance for goods ordered.
I can agree terms and conditions in the credit which will require documents
that will evidence that the supplier has performed under the contract.
By providing a documentary credit to the exporters it is possible to get
extended payment terms.
With extended payment terms I can sell the imported goods with the profit
margin before the payment is due to be made.
Documentary credits in most instances cost a lot less then borrowing in
local currency to import goods.
My local bank can be more amenable to issue a letter of credit than to give
me an import loan as they can on occasion take the goods as collateral.
Banks also like to finance imports by documentary credit as they are certain
as to the purpose of the documentary credit finance facility.
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Trade Finance Products> Guarantees/Standby Letters of Credit >
In this section I will outline how Bank Guarantees and Standby Letters of Credit are used to secure and facilitate
international trade transactions.
This will be achieved by becoming familiar with:
A simple definition of a Bank Guarantee
The use of Direct and Indirect Guarantees
The applicable international rules for bank guarantees
The workflow for a Bank Guarantee or ‘how it works’?
The fundamentals of Standby Letters of Credit and the applicable rules.
The benefits
Here is a simple but complete definition of a bank guarantee which in the context of international trade is often
referred to as a demand guarantee.
Guarantees can be issued by parties other than banks but in the context of international trade most guarantees are
issued by banks. For instance Guarantees can be issued by Insurance Companies, Corporate bodies or other financial
institutions.
In the context of securing international trade and finance transactions guarantees are issued by banks and are
typically payable on demand.
In common with Documentary Credits guarantees are used to secure a payment obligation relating to an underlying
contract but in the context of guarantees this is referred to an underlying relationship.
Bank Guarantee
A bank guarantee is an irrevocable undertaking issued by a bank on behalf of an
instructing party, usually the Applicant, to another party that the bank will pay a sum
of money against a written demand for payment or against submission of a document
(or documents) stipulated in the guarantee document itself.
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Demand Guarantee
When a bank issues a demand guarantee that bank has an obligation to pay on
demand without contestation provided that bank receives a demand that is a
complying demand under the demand guarantee
Underlying Relationship
The parties to the underlying contract or agreement are understood to be the parties
to the underlying relationship. The party with the obligation under the underlying
relationship, which is secured by the Guarantee, is known as the ‘Applicant’ whereas
the party in whose favour the guarantee is issued is known as the ‘Beneficiary’.
Historically bank demand guarantees tended to be issued
subject to the local law of a particular country but in the
evolution of modern international guarantee practice there has
been a dramatic increase in the use the international rules of
the ICC.
In day to day international guarantee practice the international
rules for demand guarantees are known as the URDG.
The benefits of using standardised international rules which
have been agreed by the international trade banking community
is that the rules supplement the local law and clearly establishes
the payment must be made on presentation by the beneficiary
of a complying demand and furthermore defines what is the
nature of a demand guarantee issued subject to the URDG.
Simply put, the bank must pay on demand against a complying
demand which under the URDG rules must meet the
requirements of a complying presentation.
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There are two general categories of demand guarantees used to secure international trade and finance – these
are Direct Guarantees and Indirect Guarantees.
Both categories are used in international trade transactions but with transactions between parties located in
different countries the use of Indirect Guarantees is more common.
In common with Documentary Credits, guarantees whether they are Direct Guarantees or Indirect Guarantees are
used to secure a payment obligation relating to an underlying contract or agreement.
In the context of bank demand guarantees this relationship is typically referred to an underlying relationship.
Direct Guarantees
Direct Guarantees are used when the beneficiary of the guarantee is willing to accept
the guarantee issued directly by the foreign bank in favour of the beneficiary.
Indirect Guarantees
Indirect Guarantees are when the beneficiary of the guarantee will typically only
accept a guarantee issued by a local bank in the country of the beneficiary.
Underlying Relationship
The parties to the underlying contract or agreement are understood to be the parties
to the underlying relationship.
The party with the obligation under the underlying relationship, which is secured by
the Guarantee, is known as the ‘Applicant’ whereas the party in whose favour the
guarantee is issued is known as the ‘Beneficiary’.
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DIRECT GUARANTEES
Five steps of the Direct Guarantee Cycle in this example:
Step 1: The applicant establishes an underlying relationship or contract with the beneficiary whereby it is agreed
that the contract performance be secured by way of a demand guarantee. The party to perform under the
underlying relationship is the seller or exporter so the seller or exporter will be the applicant or instructing party.
Step 2: The applicant instructs his bank (Guarantor) to issue a demand guarantee by completing a guarantee
application form in favour of the guarantor bank.
Step 3: The guarantor issues a demand guarantee in favour of the beneficiary which in our case is the exporter to
cover the risk of non-payment by the importer.
Step 4: In the event that the applicant is in default or breach of the underlying relationship or contract the
beneficiary presents a written demand for payment to the guarantor bank. The guarantor pays the beneficiary
provided that the demand is a complying demand.
Step 5: The guarantor claims reimbursement from the applicant account based on the agreement usually included
as part of the demand guarantee application form.
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INDIRECT GUARANTEES
Six steps of the Indirect Guarantee Cycle in this example:
Step 1: The applicant establishes an underlying contract or commercial relationship with the beneficiary whereby
it is agreed that the contract performance be secured by way of a demand guarantee. The party to make payment
under the underlying relationship is the buyer or exporter so they will be the applicant or instructing party.
Step 2: The applicant instructs her bank (counter guarantor) to facilitate the issuance of a local demand guarantee
in the country of the beneficiary by completing the bank’s guarantee application form.
Step 3: The counter guarantor issues a counter guarantee in favour of a local bank (the guarantor) in the
beneficiary’s country which in turn issues its local guarantee in favour of the beneficiary.
Step 4: The local guarantor, on the strength of the counter guarantee, issues the local demand guarantee in favour
of the beneficiary.
Step 5: In the event that the applicant is in default or in breach of the underlying relationship or contract, the
beneficiary presents a written demand for payment to the guarantor bank. The guarantor pays the beneficiary
provided that the demand is a complying demand.
Step 6: The guarantor bank claims payment from the counter guarantor bank who in turn claims from the
applicant account based on the agreement, usually included as part of the demand guarantee application form.
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Depending on the contractual relationship between the parties involved there are various forms of demand
guarantees that fulfil important functions in supporting :
Delivery of Goods between Exporters and Importers
Completion of major construction, infrastructure or development contracts between contracting parties.
Here are some common various forms of demand guarantees that are used to support secure international trade
and contracts.
Payment Guarantee:
The payment guarantee provides security for a contractual payment obligation, such as in connection with a
contract of sale, a construction contract, loan or any other financial commitment.
A payment guarantee can be issued for the full amount of the contract or, where part of the amount has been paid
in advance, for the remaining amount due under an underlying relationship.
Tender Guarantee (Bid Bond):
The tender guarantee covers the risk that the company submitting the tender under the underlying relationship:
- Withdraws its offer prior to the actual awarding of the tender;
- Fails to sign the contract, if awarded the tender under the underlying relationship
- Fails to submit the required performance guarantee, if required.
These guarantees are normally issued for a specified percentage (usually 1%-5%) of the contract value
Performance Guarantee:
A performance guarantee is issued for a specified percentage (usually 10%-15%) of the contract sum under the
underlying relationship. The performance guarantee may be issued as a single guarantee to cover all phases of the
contract or issued to cover distinct segments of the contract. The performance guarantee will provide that the
beneficiary may make an on demand claim in the event of non or delayed performance by the applicant in respect
of the underlying relationship or contract.
Warranty Guarantee:
The purpose of the warranty guarantee is to cover the applicant’s obligations after it has delivered the goods or
completed its work during the contractual warranty period. In the event that there is a breach of warranty or, for
example, machinery breaks down, the beneficiary may demand payment under the warranty guarantee.
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Advance Payment Guarantee:
The contractor (applicant) may receive a pre-payment (the advance payment amount) on the contract value. The
aim of this pre-payment is usually to purchase raw material or hire machinery related to the contract.
This demand guarantee is used to secure the beneficiary’s right to recover the advance payment received by the
applicant in the event of the applicant’s failure to perform the contractual obligations relating to the advance
payment. The amount in such guarantee is usually agreed between the contracting parties.
The use of Standby Letters of credit to support and secure international trade and finance is growing rapidly.
At a basic level the Standby Letter of Credit has many features similar to a demand guarantee.
Standby Letters of Credit are most often used as a ‘Standby Security’ which stand-by in the event that the buyer of
a contractor fails to perform under an underlying contract or agreement – or fails to pay an amount of money due.
In common with Documentary Credits and Demand Guarantees, Standby Letters of Credit
are issued subject to international rules of the ICC.
A Standby Letter of Credit can be issued subject the UCP 600 rules or another set of rules
developed specifically for use with Standby Letters of Credits. These specific rules are
known as the ISP or ‘International Standby Practices’ and the version currently in effect is
ISP98. A Standby Letter of Credit can be issued subject to the UCP 600 rules, or the ISP98
rules.
The ICC
The International Chamber of Commerce (ICC) developed the ‘Uniform Customs and
Practice for Documentary Credits’ to provide importers and exporters with a set of
common rules to govern the operation of documentary credits.
The ISP98 Rules
International Standby Practices (ICC Publication No. 590, 1998 Edition) are rules
developed and designed specifically for use with Standby Letters of Credit.
EBRD TFP e-Learning – Introduction to Trade Finance – TRADE FINANCE PRODUCTS Page 25
Guarantees/Standby Letters of Credit - The Benefits for the Exporter
With one bank demand guarantee or a Standby Letter of Credit in my favour I can
cover the risk of non payment for many exports to my regular import customers.
As an exporter I can tender or bid for large contracts when my bank will support my
tender with a tender guarantee.
The independent nature of a demand guarantee provides a lot of security for the
parties involved as it is independent of the underlying contract or relationship.
I can offer greater amount of credit and extended credit to my customers when their
payment obligations are supported by a bank guarantee.
There is significant comfort for my business when there is a bank guarantee or standby
letter of credit standing by in the event of a default.
By getting my bank to issue an advance payment guarantee in favour of my customers I
often receive an advance payment on the contract amount which is much more cost
effective than borrowing in local currency.
Guarantees/Standby Letters of Credit - The Benefits for the Importer
My customers provide me with greater credit and extended credit when I can get my
bank to issue guarantees in their favour.
Some of my suppliers provide me with performance and warranty guarantees which
cover the risk of non performance of the seller or poor quality of goods supplied.
I can comfortably and securely provide an advance payment to the supplier when I
receive an advance payment guarantee as if the supplier does not perform I can claim
the return of the advance payment on demand.
Guarantees generally cost a lot less than borrowing in local currency.
With one bank guarantee issued by my bank in favour of my regular suppliers I can do
many repeat transactions.
Guarantees are issued subject to international rules and while this is very good for me
it is also good for my supplier as we know the specific obligations of the banks
involved.
EBRD TFP e-Learning – Introduction to Trade Finance – TRADE FINANCE PRODUCTS Page 26
Trade Finance Products> Trade Loans >
This section outlines how Trade Finance Loans ‘Trade Loans’ are used to finance international trade transactions.
This will be achieved by becoming familiar with:
A simple definition of Trade Loans
Examples of where trade finance loans are suitable for export and import business
The workflow for a Trade Loan or ‘how it works’?
Bank-to-Bank Trade Loans
The benefits
The term Trade Finance includes the traditional trade finance instruments covered in this section such as
Documentary Credits, Documentary Collections, Guarantees and Standby Letters of Credit but it also includes
Trade Finance Loans.
Trade Finance Loans are loans granted for the specific purpose of financing international trade transactions,
commonly known as cross border trade finance. These trade related loans are directly linked to the asset
conversion cycle or ‘trade cycle’ of the underlying goods being traded between the seller and the buyer.
Trade Finance Loans are typically denominated in the currency of the underlying transaction and can mean
reduced levels of Foreign Exchange Risk and also reductions in costs of financing.
Documentary Credits
A documentary letter of credit is an undertaking by a bank, on behalf of an importer
(buyer), to pay a certain amount of money to an exporter (seller) within a specified
period of time, provided that the exporter presents documents specified in the letter
of credit, which comply with the terms and conditions set out in the letter of credit.
Documentary Collections
Documentary collections are a service provided by a bank whereby the bank will use
its correspondent bank relationships as a network to collect the proceeds of export
EBRD TFP e-Learning – Introduction to Trade Finance – TRADE FINANCE PRODUCTS Page 27
shipments using the documentary collection product operating under internationally
accepted rules known as the URC 522.
Guarantees
A bank guarantee is an irrevocable undertaking issued by a bank on behalf of an
instructing party to another party that the bank will pay a sum of money against a
written demand for payment or against submission of a document (or documents)
stipulated in the guarantee document itself.
Standby Letters of Credit
A Standby Letter of Credit is a guarantee of payment issued by a bank on behalf of a
client that is used as "standby payment of last resort" should the client fail to fulfill a
contractual commitment with a third party.
Cross Border Trade Finance
This means that the finance provided is used for export, import or distribution trade
contracts where goods or services actually cross the border of at least one of the
countries involved.
Asset Conversion Cycle
The Asset Conversion Cycle represents the number of days it takes a company to
purchase raw materials, convert them into finished goods, sell the finished product to
a customer and receive payment from the customer/account debtor for the product,
goods or services.
Exchange Rate Risk
The Exchange Rate Risk is that one currency either depreciates or increases in value
with another currency over a period of time.
For example, if the currency expected for settlement of goods exported depreciates
this is an exchange rate risk that can result in an exchange rate loss as the currency
amount received will convert into a smaller amount of local currency.
EBRD TFP e-Learning – Introduction to Trade Finance – TRADE FINANCE PRODUCTS Page 28
SHOW ME THIS IN SIMPLE TERMS
CONSIDERATIONS
The key question for an SME Importer or Exporter is where to source the funds needed to finance their
international trade transactions.
The SME Company may use their own funds or capital to finance the transaction but in practice SME
companies rarely have surplus funds available to fund or finance trade finance transactions.
The SME Company will most often finance their international trade transactions by means of a local loan
or overdraft from their local bank in their local currency.
The SME Company will usually not have their trade finance needs separated from general banking or
working capital facilities with their local bank.
By organising finance in these typical methods the SME Company is:
Restricting its access to finance.
Most often paying higher costs for finance than necessary.
Incurring exchange rate risks that can often be avoided.
EBRD TFP e-Learning – Introduction to Trade Finance – TRADE FINANCE PRODUCTS Page 29
Here are the steps involved:
1. The Exporter/Importer approaches their local bank for a trade finance loan in the currency of the contract,
for example in EURO.
2. The Exporter/Importer outlines the asset conversion cycle or ‘trade cycle’ to their local bank.
3. The trade cycle outlines for the local bank the period of time for which trade finance is required and the
final repayment source for the goods.
4. Provided the local bank is satisfied that the trade cycle is realistic (and is satisfied with the credit risk) the
bank grants a trade finance loan to the Exporter/Importer to cover the trade cycle time period.
Note: The bank will often add an extra 10-20 days to the trade cycle to cover minor operational delays that
commonly arise.
SHOW ME HOW THIS WORKS FOR THE EXPORTER
❶
Viktor the Carpet Manufacturer normally borrows in his local currency ‘Alds’ from his local bank in Aldastan to pay
the local farmers who supply him with wool to produce carpets for export. The cost of local finance for an SME
Company is 18% per annum.
❷
If Viktor starts paying the farmers and his other costs on 1 May and then produces the carpets ready for shipment
by 30 June and gives his customer Anna the importer from Qumran 60 days credit from the shipment date then we
can say that Viktor’s Asset Conversion Cycle is approximately 120 days.
EBRD TFP e-Learning – Introduction to Trade Finance – TRADE FINANCE PRODUCTS Page 30
❸
Viktor will incur an interest cost of 18% on the local currency for approximately 120 days or longer if there is a
delay receiving payment from Anna.
As Viktor has borrowed the money in local currency ‘Alds’ but exports to Anna in EURO he also carries an exchange
rate risk as the currency he is paying out is different from the currency he will receive in payment.
If the EURO depreciates before Anna’s payment into local currency ‘ALDS’ then Viktor will receive less local
currency than he expected. This will result in a local currency loss.
If on the other hand, the EURO appreciates then Viktor will receive more ‘ALDS’ than expected i.e. a local currency
gain.
Viktor needs to avoid foreign exchange risk and should know in advance:
• The date and currency of the anticipated payment
• The profit he can expect upon receipt of payment
Features
Viktor is borrowing in EURO so when the goods are exported and sold he will be paid in EURO so there is
no foreign exchange risk.
As Viktor is borrowing in EURO he may pay interest at 6% which is far cheaper than paying interest on his
local currency at 18%.
By clearly defining the asset conversion cycle Viktor is able to increase his access to finance by way of the
trade finance loan or ‘trade loan’.
Summary
By using a trade finance loan Viktor has:
Avoided the Foreign Exchange Risk
Obtained financing at a reduced cost
Gained access to financing that may not normally be available from his local bank for international trade
activities.
EBRD TFP e-Learning – Introduction to Trade Finance – TRADE FINANCE PRODUCTS Page 31
SHOW ME HOW THIS WORKS FOR THE IMPORTER
❶
Anna, the Importer from Qumran, banks with her local bank and normally borrows in local currency ‘Qams’ at the
high local interest rate of 20% per annum. Anna needs to borrow money from her local bank to pay Viktor for the
supply of goods she wishes to import.
❷
If Anna pays Viktor on 2 April for the goods ordered and if the goods arrive at her import warehouse on 10 July and
it takes between 40-60 days to sell the goods locally market then we can say that Anna’s Asset Conversion Cycle is
approximately 160 days.
Consequences
Anna will incur interest costs of 20% on the amount of money borrowed from her local bank in the local currency
for approximately 160 days or longer if there is any delay in the delivery and sale of the goods in the local market.
As this transaction is clearly an international trade transaction then it makes sense to finance it with a trade
finance loan or ‘trade loan’ denominated in the currency of the international contract which is EURO.
Summary
By using a trade finance loan Anna has:
• Obtained financing cheaper than borrowing in her local currency
• Gained access to financing that may not normally be available from her local bank for international trade
activities.
However, in this instance there was a foreign exchange risk which should be taken into consideration.
EBRD TFP e-Learning – Introduction to Trade Finance – TRADE FINANCE PRODUCTS Page 32
BANK TO BANK TRADE FINANCE LOANS
In the context of international trade banking, trade finance is generally considered to be lower risk than
conventional lending or working capital finance.
As a result international banks:
are often able to provide short term bank-to-bank trade finance loans on favourable terms to local banks
provided the loans are used to fund trade finance activities of customers of the local bank.
where the international bank will provide a trade finance loan or funding to a local bank and that local
bank will then on lend the funds to its customers for the purpose of financing international trade
transactions of their customers.
International banks providing bank-to-bank loans will also be concerned with the credit risk, the bank risk and the
country risk. The funding bank also needs to understand the underlying trade transaction and the applicable asset
conversion cycle in advance of providing funds for on-lending to the local customer.
It would also be common practice for international funding banks to occasionally check that the funds provided by
way of trade finance loan are actually being used to finance international trade activity which as we have seen has
a lower risk profile than conventional or working capital lending.
The Credit Risk (Counterparty Risk)
This is the risk of non-payment by the purchaser of goods or services. The risk of non-
payment is possibly greater in international trade than in domestic trade because the
exporter may not be able to accurately assess the creditworthiness of a customer
located in another country.
Bank Risk
Sometimes an exporter will insist that the importer’s bank guarantees the payment
for goods being shipped. Bank risk is the risk that the bank fails to honour such a
payment obligation. Such a payment obligation could be by way of a bank guarantee,
a documentary credit or a Standby LC.
Country Risk
Country risk arises when a foreign buyer is prevented from making payment due to:
exchange control regulations
other government restrictions
political uncertainty
EBRD TFP e-Learning – Introduction to Trade Finance – TRADE FINANCE PRODUCTS Page 33
or in extreme situations, such as the breakout of war
Asset Conversion Cycle
The Asset Conversion Cycle represents the number of days it takes a company to
purchase raw materials, convert them into finished goods, sell the finished product to
a customer and to receive payment from the customer/account debtor for the
product, goods or services.
EBRD TFP e-Learning – Introduction to Trade Finance – TRADE FINANCE PRODUCTS Page 34
Trade Loans - The Benefits for the Exporter
I can obtain greater levels of finance when I can demonstrate that the trade loan is
to finance my international trade activity.
The trade finance loan can be denominated in the currency of the international
contract of sale which can mean that I can achieve a reduction in the cost of
financing.
Provided the currency of the trade finance loan matches the currency in which I sell
my goods then foreign exchange risks can be avoided.
By understanding the asset conversion cycle and explaining it to my bank I can
obtain financing that will fluctuate in accordance with my trading operations and
match my financing needs.
The documentation for trade finance loans is not complicated so it is much easier to
provide for my bank.
Trade Loans - The Benefits for the Importer
By using trade finance loans I can obtain better terms from my suppliers as by paying
them in advance or early they will often give me a discount on the cost of the goods.
Trade finance loans can be packaged to match my asset conversion or ‘trade cycle’
which gives me greater flexibility in managing my trade finance needs.
By obtaining a trade finance loan in the international currency of my supplier I can
often get my financing at a much cheaper cost than financing in local currency.
Once my bank understands that the repayment source for the trade finance loan is
from the sale of the underlying goods for which there is demand I can achieve
greater levels of trade financing which will help me expand my business.
The documentation to be provided to the bank to organise trade finance loans is
comparatively simple and pretty much standardised.