While getting paid in full and on time is crucial in any transaction, in international trade it can be a more complex process. Currency fluctuation can cause your costs to increase, or your revenues to fall, so understanding and managing the risks involved is therefore vital to successful trading.
The Risk Ladder
For importers and exporters, the level of risk involved in a transaction fluctuates depending on what payment method is used. For example, as an importer paying cash in advance is high risk – you have paid but you may never get the goods you ordered. But as an exporter, being paid in advance removes nearly all risk from the transaction.
At the start of a business relationship (and even later, if there is some element of risk involved) an exporter may request advance payment. The importer may well agree to it in order to encourage the exporter to build a strong trading relationship. In advance payment, all the advantages accrue to the exporter, and all the disadvantages accrue to the importer, who has parted with his money and has no assurance of receiving the goods. More usually, some element of credit will be involved in the trading cycle.
Open account trading
This is the simplest and most convenient way to trade, but requires a high degree of trust on both sides of the deal. It is therefore most commonly seen in mature trading relationships within established markets. The exporter despatches goods to the importer and at the same time sends an invoice for those goods, for payment at an agreed date or after an agreed period – with the advantages all accruing to the importer. If the customer does not pay, or if he does pay but his country blocks remittance of funds to the exporter, the exporter has neither the goods nor the money, and may not be able to get his goods back.
Although most exporters aspire to the level of trust and simplicity that come with open account trading, many who are building new relationships prefer to mitigate risks by using trade instruments.
A documentary collection enables an exporter to maintain control of the goods pending payment or acknowledgement of the debt by the importer. Following shipment the exporter presents the commercial documents through his bank, who in turn sends them to the importer’s bank. Documents will only be released to the importer against payment, or payment at a future agreed date (based on acceptance of a bill of exchange).
Letters of Credit – unconfirmed
A Letter of Credit (L/C) is issued by a bank on behalf of the importer, conditionally guaranteeing payment to the exporter. Payment will only be made if the documentation submitted by the exporter complies with the stipulations contained in the L/C. Hence the exporter benefits from the knowledge that if all L/C conditions are met, they will be paid by a financial institution. The L/C is a separate agreement, which is independent from the underlying sales contract.
Letters of Credit – confirmed
With an unconfirmed L/C the exporter is still at risk of non-payment from the importer’s bank. For example, payment may not be made due to an adverse political event or insolvency of the importer’s bank. To mitigate this risk, the exporter can request a confirmation from a second bank to be added to the L/C. In such instances if the importer’s bank fails to honour the L/C, the confirming bank will guarantee payment, providing the L/C conditions are met.
Bonds and Guarantees
Many different types of bonds and guarantees exist for different purposes, and all are vitally important to world trade. Designed to contractually guarantee a promise from one party to another, they underpin sales and rental contracts, payments and many other things. Buyers may insist on them to ensure a sales contract performs as agreed, and sellers may willingly provide them to show their good intentions to complete their contract. Bonds and guarantees are a key feature of global infrastructure projects, making them an essential tool for the UK’s worldclass engineering and construction sectors as they access new opportunities.
RBS can provide all the products and services listed in this section and for more information about how we can make your trading safer, see rbs.co.uk/international
This article is taken from RBS’s Route to Growth publication.