SG is a business consultant specialising, inter alia, in the area of corporate finance including international finance.
Throughout the history of international trade many methods of payment have been devised to deal with the risks faced by traders. In the case of an unknown buyer and seller, the buyer is reluctant to pay before delivery of the goods and the seller is reluctant to surrender the goods without payment. It is this perennial problem in international trade that the payment methods attempt to solve.
This article explains the main methods of payment in international trade and any risks associated with them.
Payment in Open Account
This payment method is appropriate when the buyer and seller have a good trading relationship. The seller, first, ships the goods and then sends the buyer the invoice together with the title documents to the goods. The buyer could make the payment through any of the following means; buyer’s own cheque, banker’s draft, international money order, mail or telegraphic transfer, SWIFT transfer or international direct debit.
This method provides no payment protection to the seller and therefore should only be used where there is a great deal of trust between the buyer and seller; and the seller has no doubt about the credit worthiness the buyer. On the plus side, this is the cheapest and simplest method of payment in international trade.
Bill of Exchange
In this payment method, the seller draws a bill of exchange on the buyer and sends it together with the title documents through the banking channels for presentation to the buyer. The bank presents the bill and releases the title documents according to the instructions given by the seller.
There are two types bills of exchange that are widely used, namely; sight bill of exchange and time bill of exchange. In the former, the bank releases the title documents to the buyer upon payment of the value of the bill and in the latter the documents are released to the buyer upon the acceptance of the bill. The bill provides a credit period for the buyer.
The sight bill of exchange provides payment protection to the seller as the documents of title are only released upon payment. In the time bill of exchange the seller is exposed to the credit risk of the buyer. The buyer may be unable or even unwilling to pay the amount due at the maturity of the bill. The seller could transfer this risk to a financial institution by discounting the bill.
This is an arrangement whereby the seller makes a request from his bank to hand over the title documents to a bank in the buyer’s country, known as the collecting bank, and the collecting bank collects payment for the goods from the buyer’s bank. The buyer's bank will deliver the documents to the buyer upon settlement of the payment.
The banks provide this arrangement for a fee. The banks act strictly upon the collection instructions given by the seller and have no exposure, as no guarantee is given by the bank.
Letter of Credit
Perhaps the most commonly heard method of payment in international trade. A letter of credit is an undertaking given by a bank, known as the issuing bank, to pay the seller the money due for the goods upon the delivery of the sale documents (including the bill of lading). The issuing bank hands over the title documents to the buyer once the buyer reimburses the money paid to the seller.
This is a preferred method of payment as it avoids payment risk. The banking system guarantees payment to the seller regardless of any dispute between the buyer and seller. Thus, any credit risk of the buyer is transferred to the issuing bank.
While in a collection agreement it is the seller who originates the collection, in a letter of credit it is the buyer who opens it. Another attraction of a letter of credit is that the payment is arranged in the seller’s country, whereas in a collection arrangement the payment is in the buyer’s country. Therefore, the seller is not exposed to any foreign exchange risk.
The cost of a letter of credit is the fee charged by the issuing bank. Since the issuing bank takes on a risk by guaranteeing payment it would only open a letter of credit to a buyer with whom it has a good relationship or upon the buyer depositing the full value of the letter of credit or furnishing some other acceptable form of security.
There are several types of letters of credit:
Sight credit - payment is made immediately upon presentation of the title documents by the seller's bank. This is the most convenient type of letter of credit for the seller.
Deferred payment credit - the issuing bank undertakes to pay the seller's bank after a period of time.
Acceptance credit - the seller draws a time bill of exchange on the issuing bank and after verification of the documents the issuing bank accepts the bill of exchange.
Negotiation credit - where the bill drawn on the issuing bank is available for negotiation with a bank designated in the letter of credit or a bank of the seller's choice.
Bank Guarantee or Performance Bond
Where a buyer is insecure that the seller would not deliver the goods as agreed, the buyer could request the seller to furnish a guarantee from a bank promising to pay a specified sum if the seller fails to perform his obligations. Conversely, the seller could also request a guarantee from the buyer that the buyer would pay and perform his contractual obligations.
The bank must honour and make payment on any demand on the guarantee/bond irrespective of the dispute between the buyer and seller.
Here the seller draws a bill of exchange on the buyer, which is accepted by the buyer and backed by a guarantee from the buyer’s bank. The seller could endorse this bill as without recourse and discount it at the seller's bank (the bank is then known as the forfeiter).
The effect of the endorsement ‘without recourse’ is that, if the buyer fails to pay on the bill of exchange, the seller does not have to reimburse his bank (forfeiter). Thus, the credit risk is transferred to the bank/forfeiter.
In factoring the seller assigns his debt to a financial institution, know as the factor, and the factor collects the debt from the buyer. The factor would charge a commission for its services based on the value of the seller’s debt.
This could be recourse financing or without recourse financing. In the case of the former, if the buyer fails to pay, the seller must reimburse the factor. Whereas, in the latter i.e. without recourse financing, the credit risk is transferred to the factor.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
© 2020 SG