The most efficient trade finance models allocate the risks to the parties best placed to manage them.
PrimaDollar’s trade finance solutions follow this approach. This allows us to pay exporters at shipment with a low cost and with a high advance rate.
- Keeping the costs low is essential for buyers – as they know (in the end) that any finance charges carried in the supply chain end up in the unit price of the products that they are buying.
- Achieving a high advance rate (90%, 93%, 95%, 100% of the invoice face value) is essential for exporters, especially where exchange controls require full payment to be received in foreign currency. In some countries that we work in, foreign exchange overdues (= a failure to repatriate proceeds) is a criminal offence for both the exporter and the local bank involved.
- Paying at shipment is very important. Many exporters in lower cost locations use pre-shipment finance to buy materials and pay wages. The local bank has a pledge over the goods and wants to retain control over the goods until cash is received. This is sensible banking practice.
Aside from fraud risk (which is a topic for another day), there are three main sources of loss that can affect a trade:
- Buyer credit
- Quality of goods
There are three parties involved in cross-border trade finance: the financier, the exporter and his customer, the “buyer”.
A well-designed trade finance product allocates these risks between the parties on the trade, such that the risk is carried by the party best placed to evaluate, manage and recover if something goes wrong.
1. Buyer credit
This is the main risk that exporters face. Buyers generally want to work on the basis of “ship now, pay later”. This is called “open account”, or “DA”, or “sale contract” depending upon which country you are in.
For many centuries, buyers used a banking solution called the “letter of credit” to address this issue. The letter of credit (“LC”) neatly deals with the tension between the buyer who wants to pay later and the exporter who wants to be certain of payment before handing over the goods. The LC is a payment guarantee from a reputable bank that pays out if correct documentation is provided.
Unfortunately, the LC is out-of-fashion because it is expensive, slow, difficult for banks to physically action and uses up the scarce banking lines of the buyer. So there has been a significant shift away from LC over the last 20 years, with LCs now supporting less than 10% of world trade compared to over 50% historically. Buyers want deferred payments terms without having to provide any support. Exporters are being asked to take the risk.
Buyer credit risk is something that a trade financier can manage.
PrimaDollar’s trade finance solutions take the buyer credit risk so the exporter is protected. This is a risk that we can understand, we can underwrite and we can also manage the collection of cash later.
PrimaDollar’s ability to accept buyer credit risk is based upon a variety of capabilities:
- Like most trade finance businesses, we are credit people, schooled in the banking sector and with the ability to understand how to manage credit risk across the world.
- We also use the international and global networks of our partners – insurers and banks – to understand and manage the risks that we take.
- And we also have a global collections capability through long term agreements that we have in place with specialists who have the resources to enforce debts around the world.
- We divide up the risks into two kinds:
- In countries with a strong rule of law (such as the major Western economies), underwriting and taking buyer credit risks is reasonably straightforward;
- But there are many countries where providing credit requires local knowledge to understand and enforce (eg: Brazil, Russia, India, China, Africa etc). Here we seek local partners who know how to manage the local credit risk and we provide a platform to link funding from these local partners to the trades that we can originate through our network.
In this way, it is possible to provide a global capability to manage the credit risk of the buyer.
Moreover, the trade financier can (and should) accept the credit risk of the buyer. This is a service/skill that the exporter needs someone to supply, and it is something that is core to the trade finance product.
As with most trade finance solutions, PrimaDollar pays the exporter at shipment and this payment is non-recourse (i.e. not returnable if the buyer later becomes insolvent). It is our risk and we are comfortable accepting it. This is our job.
- The trade financier is the most efficient person to take the credit risk of the buyer.
- Exporters using trade finance should look to shed the buyer risk to their financier rather than try to manage it themselves
2. Logistical failure
Every international trade involves logistics. This is the process of getting the goods safely from the exporter to the buyer. There is a lot that can go wrong. Containers can fall off the ship, goods can go missing or get damaged during loading and unloading, trucks can have accidents and even Somali pirates could take over a vessel.
Most international trade is conducted on the basis of “Incoterms”. These are internationally agreed standards that deal with the allocation of risks between the exporter and his buyer. Whilst there are many variations, there are two main terms that also illustrate what is involved:
- “FOB”, which means “free on board”. Under this arrangement, the buyer takes responsibility for logistics and title to the goods switches from exporter to buyer as the goods are loaded in the port of embarkation.
- “DDP”, which means “delivered duty paid”. Under this arrangement, the buyer has no responsibilities for the delivery process, and title to the goods passes when the goods are delivered.
Under FOB trades, the buyer has responsibility for logistics and has the risks associated. The buyer, of course, will arrange point-to-point freight insurance.
Under DDP trades, the exporter has the responsibility for logistics and will arrange and benefit from the insurance – but there is a twist in the tail for the trade financier.
Trade financiers (PrimaDollar included) are reluctant to pay the exporter for the goods before title moves to the buyer. Moreover, if the buyer is only going to accept liability for an invoice after delivery, paying funds to the exporter before then is also problematic. If the exporter is paid at shipment and then delivery fails, the trade financier is left trying to recover the funds he has paid to the exporter – since the buyer has no obligation.
So liability for logistical failure is, unfortunately, intermingled with the risk allocation for the whole transaction. In a DDP trade, the trade financier either pays after delivery, or has credit risk on the exporter.
PrimaDollar has financed DDP trades into North America and Europe for buyers who insist on this shipment basis with their suppliers. We have several approaches that allow us to mitigate the resulting risks of DDP (with payment to the exporter at shipment rather than delivery). This also means that we can avoid charging a premium for the additional risks involved. This is very important because DDP is becoming the standard model for US buyers – so a trade finance company that cannot deal with transactions on a DDP basis is cutting out a large part of its potential market.
- FOB trades are straightforward for trade financiers to handle. Logistical risks are taken by the buyer, and logistical failure does not result in credit risk on the exporter.
- DDP trades are not easy to finance, because the buyer (usually) only accepts the invoice after delivery. Whilst logistical failure risk sits with the exporter, which is okay, if the exporter wants to be paid before delivery, this creates additional risks for the financier which are problematic.
- PrimaDollar does have solutions that enable these situations to be managed.
3. Quality of goods
This is always at the heart of any risk allocation discussion. What happens if the goods are delivered but are found to be faulty, incomplete, or simply unacceptable.
Exporters clearly have responsibility for the goods that they make and sell. This would be in the paperwork between the exporter and the buyer. The buyer has a claim on the exporter if the goods do not conform with the purchase order. So far, so good and very simple.
The real world, unfortunately, is more complicated. There are many stories in the market of unscrupulous buyers alleging quality issues to avoid payment. Also, on the other hand, there are many examples of exporters getting paid before delivery, but sending sub-standard products.
The trade financier can end up as the “jam in the sandwich” – in other words, in the middle of a trade dispute between the exporter and the buyer. The trade financier will often pay the exporter before delivery and collect from the buyer after delivery.
In this scenario, product quality risk can be allocated to the trade financier or accepted by the buyer.
The trade financier has the risk if there is the ability for the buyer to not pay the invoice in full by “charging back” some amount in respect of perceived issues with the delivery. This moves the problem into the hands of the trade financier who then has to recover from the exporter himself. We refer to this as “chargeback”.
Some trade finance solutions accept chargeback risk, others do not.
- If the buyer is permitted to charge back for perceived product quality issues, this leaves the trade financier with credit risk on the exporter. The buyer can legitimately pay less than the invoice face value, and if the exporter has already been paid (at shipment), it is for the financier to claim back the over-payment.
- If the trade finance solution is set up to deny chargeback, then this leaves the buyer with credit risk on the exporter. The buyer has to pay the invoice in full, and then claim back from the exporter himself.
What is the right answer? Why should buyers agree to work without chargeback rights on the invoice?
This is a question about risk allocation, and also about what the risks are. A trade finance company is always under pressure to provide a high advance rate at a low cost, and to pay at shipment (before goods are delivered). The reasons for this are set out earlier in this article.
But a trade finance company is not in a position to:
- Check that the goods conform the purchase order before shipment.
- Assess who is right if there is a dispute.
- Place future business to achieve a recovery (by adjusting future prices).
If the trade finance company accepts chargeback risk, then there are four consequences:
- The risk has to be priced, which is not impossible in developed markets. In emerging markets it can be difficult or impossible. But in either case, the supply chain will have to bear a higher financial cost.
- The advance rate has to be lower. Typically not above 80%. This is to provide room to accept chargeback from the buyer if it happens.
- Operational costs go up, because he has to monitor the credit risk of the exporter as well as the importer and the upfront due diligence on an exporter is much more significant.
- Local enforcement capabilities are needed as the trade finance company needs legal and administrative resources in the exporter country to enforce claims against exporters. If the exporter is in the OECD, this can be feasible – but collection in emerging markets is a specialist and local activity.
This highlights the differences between trade finance and factoring.
- Trade finance solutions usually do not accept chargeback risk. As mentioned earlier, the sight letter of credit never did accept chargeback risk either.
- Factoring solutions usually do accept chargeback risk, but have a much higher cost (typically double) and a much lower advance rate.
It is also not just a matter of the buyer deciding which route he would like to use and deciding what he wants to pay for (as in “you pay your money, you take your choice”). In many low-cost exporting countries, there is simply no available legal model to manage unsecured exporter credit risk. Countries like Bangladesh, Pakistan, India have local finance markets, but these work on the basis of collateralized facilities, and they are highly regulated meaning that only banks are in a position to take local credit risks. A chargeback claim would usually be an unsecured risk on the exporter which no one wants to take.
So this leaves a major headache for the buyer. If he wants to source from lower cost locations without paying upfront himself or issuing an LC, his supply chain will need the support of a trade finance solution that, usually, will not accept chargeback risk.
But buyers do have the tools to manage chargeback risk.
They are better able than the financier to assess the risks and deal with the consequences. Passing the chargeback risk to the financier results in a high frictional cost in the trades, and a direct economic cost that the buyer eventually bears through the unit cost of his goods. Smart buyers understand that the financier is the wrong party to hold this risk.
The tools available to the buyer include:
- Selecting suppliers with care. Regular suppliers can often be trusted.
- Putting people on the ground to check the goods before shipment, or using third parties to check the goods (like SGS, Bureau Veritas etc).
- Only financing part of the trade volume with trade finance, so that there is a separate volume of business against which chargebacks can be made.
- Ensuring that trade finance is only used on the regular repeating orders, so that the supplier has a strong incentive to deliver good quality products because of the future business, and any chargeback issues can be moved forward and applied as discounts on new orders.
- The allocation of product quality risk to the financier is usually not efficient. The buyer has the tools to assess and manage this risk. The financier is not in a position to make a judgement.
- Converting product quality risk into credit risk on the exporter is only sensible if the exporter is in a jurisdiction where unsecured lending to corporates works. This is not the case in most emerging markets, and so leaves the financier with a high cost and difficult collection.
- If buyers want a low-cost solution, they should be prepared to work (as many of them did in the past when they arranged LCs) on the basis that the invoice will not be charged-back.
- If exporters want or need a high advance rate (90-100%), typical in many low cost locations, then buyers really do have to accept chargeback risk or the trades not easily work.
So where does all this lead?
International financiers are good are doing certain things:
- Assessing the credit risk of buyers in high quality jurisdictions
- Providing finance, so that exporters can be paid at shipment and buyers can pay later
- Managing buyer-side cash collection risks involved in cross-border trade
For many years, trade finance was supported by letters of credit – which meant that the financial supporter of the trade (the buyer’s bank) was taking the credit risk of the buyer and not logistics or chargeback risk.
The new breed of efficient, low-cost trade finance solutions is similar.
Moving away from letters of credit to work with delayed payment and “open account” re-opens the debate about who should take what risks.
If the buyer would like the financier to take risks on top of buyer credit risk (like logistics risk, product quality risk), then this is always possible. But there are consequences for advance rates, pricing and timing of payments.
In many of the markets where PrimaDollar works, passing these risks on to the financier means that the financing no longer meets the needs of the exporter (advance rate is too low, finance cost is too high, payment comes too late).
In trade finance, allocate the risks to the party best-placed to manage them. This is always going to be the most efficient model for all the parties involved.