Deutsche Bank A Guide to Trade Finance PDF

Deutsche Bank Corporate Bank A Guide to Trade Finance Copyright© 2020 Deutsche Bank AG. All rights reserved //3 Contents 1 2 Foreword 07 Introduction to trade finance 08 1.1 Background to trade 08 1.2 Financing trade 10 1.3 Risk mitigation 11 1.4 Contracts and role of the Inte...

Deutsche Bank Corporate Bank A Guide to Trade Finance Copyright© 2020 Deutsche Bank AG. All rights reserved //3 Contents 1 2 Foreword 07 Introduction to trade finance 08 1.1 Background to trade 08 1.2 Financing trade 10 1.3 Risk mitigation 11 1.4 Contracts and role of the International Chamber of Commerce (ICC) 12 1.4.1 Conditions for a valid contract 12 1.4.2 ICC Banking Commission 13 Transactional trade finance 14 2.1 Basic principles of the risk ladder 14 2.2 Open account 15 2.3 Payment in advance 16 2.4 Documentary collections 17 2.4.1 How it works 17 2.4.2 Key considerations 18 2.4.3 Workflow 18 2.4.4 In practice 19 2.5 Contributing Editor David Meynell (TradeFinance.Training) Deutsche Bank contributors Russell Brown (Global Head of Trade Finance, Financial Institutions) Clarissa Dann (Editorial Director, Corporate Bank Marketing, Trade Finance) Sandra Primiero (Global Head of Structured Commodity Trade Finance) Daniel Schmand (Global Head of Trade Finance and Lending) Werner Schmidt (Global Head of Structured Export Finance) Published April 2020 2.6 Documentary credits 20 2.5.1 Definition 20 2.5.2 Revocation and confirmation of credits 20 2.5.3 Key considerations 21 2.5.4 Special types of documentary credit 22 2.5.5 Bank procedure 24 Demand guarantees 26 2.6.1 Definition 26 2.6.2 Essential basics 26 2.6.3 Key considerations 27 2.6.4 Types of demand guarantee 28 2.6.5 Workflow 30 2.6.6 In practice 31 4// A Guide to Trade Finance 2.7 2.8 2.9 3 4 Copyright© 2020 Deutsche Bank AG. All rights reserved //5 Standby credits 32 4.3 Reserve-based lending (RBL) 54 2.7.1 Definition 32 4.4 Warehouse financing 55 2.7.2 Essential basics 32 2.7.3 Key considerations 32 2.7.4 Types of standby 33 2.7.5 Workflow 34 2.7.6 In practice 35 ICC Rules and standards 35 2.8.1 UCP 600, URR 725, ISBP 745, eUCP 36 2.8.2 URDG 758 37 2.8.3 ISP98 37 2.8.4 URC 522 38 2.8.4 URF 800 38 2.8.5 URBPO 38 Dispute handling and arbitration 5 6 7 Structured trade and export finance, and export credit insurance 56 5.1 Export Credit Agencies (ECAs) 57 5.1.1 OECD ECAs 58 5.1.2 China’s export financing infrastructure 58 5.2 Export finance 59 5.3 Export credit insurance 60 Development finance 61 6.1 Role of multilateral development banks (MDBs) 61 6.2 Trade finance/facilitation programmes 62 Other forms of trade finance 64 39 7.1 Islamic finance 64 Supply chain finance 40 7.2 Countertrade 65 3.1 Definition 40 7.2.1 Countertrade 65 3.2 Physical and financial supply chains 42 7.2.2 Barter 65 3.3 Moving towards standardisation 43 7.2.3 Counter-purchase 65 3.4 Receivables discounting 44 7.2.4 Buyback 65 3.5 Forfaiting 45 7.2.5 Offset 65 3.6 Factoring 46 3.7 Payables finance 47 3.8 Loan or advance against receivables 7.3 8 Smart Asset Financing (SAF) 66 Foreign exchange (FX) 67 48 8.1 Terminology 67 Spot and forward rates 68 Managing risk 68 3.9 Distributor finance 48 8.2 3.10 Loan or advance against inventory 48 8.3 3.11 Pre-shipment finance 48 3.12 Trade finance securitisation 49 9 Sustainable trade finance 69 9.1 Trade and the planet 69 Structured trade and commodity finance 50 9.2 Sustainability reporting and market performance 69 4.1 50 9.3 Sustainability initiatives 72 50 9.3.1 ICC Banking Commission 72 51 9.3.2 International Finance Corporation (IFC) 72 52 9.3.3 Banking Environment Initiative (BEI) 72 Pre-export finance/prepayment finance (PXF/ PPF) 4.1.1 4.1.2 4.2 PXF PPF Borrowing base finance (BBF) 6// A Guide to Trade Finance 10 11 12 Digitalisation 73 10.1 Move to digitalisation 73 10.2 Industry 4.0 74 10.3 Big Data and Internet of Things (IoT) 78 10.4 Distributed ledger technology (DLT) including blockchain 79 10.5 Smart contracts 81 10.6 Artificial intelligence (AI) and machine learning 81 10.7 Multi-banking and SWIFT messages 83 10.8 ICC initiatives 84 10.8.1 ICC eRules 84 10.8.2 Uniform Rules for Digital Trade Transactions 85 10.8.3 Electronic Bills of Lading (eBLs) 85 Financial crime 86 11.1 Definition and overview 86 11.2 Money laundering 87 11.3 Terrorist financing 88 11.4 Proliferation financing 89 11.5 Dual-use items 89 11.6 Sanctions 90 11.7 Fraud 91 11.8 Red flags 92 11.9 Industry groups 93 11.9.1 The Financial Action Task Force (FATF) 93 11.9.2 The Wolfsberg Group 93 Future of trade finance 94 12.1 Digitalisation and fintech industry participation 94 12.2 The Fourth Industrial Revolution (4IR) 94 12.3 Sustainable trade 94 12.4 Convergence of sources of finance 94 12.5 Data and privacy 94 12.6 Covid-19 94 References 96 Glossary of terms 99 Copyright© 2020 Deutsche Bank AG. All rights reserved //7 Foreword Trade is at an inflection point and so, in turn, is the finance that underpins it. Trade and geopolitics, noted the Organisation of Economic Co-operation and Development (OECD) in 2019, are moving away from the multilateral order of the 1990s – and this is a structural change to the ecosystem. Other ongoing themes include the sudden external shock of Covid-19 in 2020, as well climate change and digitalisation. Despite the increased focus on digitalisation, however, conversations have been affected by the difficulty governments and corporates have had in achieving consensus at what this actually means in terms of skills upgrading and technology investment. While the trade war between the US and China is of course bad for trade – with Covid-19 wreaking a different sort of damage of its own – uncertainty and volatility helps trade finance demand. I see a massive opportunity. Doing crossborder business, particularly in emerging markets, is a risk for which there is risk premium. So it is a good time to be in the business, provided you are efficient. As the bank starts a new decade and celebrates its 150th anniversary – our foundation having been fostered on international trade finance – it remains at the heart of trade finance evolution and education. And it is for this reason we present this Guide to Trade Finance to the industry as an anniversary gift. Put together by seasoned trade finance experts, it explains the fundamentals of financing crossborder trade in practice, so is ideal for discussions when some parties may not be familiar with this technique and all its many variations. Enjoy the journey Daniel Schmand Daniel Schmand, Global Head of Trade Finance and Lending, Deutsche Bank 8// A Guide to Trade Finance Copyright© 2020 Deutsche Bank AG. All rights reserved //9 1 Introduction to trade finance 1.1 Background to trade Figure 1: World’s leading traders of goods and services 2008 and 2018 2008 United States Trade has a daily impact on the lives of all the world’s population and encompasses the trading of goods and the provision of services across international borders, with a view to securing payment and/or financing with minimal risk. Global economic growth depends on trade. The ability of one economy to export what it is good at and generate revenues for what it cannot produce itself has been going on for thousands of years. As academics Lipsey and Chrystal put it, “With trade, each region can specialise in producing goods or services for which it has some natural or acquired advantage. Plains regions can specialise in growing grain, mountain regions can specialise in mining and forest products, and regions with abundant power can specialise in manufacturing.”1 According to the World Trade Organization, in 2018 the value of world merchandise trade stood at US$19.67trn, having grown at 3% on the previous year. Commercial services hit US$US5.63trn, having grown at 8% with the United States (US) at the top of the leader board as the world’s leading overall trader of merchandise and services, but with China at the top when it comes to exports.2 However, from 2020, the WTO predicts significant contractions as Covid-19 demand and supply shocks bite around the world. Developing economies outperformed or equalled the performance of developed economies in world trade in most of the past 10 years, and the world trade order continuously shifts as developing economies become developed (for example China), and geopolitics, such as the US/China trade wars and the emergence of the Belt and Road Initiative reroute and evolve trade corridors.3 However, when carrying out cross-border business, importers and exporters are exposed to specific risks, such as exchange and currency risks, non-payment, damage to goods in transit and fraud, etc. These risks and how to mitigate them are explained in Section 1.3. Germany Top 20 2018 United States China China Germany Japan Japan France France United Kingdom Netherlands United Kingdom Netherlands Italy Hong Kong, China Korea, Republic of Korea, Republic of Canada Spain Russian Federation Italy India Singapore Singapore Canada Belgium Mexico Hong Kong, China India Mexico Switzerland Chinese Taipei Spain Belgium Russian Federation Switzerland Ireland Chinese Taipei Ireland Source: WTO-UNCTAD-ITC estimates 10// A Guide to Trade Finance 1.2 Financing trade In a book published in 1776, the philosopher and economist Adam Smith stated that humans have a propensity to truck, barter, and exchange one thing for another.4 The discovery of promissory notes in the form of clay tablets, providing for repayment of an amount and interest on a specific date, found at the site of ancient Mesopotamia, adds great weight to his statement.5 The earliest forms of trade, prior to the existence of money, depended on barter and exchange of goods. Introduction of the written word and forms of monetary exchange brought with them the opportunity for innovative financing solutions. We have now reached a moment at which our approach to the handling of international trade and finance is in the process of total re-definition. In order to mitigate the various risks, it has always been essential to have access to data for assessments to be made. In the current evolving digital world, data is more widely available and accessible than ever before. Figure 2: Trade finance: transformative developments over the past 30 years Technology Workflow Integration “ E-commerce “ Proprietary trade online solutions “ Outsourcing trade operations “ Centralisation “ Physical/financial supply chain “ Trade finance/cash management Digitalisation Data-centric solutions Increased access to trade finance Global rules and standards Fintech collaboration Source: David Meynell Copyright© 2020 Deutsche Bank AG. All rights reserved Technology has affected the lives of people all around the world, particularly in the last few decades. Many of these benefits are now surfacing in the trade finance industry as digital information becomes more readily accessible, convenient and available. The major challenge is to transparently, digitally and efficiently share information across the numerous involved entities in a trade transaction including suppliers, buyers, logistics, financial institutions, insurers, etc. 1.3 Risk mitigation However, even in a digital world, what will not change is the need for risk mitigation. The key to fulfilling a successful trade transaction is to understand and mitigate the associated risks. Not all risks may be applicable to an individual trade transaction, but it is important to have an awareness of the involved issues and associated risks. There are many risks that entities involved in international trade need to be aware of. Thorough research will help to identify and alleviate a number of these risks and various avenues are open for access to such information. When entering into an international trade transaction, the overseas entity may be unknown to the domestic party. Status enquiries and credit references can be obtained from numerous sources in order to obtain information in respect of the counter-party, based upon historical trading data. And all parties involved in the sale and purchase of goods or services overseas have to keep on top of the value of the domestic currency against a foreign currency and take steps to protect the transaction against currency movements. See Section 8 for more on foreign exchange risk management. The first step to alleviating risk is to understand the business of a customer and apply KYC (Know Your Customer) principles. The extent of such KYC may also depend on national and regional banking regulations. At a minimum it should include an awareness of sourcing of funds, purpose of transactions, compliance checks and regular ongoing reviews. //11 12// A Guide to Trade Finance Figure 3: Risk issues “ Operational “ Currency “ Political “ Sanctions “ Credit “ Legal “ Regulatory Risks of conducting cross-border trade “ Fraud “ Disputes “ Cultural “ Time zone “ Money laundering Copyright© 2020 Deutsche Bank AG. All rights reserved “ There must be consideration – each party provides something to the other; “ There must be capacity to contract – for a limited company that means that the nature of the business is within the objectives set out in the company’s memorandum and articles; “ Consent must be freely given without duress or based on false information; and “ The purpose must be legal. 1.4.2 ICC Banking Commission “ Language “ Infrastructure “ Transport Source: David Meynell 1.4 Contracts and role of the International Chamber of Commerce (ICC) Underpinning all trade relationships is the contract itself; in other words an agreement between two or more persons or entities, which may or may not contain specific terms, in which there is a promise to do something (e.g. export goods) in return for consideration (payment). 1.4.1 Conditions for a valid contract According to the London Institute of Banking & Finance, for a trade finance contract to be valid, the following conditions must be met and parties should always take legal advice as local laws may well be applicable irrespective of the governing law (e.g. English law or New York law) selected:6 “ There must be a firm offer and acceptance of that offer; “ There must be an intention to create a contract; ICC was founded in 1919 under the leadership of its first president Etienne Clementel, a former French Minister of Commerce. Since that time the international secretariat of the organisation has been located in Paris, France. ICC’s primary objective is to promote international trade and investment as vehicles for inclusive growth and prosperity.7 Core to this is ICC’s guidance on international contracts which comprehensively sets out the rights and obligations of all parties. ICC is comprised of five Policy Hubs, with one of the most prominent being the ICC Finance for Development Hub, Banking Commission (ICC Banking Commission), which serves as a global forum and rule-making body for banks worldwide, with particular focus on the financing of international trade. The ICC Banking Commission embraces three main activities: 1. Rulemaking; 2. Advocacy; and 3. Financial inclusion and sustainability. Over the years, the ICC Banking Commission has become a leading global rule-making body for the banking industry, not only producing universally accepted rules and guidelines for international banking practice, but also providing leading edge research and analysis. Further details of ICC rules and standards can be found in Section 2.8. //13 14// A Guide to Trade Finance Copyright© 2020 Deutsche Bank AG. All rights reserved //15 2 1 Transactional trade finance Figure 5: Open account settlement 1 2.1 Contract Basic principles of the risk ladder In Section 1, the inherent risk of conducting cross-border trade was set out, but what is the best way of matching settlement method to the risk? Enter the risk ladder – a very useful and important tool to help buyers and sellers determine the most appropriate form of settlement depending upon client relationship, location of the parties, goods or services that are involved, movement of funds and documents, and the options for settlement and financing. Buyer/ importer applicant 2 5 Shipment of goods/ documents sent Credit account Seller’s bank Figure 4: The trade settlement risk ladder 3 Send payment instructions 4 Buyer’s bank Payment Method of payment Receipt of goods by buyer before payment Settlement date Risk rating for seller Risk rating for buyer Open account ✓ As per contract terms Highest Lowest Source: TradeLC Advisory 2.2 Usance collection ✓ At maturity as per collection terms Medium to high Low to medium Sight collection ✗ After presentation of documents Lower Low to medium Documentary credit ✗ After presentation of documents at sight or maturity as per contract terms Low (against compliant documents) High Payment in advance ✗ Prior to shipment Lowest Highest Source: www.tradefinance.training Seller/ exporter/ beneficiary Open account It is estimated that around 80% of trade transactions by volume are handled on open account terms.8 Despite the slowdown in merchandise trade growth as a result of escalating trade tensions, this is an enormous market, with total volumes having hit a record US$19.67trn in 2018.9 In general terms, open account is normally utilised when each party is known to the other and trusted. This is how it works: a seller sends goods to its buyer together with the applicable documents including an invoice specifying the payment terms. As is apparent, the seller will be placing a great deal of trust in the buyer to pay, as the goods are shipped and are often available to a buyer in advance of when payment or acceptance to the seller has been arranged (see Figure 5). 16// A Guide to Trade Finance 2.3 Copyright© 2020 Deutsche Bank AG. All rights reserved Payment in advance In this situation, the buyer pays the seller in advance of the goods being shipped. It is only once the seller receives the funds that any arrangements will be made for the goods to be shipped or, in certain circumstances, to be manufactured. It can be seen quite clearly that whilst this is enormously advantageous for the seller, it is not necessarily so for the buyer. It is common for an advance payment to be secured by the issuance of an advance payment guarantee (see Section 2.6), guaranteeing to refund all or part of the advance. The advance is generally a percentage of the value of the contract to be paid by the buyer to the seller upon signing of the contract. The guarantee covers non-performance by the seller in delivering all the required goods. 2.4 Documentary collections Documentary collections are used where there is an intention to obtain payment and/or acceptance of financial documents and/or commercial documents by delivering the documents under certain specified terms and conditions. 2.4.1 How it works Under a collection, a collecting bank presents financial and/or commercial documents related to the goods to the importer for payment. Figure 6: Payment in advance 1 Contract Seller/ exporter/ beneficiary Buyer/ importer applicant For importers and exporters, a documentary collection attracts cheaper bank costs than those associated with a documentary credit. 5 4 Credit account Seller’s bank Shipment of goods 3 Payment Source: TradeLC Advisory For the exporter, a documentary collection bridges the gap between open account and documentary credits by providing a potentially higher level of security than open account, through the control of the documents by banks, without the often onerous terms and conditions of a documentary credit (see Section 2.5). 2 Send payment instructions Buyer’s bank Documents against payment (D/P) “ Documents are payable at sight; and “ Documents are delivered to drawee only upon payment. Documents against acceptance (D/A) “ Documents are payable at a fixed or determinable future time; “ Documents are delivered to drawee against acceptance of a financial; and “ Document or execution of a payment undertaking (e.g. a promissory note). //17 18// A Guide to Trade Finance Copyright© 2020 Deutsche Bank AG. All rights reserved 2.4.2 Key considerations 2.4.4 In practice Parties involved: As noted in the risk ladder diagram (see Figure 4), collections sit between open account and documentary credits. However, this does not absolve participants from undergoing necessary due diligence exercises on counterparties. “ Principal − the party entrusting the handling of a collection to a bank. “ Remitting bank − the bank to which the principal has entrusted the handling of a collection. “ Collecting bank − any bank, other than the remitting bank, involved in processing the collection. “ Presenting bank – the collecting bank making presentation to the drawee. “ Drawee – the party to whom presentation is made for payment, acceptance, or other specified consideration. See also Section 2.8: ICC rules and standards The exporter needs to have a certain amount of trust in the importer. As such, it is useful for the exporter to obtain an awareness of not only the financial standing of the importer, but also an insight into historical trading activities including payment delays and any instances of non-payment. The political stability of a country may additionally need to be considered as well as the choice of currency to settle the transaction. In all trading circumstances, there must be an understanding that one of the parties will take out necessary insurance cover for the transit of the goods. 2.4.3 Workflow Figure 7: Collections workflow 1 Contract Seller/ principal Buyer/ drawee 2 3 Shipment of goods Prepare documents 5 6.2 4.1 Payment/ accepted bill Documents against payment/ acceptance Collection instruction and documents 4.2 Collection instruction and documents 6.1 Remitting bank Source: David Meynell Payment/accepted bill Risks still exist, with the most prevalent examples being: “ Credit – a buyer may not pay for the goods owing to insolvency or wilful default. “ Sovereign – introduction of laws and/or regulations that may prevent settlement. “ Transit – damage, loss, or theft during the movement of goods. “ Exchange – movements in exchange rates can easily create an unexpected profit or loss. Collecting/ presenting bank //19 20// A Guide to Trade Finance 2.5 Copyright© 2020 Deutsche Bank AG. All rights reserved Documentary credits 2.5.1 Definition A documentary credit is a written undertaking given by a bank (issuing bank) to the seller (beneficiary) on the instruction of the buyer (applicant) to pay at sight or at a determinable future date up to a stated amount of money. This undertaking is conditional upon the beneficiary’s compliance with the terms and conditions stated in the credit issued in its favour and is satisfied by a ‘complying presentation’. As defined in Uniform Customs and Practice for Documentary Credits 600 (UCP 600) (see Section 2.8.1), a complying presentation is one that is in accordance with three considerations: “ The documents must comply with the terms and conditions of the documentary credit. “ If the documentary credit is stated to be subject to UCP 600, the documents must be in accordance with the applicable articles and subarticles of UCP 600. “ The documents will be examined on the basis of international standard banking practice. It is important to note that ‘international standard banking practice’ is far wider than the principles enshrined in ISBP 745 (International Standard Banking Practice for the Examination of Documents under UCP 600), and includes practice related to all aspects of the documentary credit cycle. 2.5.2 Revocation and confirmation of credits “ Revocable. This is a credit which can be amended or cancelled by the issuing bank at any time, without prior warning or notification to the seller. It is very rarely used and not recommended. It no longer appears in the UCP rules. “ Irrevocable. In other words, it can be amended or cancelled only with the agreement of all parties thereto. “ Confirmed. As there are often two banks involved, the issuing bank and the advising bank, the buyer can ask for an irrevocable credit to be confirmed by the advising bank. If the advising bank agrees, the irrevocable credit becomes a confirmed irrevocable credit. Confirmation means a definite undertaking of the confirming bank, in addition to that of the issuing bank, to honour or negotiate a complying presentation. In essence, it is used when the issuing bank has a poor credit rating and/or is located in a country with a high country risk rating or is not considered a good risk by the beneficiary. 2.5.3 Key considerations Sir Michael Kerr, in a landmark fraud judgment, described documentary credits as “[…] the lifeblood of international commerce”.10 It is important to note that credits are separate from the underlying sale or other contract on which they may be based. In this respect, banks deal only with documents and not with the goods, services or performance to which the documents may relate. The documentary credit is a means to facilitate the settlement of international trade transactions. As such, it is not: “ A contract between buyer and seller. “ A guarantee that the seller will definitely receive payment. “ A guarantee that the buyer will receive the goods ordered. //21 22// A Guide to Trade Finance 2.5.4 Special types of documentary credit “ Red clause. This contains a special clause that authorises advance payment to the beneficiary in advance of shipment and before presentation of documents. Originally written in red ink, it specifies the amount to be advanced. The clause is often used for: “ Provision of pre-export financing by the buyer to the seller; “ Finance of the seller’s purchase of raw material; and “ Settlement of progressive payments during the manufacturing/ installation/commission process. Under a secured or documentary red clause credit, advances are made against presentation of warehouse receipts or similar documents together with the beneficiaries undertaking to deliver the bill of lading and/or other documents required upon shipment. With an unsecured or clean red clause, the documents required do not include evidence of goods. Note that green clause credits are available which allow for advance payment but provide for storage in the name of the bank as security. “ Revolving. Here the credit contains a condition that the amount is reinstated without specific amendments and may revolve in relation to time (e.g. monthly) or in relation to value (by drawing). Copyright© 2020 Deutsche Bank AG. All rights reserved Such a credit can be used to reduce administrative workload for repetitive purchases of the same kind of goods from the same supplier at regular intervals and allows for the value made available under the credit to be restored. It is popular with commodity trading houses, who value the flexibility of being able to draw down and repay the facility as needed. “ Transferable. This may be made available in whole or in part to another beneficiary (second beneficiary) at the request of the beneficiary (first beneficiary). Such a credit must clearly state that it is transferable. “ A bank is under no obligation to transfer a credit except to the extent and in the manner expressly consented to by that bank. “ Unless otherwise agreed at the time of transfer, all charges (such as commissions, fees, costs or expenses) incurred in respect of a transfer must be paid by the first beneficiary. “ A credit may be transferred in part to more than one second beneficiary provided partial drawings or shipments are allowed. “ A transferred credit cannot be transferred at the request of a second beneficiary to any subsequent beneficiary. “ Back-to-back. This is where a trader, who acts as a middleman between the source supplier and the final buyer, uses such a credit. Two separate credits are issued: “ The master credit in favour of the middleman; and “ The back-to-back credit in favor of the source supplier. The terms and conditions of the back-to-back credit are similar to the master credit except: “ The credit amount, the unit price, the expiry date, the latest shipment date and the presentation period. The primary source of repayment for the second issuing bank is from the proceeds received from the master credit. //23 24// A Guide to Trade Finance Copyright© 2020 Deutsche Bank AG. All rights reserved Figure 8: Workflow of issuance and settlement Issuance Importer Contract 1 will enable the smooth importation of the goods, and provide a suitable level of assurance, as to the quality, standard and/or type of goods being purchased; while ensuring that the documentary credit is in accordance with the bank’s internal policies and procedures and regulatory guidelines to which it must adhere. Settlement Goods/services/ performance Exporter Importer 1 Often, the policy of a bank will determine whether or not it may act in the capacity of an advising bank, second advising bank and/or confirming bank. Exporter Payment LC application LC advised 2 5 Issuing bank Advising bank LC issuance Transmission 3 6 Discrepancies (if any) communicated and resolved 5 Issuing bank LC receipt 4 6 Documents 2 Negotiating bank Payment Payment 6 Documents re-examined 4 Documents Documents examined 3 Source: TradeLC Advisory 2.5.5 Bank procedure The issuance of a documentary credit is not always a simple formality or an act that can be completed in a standard or repetitive manner. It often requires attention to detail and, more importantly, to contain wording that is not ambiguous or subject to more than one interpretation. An issuing bank has a responsibility to work with its clients to ensure that the issued documentary credit fully meets the needs of each applicant in terms of specifying the appropriate documentary requirements, that Bank policy will usually extend to matters such as the parties and countries involved in a transaction; the goods (i.e. a bank may have specific guidelines for transactions covering the shipment of drugs, armaments, security material and hardware, sale of software, etc.); the structure of a documentary credit with regard to its terms of settlement; and preferred reimbursement instructions (especially when confirmation is to be added). Linked to some of these issues are regional and global sanctions (see Section 11.6) regulations that have been put in place by various governments and international organisations such as the United Nations (UN), European Union (EU), the Office of Foreign Asset Control (OFAC), etc. These can directly affect the ability of a bank to act in a particular role, including as an advising bank, second advising bank and/or confirming bank. A number of documentary credits are currently issued, advised or confirmed with wording to the effect that a bank will be unable to handle a presentation that may violate any conditions of these sanction regulations. In this respect, ICC has issued a recommendation paper concerning the use of such wording. At the time of writing this was being updated but no release date was available.11 //25 26// A Guide to Trade Finance 2.6 Demand guarantees 2.6.1 Definition Demand guarantees are invariably written for a stated amount and contain an expiry date or expiry event by which documents must be presented. A demand guarantee represents the guarantor’s undertaking to pay a named beneficiary a sum of money upon presentation of specified documents conforming to the terms and conditions of the guarantee. The intent of a demand guarantee is to substitute the creditworthiness of the guarantor for that of its customer, the principal (as applicant of the guarantee).12 If documents comply, they will be paid; if not, they won’t. If a demand is made under the guarantee and the principal feels the claim is unjust and/ or the documents are untrue, the guarantor will still go ahead and pay if the demand complies (absent any court injunction stating otherwise), and the principal is expected to be able to recover any undue payment by litigating under the underlying contract. 2.6.2 Essential basics Guarantees are often used to cover, and to mitigate, the many risks that can occur in finalising a contract between a buyer and seller. The benefits and attributes of a guarantee include: “ Independence from any underlying contract. “ Provision of security. “ Protection against non-performance of obligations, as opposed to a performance that results in non-payment (as is covered by instruments such as documentary credits i.e., shipment of goods and presentation of complying documents). “ Can cover financial or non-financial obligations. “ Can be used for cross-border or domestic transactions. “ They share many characteristics of documentary credits e.g., independent from the underlying contract, payment made only if certain conditions are fulfilled, compliance, typically issued by banks, may be subject to a set of international rules. Copyright© 2020 Deutsche Bank AG. All rights reserved “If documents comply, they will be paid; if not, they won’t” 2.6.3 Key considerations The rights of a beneficiary to claim under a demand guarantee are covered by the terms and conditions of the guarantee itself and not by reference to the underlying commercial contract. In order to demand payment, the beneficiary need only comply with the terms and conditions of the guarantee and has no need to provide any separate or additional documentation. The only exception to this would be if the guarantee were subject to Uniform Rules for Demand Guarantees (URDG) 758 (See Section 2.8.2). These rules require a separate statement of breach to be presented. For a bank receiving a demand under a guarantee, this means that it only need be concerned with the terms and conditions of the guarantee and has no mandate or necessity to refer to any extraneous documentation such as the underlying commercial contract in order to determine compliance. Certain pieces of information are consistently found in the text of a demand guarantee, regardless of the type that is issued.13 These include, but are not limited to: “ Names and addresses of the contracting parties: applicant and beneficiary. “ Guarantee reference number. “ Guarantee currency and amount. “ Brief details of the underlying transaction. “ Details of the document(s) that is/are required to be presented in order to fulfil a demand for payment. “ Place for presentation of a demand and the required format for that demand. “ Expiry date or expiry event. “ Party responsible for fees and charges. “ Law and jurisdiction clauses. “ Rules, if required. //27 28// A Guide to Trade Finance Copyright© 2020 Deutsche Bank AG. All rights reserved Advance payment An advance payment guarantee also covers non-performance and will reimburse money paid in advance – a percentage of the value of the contract to be paid by the purchaser to the vendor as a down payment or advance payment or deposit upon signing of the contract. The guaranteed amount is usually the same as the amount of the down payment – between 5-25% of contract value. This type of guarantee often includes a reduction clause upon evidence of ‘progressive’ or ongoing successful completion of performance i.e. presentation of copy invoices indicating completion of a shipment, services or performance. 2.6.4 Types of demand guarantee Tender/Bid Tender/Bid guarantees are usually required in public tenders, accompanying the tender or bid as required in the conditions of tender, since major contracts in the public sector often require the additional security of a tender guarantee or bid bond. Normally issued for 2−5% of the value of the tender and payable on demand, these guarantees ensure the bidder cannot withdraw from the tender process. Tender regulations normally require provision of a performance guarantee within a certain period (if the tenderer wins the contract). These guarantees also typically include a fixed expiry date, though they may have provision for an extension, and cannot be called upon once contract awarded to another bidder. Performance A performance guarantee is an undertaking to deliver the performance promised in the contract. Contractual obligations include, inter-alia, the supply of goods, services or expertise and the completion of projects. In turn, the guarantee assures payment in the event that the counter-party does not fulfil contractual obligations, with the text set out under the guarantee relating to non-performance by the applicant. It usually covers a percentage of the contract value, normally around 5−10%. An advance payment guarantee does not normally become effective until advance (down) payment is received. Warranty/Maintenance A warranty/maintenance guarantee covers the maintenance or warranty period and guarantees recompense for defects etc. This type of guarantee is available throughout the maintenance or warranty period during which the applicant is responsible for the stated obligations. The percentage of contract value is much lower than for a performance guarantee – normally 5%. A warranty/maintenance guarantee is often used for construction projects and can be valid for 24 months or more. Retention A retention guarantee allows payment by the purchaser for the full contract amount instead of withholding part of that amount as security for defects, normally around 10−15% of contract value. It is payable on first demand and ensures a refund of payments made – similar to a performance guarantee when a contractor fails to complete a project. This type of guarantee can be valid for 24 months or more. Other forms of demand guarantee can include: customs, payment, re-insurance, and many others. //29 30// A Guide to Trade Finance 2.6.5 Workflow 2.6.6 In practice In view of the fact that the concept of confirmation does not exist with a demand guarantee, and in order to facilitate such transactions, it is normal practice that a counter-guarantee is issued by one bank, in favour of another bank, to support the issuance of a guarantee by that other bank. Figure 9: Workflow of direct and indirect demand guarantees Applicant/Seller Beneficiary/Buyer Applicant/Seller Beneficiary/Buyer To achieve the same result as confirmation, i.e. another (local or preferred) bank giving an undertaking to a beneficiary, a counter-guarantee is issued in favour of that bank as an inducement for them to issue its own guarantee in favour of the beneficiary. Contract Contract Application Application Guarantee Guarantee Counter-Guarantee Guarantor Direct Copyright© 2020 Deutsche Bank AG. All rights reserved Counter-Guarantor Guarantor Indirect Source: TradeLC Advisory “ Direct guarantee. The seller’s bank provides the guarantee directly to the buyer with the seller giving the bank a counter indemnity. Due to local regulations or commercial practice, the buyer may insist that their own bank provides the guarantee. “ Indirect guarantee. The seller arranges for his bank to instruct the local bank to issue a guarantee to the buyer. The seller’s bank provides a counter guarantee to the local bank for the issuance and the seller provides their counter indemnity in the usual way. Such a document may incorporate the required wording of the guarantee to be issued by the guarantor or issuing bank, or request issuance in the standard form of the guarantor for the type of guarantee that is to be issued. //31 32// A Guide to Trade Finance 2.7 Standby credits 2.7.1 Definition Although very similar to demand guarantees, the functional variations are primarily in terminology and practice. The term ‘standby letter of credit’ originated in the US. They were introduced due to the legal statute that banks in the US were not allowed to issue guarantees. This prohibition has since been repealed with the introduction of URDG 758, and it is accepted that banks can now issue demand guarantees in addition to standby credits. Copyright© 2020 Deutsche Bank AG. All rights reserved Issuing banks will look for certainty in the text with regards to the expiry provision, the form and presentation of any demand and the application of any additional conditions. It is not unusual that the standby will include the wording for the demand that is to be presented, should it be necessary for the beneficiary to make a claim. When documents such as a copy of a transport document and/or a copy of an (unpaid) invoice are to be presented together with a demand, the standby should specifically indicate the data requirements for such documents as they will not be examined in the same manner as they would under a documentary credit. 2.7.2 Essential basics 2.7.4 Types of standby A standby credit represents a secondary obligation covering default only. In essence, this instrument provides security against non-performance as opposed to performance (as is the case with a normal documentary credit). A wide variety of types exist but those more commonly seen in trade finance transactions are listed below.15 Most of these will be familiar to those acquainted with demand guarantees. “ Performance − agreeing to undertake, deliver and/or complete contractual obligations. “ Advance payment − undertakes repayment of all or part of a percentage of the value of a contract that has been paid by the beneficiary to the applicant as a down payment, advance payment, or deposit, upon the signing of the contract. “ Bid or tender bond − ensures a bidder (applicant) cannot alter its tender proposal, or withdraw from the tender process, before the tender is awarded. “ Counter − a standby issued by one bank, in favour of another bank, to support the issuance of a standby, guarantee, documentary credit or other form of undertaking, by that other bank. Standbys can be subject to a variety of rules in addition to, such as International Standby Practices (ISP) 98, UCP 600 or URDG 758. However, ISP98 is the most appropriate.14 ISP98 was introduced in 1998 due to the fact that many facets of UCP were inappropriate (if not incorrect) for the handling of standby credits. 2.7.3 Key considerations As is the case with a guarantee, it is common for a beneficiary to provide an applicant with its preferred wording for the issuance of a standby, very often with an instruction that the wording cannot be amended in any way. Alternatively, an applicant and beneficiary will agree the text as part of their sale contract negotiations and deliver it to the bank for issuance on an “as is” basis. Where an issuing bank maintains standard clauses for inclusion in its standby issuance, it is advisable to make these known or available to regular applicants of a standby, so that they do not agree a text that may not be possible to issue without some form of amendment, enhancement or internal legal approval. //33 34// A Guide to Trade Finance Copyright© 2020 Deutsche Bank AG. All rights reserved “ Financial − supports a financial obligation to pay or repay. “ Insurance − reinforces applicant obligations in respect of insurance or re-insurance activity. “ Direct-pay − not necessarily related to a default and is likely to be the primary means of payment rather than secondary which is normally the case. “ Commercial − acts as a security for payment of goods or services not settled by a buyer under other arrangements i.e., via open account trading or documentary collection. 2.7.6 In practice An applicant and beneficiary should be aware that banks will often maintain standard text or clauses that they are required to insert into a standby, from a regulatory or internal policy perspective, and should seek the intended issuing bank’s concurrence on the wording before any formal agreement is reached on the final text. ISP98 Model Forms, designed by a team of standby bankers and attorneys and aligned with ISP98 (ICC Publication No. 590), are the most widely used rules for standbys.16 2.7.5 Workflow The Institute of International Banking Law & Practice (Institute) began releasing the ISP98 Model Forms on 15 May 2012. They are intended to help standby users, including their regulators, to develop sound, workable, and appropriate texts for standbys in light of specialised standby practices and laws worldwide and can also be used for demand guarantees subject to ISP98. Figure 10: Workflow of standby credits Issuance Importer Contract 1 Settlement Goods/services/ performance Exporter Importer 1 Exporter Payment Standby LC application Advising of standby LC 2 5 Issuing bank Advising bank 6 Issuing bank Standby LC issuance Transmission 3 Receipt 4 2 6 Negotiating bank Payment Payment 6 Examination of demand 4 Source: TradeLC Advisory Presentation of demand Resolution of discrepancies (if any) 5 Demand Examination of demand 3 2.8 ICC Rules and standards As explained in Section 1.4.2, the ICC has become a leading global rulemaking body for the banking industry, not only producing universally accepted rules and guidelines for international banking practice, but also providing leading edge research and analysis. In trade finance, it is vital to gain an understanding of existing and developing rules and practice and then to implement appropriate procedures and guidelines in order to ensure more certainty and reduce lending risk. //35 36// A Guide to Trade Finance Copyright© 2020 Deutsche Bank AG. All rights reserved 2.8.2 URDG 758 The first release of an ICC publication addressing rules for demand guarantees was in 1992 with URDG (Uniform Rules for Demand Guarantees) ICC Publication No. 458. The rules achieved relative success but never attained global adoption, partially due to the article covering demands for payment, which was seen by many in the trade community as not in line with practice. 2.8.1 UCP 600, URR 725, ISBP 745, eUCP The most widely used set of ICC rules, Uniform Customs and Practice for Documentary Credits (UCP), was introduced in 1933 to alleviate the disparity between national and regional rules on letter of credit practice. Since then, there have been six revisions, the current version known as UCP 600. Justification for the existence of UCP 600 revolves around four essential tenets: “ Harmonisation as opposed to differing customs. “ Common understanding of terms and intentions. “ The ability to rely on a set of contractual rules that would establish uniformity in practice, so that practitioners would not have to cope with a plethora of often conflicting national regulations. “ A platform in which to conduct business between countries with widely divergent economic and judicial systems. The rules are supplemented by: “ ICC Uniform Rules for Bank-to-Bank Reimbursements under Documentary Credits (URR 725). “ International Standard Banking Practice for the Examination of Documents under UCP 600 (ISBP publication No. 745). “ ICC Supplement to the Uniform Customs and Practice for Documentary Credits for Electronic Presentation (eUCP Version 2.0). In 2010, a revision of the rules was introduced, URDG 758. This revision provided an opportunity to bring all comments, experiences, criticisms and feedback regarding URDG 458 and the practice of demand guarantees into a new revised and comprehensive set of rules. This version is more exact and avoids the possibility of misinterpretation, which existed with URDG 458. In addition, it is made more transparent and readable by following the logical sequence of a guarantee lifecycle. 2.8.3 ISP98 The International Standby Practices (ISP98) became effective on 1 January 1999. It is considered to be more suitable for standby credits than UCP 600, which focuses primarily on commercial letters of credit and contains a number of rules that are not suitable or applicable for typical standbys. ISP98 contains the following sections: General provisions; Obligations; Presentation; Examination; Notice, Preclusion and Disposition of documents; Transfer, Assignment and transfer by operation of law; Cancellation; reimbursement obligations; Timing; Syndication and participation. //37 38// A Guide to Trade Finance Copyright© 2020 Deutsche Bank AG. All rights reserved 2.9 “UCP was introduced in 1933 to alleviate the disparity between national and regional rules on LC practice” Dispute handling and arbitration The ICC rules remain the most successful set of private rules for trade ever developed. However, no rules can protect you from bad practice, poor application of the rules, mishandling, or dishonest parties. 2.8.4 URC 522 Problems and misunderstandings do occur which can give rise to a dispute. In such circumstances, it is always hoped that the parties can reach a mutual understanding and agreeable conclusion. The worst-case scenario is that the dispute will end up in a court of law. The Uniform Rules for Collections (URC) were originally introduced in January 1979, under ICC Publication No. 322. The latest revision, Publication No. 522, came into effect on 1 January 1996. However, there does exist an intermediate stage, one of arbitration, whereby the parties concerned may agree to an independent assessment of the issue under dispute. The purpose of the URC is to set a standard under which all parties to a documentary collection are aware of their roles and responsibilities. The rules are applicable when indicated in the collection instruction. Whilst there are a number of formal arbitration services, including the ICC International Court of Arbitration, a less formal alternative exists in the form of a rapid, cost-effective, document-based procedure known as the ICC Rules for Documentary Instruments Dispute Resolution Expertise (DOCDEX). In July 2019, the ICC released a Supplement for Electronic Presentation (eURC) Version 1.0 (refer Section 10.8.1). 2.8.4 URF 800 The Uniform Rules for Forfaiting entered into effect on 1 January 2013 and sets out clear procedures along with model agreements for both corporates and financial institutions engaged in monetising receivables using forfaiting. URF 800 contains model agreements.17 2.8.5 URBPO The Uniform Rules for Bank Payment Obligations demonstrates ICC’s support for payment method using electronic data matching.18 They were adopted in April 2013. The rules define the BPO as “an irrevocable and independent undertaking of an obligor bank to pay or to incur a deferred payment obligation and pay at maturity a specified amount to a recipient bank in accordance with the conditions specified in an established baseline”. The purpose of DOCDEX is to provide parties with a specific dispute resolution procedure that leads to an independent, impartial and prompt expert decision settling disputes involving trade finance instruments, undertakings or agreements.19 DOCDEX was first launched in 1997 as an alternative dispute resolution system for parties using ICC rules relating to letter of credit transactions. In 2002, the scope of the DOCDEX rules was broadened to also encompass cases relating to URC and URDG. In November 2014, the Banking Commission approved a new set of DOCDEX rules that additionally caters for transactions subject to ISP98 and also trade finance transactions that are not subject to ICC rules. The process is monitored and handled by the ICC International Centre for Expertise. //39 40// A Guide to Trade Finance Copyright© 2020 Deutsche Bank AG. All rights reserved 1 3 Supply chain finance 3.1 Definition Supply chain financing is a generic term that typically covers the financing of open account transactions along the supply chain from development to distribution. Enabling accessible financing along the entire physical supply chain ensures exponential benefits to all entities involved in a trade transaction. Traditional trade finance has provided enormous benefits to traders but the problem has been that many of these solutions are predicated upon a paper environment. Dematerialisation into a digital format has proved to be the way forward. In modern times, efficient and speedy global modes of transport, combined with containerisation, have transformed the physical supply chain. However, due to the intrinsic need for paper, the financial supply chain has not kept pace with physical supply chains. The major challenge is to transparently, digitally and efficiently share information across the numerous involved entities in a trade transaction including suppliers, buyers, logistics, financial institutions, insurers, etc. Figure 11: Benefits of supply chain finance Figure 12: What financial intermediaries provide buyers and sellers Banks Buyers and suppliers “ Learn more about the business of its clients thereby enabling enhanced data integration, advanced financing solutions, and automated processing, particularly in a digital environment “ More accessible risk mitigation and improved working capital flows “ Reduced operational costs “ Lower transaction cost enabling reduced transaction pricing “ Automated processes including reconciliation, settlement, forecasting and monitoring “ Shorter transaction processing times and completion Source: TradeLC Advisory Closer matching of the physical, financial and information supply chains will continue to fuel the development of innovative financing solutions. Integration of data and information is, and will be, the basis of future trade solutions. Technology-based, automated, digital, paperless, online solutions to enable lower financing and operating costs, improving timeliness and improving efficiency and effectiveness Assistance in optimising working capital Financing which includes, but is not limited to, pre-shipment, warehouse, post-shipment and receivables purchase Additional access points across the supply chain allowing improved and increased financing opportunities Support multiple entities, in particular numerous suppliers. Modern supply chains can be very intricate and complex Risk mitigation as has been available for more traditional means of settlement and finance Source: TradeLC Advisory //41 42// A Guide to Trade Finance 3.2 Physical and financial supply chains Globalisation and the proliferation of technology have transformed business as we know it. But digitalisation (see Section 10) is a priority for one industry in particular: trade finance. Greater use of technology could bring numerous benefits to the industry with the increased transparency a digital process brings and even help plug the trade finance financing gap, estimated at US$1.5trn by the Asian Development Bank.20 The integration of physical, financial and information supply chains is stimulating ever more innovative financing solutions and such coordination of data and information will be the basis for future trade finance offerings as digital information becomes more readily attainable, convenient and available. The key to this success has been, and will continue to be, common standards for the sharing of data and information. Each party involved in a trade transaction needs to have access to data easily, cheaply and quickly. Copyright© 2020 Deutsche Bank AG. All rights reserved 3.3 Moving towards standardisation A relatively modern development, supply chain finance has often suffered from differing interpretations across industries and geographies. This has prompted a number of attempts in recent years to provide a common framework for understanding. The Euro Banking Association (EBA), in 2013, defined supply chain finance as, “The use of financial instruments, practices and technologies to optimise the management of the working capital and liquidity tied up in supply chain processes for collaborating business partners. SCF is largely ‘event-driven’. Each intervention (finance, risk mitigation or payment) in the financial supply chain is driven by an event in the physical supply chain. The development of advanced technologies to track and control events in the physical supply chain creates opportunities to automate the initiation of SCF interventions.”21 More recently, in 2016, Bankers Association for Finance and Trade (BAFT), EBA, Factors Chain International (FCI), ICC and the International Trade and Forfaiting Association (ITFA) jointly produced a paper under the auspices of the Global Supply Chain Finance Forum (GSCFF) entitled “Standard Definitions for Techniques of Supply Chain Finance”22. As mentioned on the ICC and GSCFF websites, the intent of this initiative is to help create a consistent and common understanding in respect of supply chain finance starting from the definition of terminology, to be followed by advocacy in support of global adoption of the standard definitions. Definitions include: “ Receivables discounting “ Forfaiting “ Factoring “ Factoring variations “ Payables finance “ Loan or advance against receivables “ Distributor finance “ Loan or advance against inventory “ Pre-shipment finance “ Bank payment obligation //43 44// A Guide to Trade Finance Copyright© 2020 Deutsche Bank AG. All rights reserved 3.5 //45 Forfaiting The without recourse purchase of future payment obligations represented by financial instruments or payment obligations (normally in negotiable or transferable form), at a discount or at face value in return for a financing charge (synonyms include without recourse financing, discounting of promissory notes/bills of exchange).25 The term “forfait” comes from the French expression to “relinquish a right”. In the context of forfaiting, the exporter will relinquish their rights to receive the proceeds on the due date in return for an immediate payment, at an agreed interest rate for the discount, and thereby pass all risks and responsibility for collecting the debt to the forfaiter. Figure 13: Summary of forfaiting transactional flow 3.4 2 Contract Receivables discounting Seller Buyer Sellers of goods and services sell individual or multiple receivables (represented by outstanding invoices) to a finance provider at a discount (synonyms include Receivables Finance, Receivables Purchase, Invoice Discounting).23 In June 2019, the GSCFF released a new guidance document, Market Practices in Supply Chain Finance: Receivables Discounting Technique, which focuses on receivables discounting a technique and form of receivables purchase; flexibly applied in which sellers of goods and services sell individual or multiple receivables (represented by outstanding invoices) to a finance provider at a discount.24 3 Delivery of goods 1 5 Commitment to acquire notes/bills Delivery of notes/bills 6 4 Delivery of notes/bills Cash payment less discount costs 4 7 7 Presentation for payment at maturity Forfaitor Source: www.tradefinance.training 8 Repayment at maturity Guarantor 8 46// A Guide to Trade Finance Forfaiting is usually experienced in transactions with tenors of more than 180 days and up to 10 years. The average is in the region of three to five years. Given the periods involved, it can be seen that forfaiting is used in large contracts and projects, long-term repayment plans to assist importers and high value transactions. Debt should be evidenced by a legally enforceable and transferable payment obligation such as a bill of exchange, promissory note, or a letter of credit. Copyright© 2020 Deutsche Bank AG. All rights res