Trade Finance trimmed (1).pdf

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 po...

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