INTERNATIONAL TRADE

FINANCE

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Outline
I. INTRODUCTION

II. DOCUMENTARY CREDIT

A. Principles of Documentary Credit
B. The role of the International Chamber of Commerce (ICC)
(1) INCOTERMS
(2) UCP 500

III. OVERVIEW OF PAYMENT METHODS

A. Open Account
B. Cash in Advance
C. Documentary Collection
D. Documentary Credit
(1) Types of L/C (Revocable/irrevocable -Confirmed/unconfirmed)
(2) Documents associated with an L/C
(3) Methods of Settlement.

IV. OVERVIEW OF BASIC FINANCING METHODS

A. Financing Importers
(1) Letter of Credit (financing with the use of an L/C)
(2) Bill of Exchange
B. Financing Exporters
(1) Special Type of L/C
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(2) Forfaiting
 I. Introduction

What is Trade Finance?

Basic Concepts
This is the provision of any form of financing that enables
a trading activity to take place. Trade financing could be
made either directly to the supplier, to enable him procure
items to produce, or for immediate sale, and/or for storage
for future activities. It could also be provided to the buyer,
to enable him meet contract obligations. Whichever way it
goes the underlying principle is that the party more able to
bear the risk is made the reimbursement source for the
facility.

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 I. Introduction

What is Trade Finance?

Buyers and sellers in international trade are confronted

with diverse geographic, social, economic and political
conditions.

In general trade is built on trust, without trust trade would

not exist. Every one relies on the honest and integrity of
those in the trading cycle, however there are always
adverse elements (or unscrupulous parties) that could to
upset this cycle, this is where the bank can intervene and
help to bridge the trust gap. One major instrument that is
used in international trade to circumvent such problems is
the Documentary the Letter of Credit.
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 II. Documentary Credit

DOCUMENTARY CREDIT IS AN ESSENTIAL PART OF

THE TRADE PROCESS

Documentary credit or letter of credit is an undertaking issued

by a bank (Issuing bank) for the account of the buyer (the
Applicant) or for its own account, to pay the Beneficiary the
value of the Draft and/or documents, provided that the terms
and conditions of the Documentary Credit are complied with.

Source: ICC Guide to Documentary Credit Operations. For further detailed

explanation of the definition refer to UCP 500 Article 2.

 Documentary credit is a trade payment (and finance) mechanism that

was developed to add a measure of security to trade transactions,
particularly between buyers and sellers from different countries, and to
assert sufficient pressure in case of any violation or non-performance to
the L/C.
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 * Letter of Credit Flow Chart
Opens L/C and forwards details
for delivery to exporter
3.
Issuing Bank Advising Bank
After examining documents
and clearing up any
6. discrepancies, Negotiating bank Advises L/C
presents documents to Issuing (validates
bank for payment authenticity of
Checks documents and 4. L/C, checks its
pays Negotiating bank workability and
7. and forwards documents completeness from
for importer to claim the Negotiating Bank a bank perspective,
goods and forwards
Presents L/C and require details to exporter)
documents for settlement
Request to open L/C by completing 5. once shipment of goods is
arranged
2. application form specifying terms
and conditions of the transaction

Importer 1. Exporter
(Applicant) Sales contract agreement (specifying (Beneficiary)
quantity, payment terms and documents)

The Issuing Bank substitute for the credit-worthiness of the Buyer

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 A. Principles of Documentary Credit
⚫ The underlying principles of the letter or credit are that it must be
autonomous and the exporter must strictly comply with the written terms
of the Documentary Letters of Credit. In documentary credit operation,
banks deal only with documents and not with the goods to which the
documents relate. Any disagreements arising from contracts or dispute
relating to the goods or services must be dealt with directly between buyer
and seller.

⚫ Although DC are completely separated transactions from the

underlying commercial contracts on which they may be based, however,
the importance of the commercial contract to the documentary credit
process cannot be under emphasized. It is usually at the contract
negotiation stage that the responsibilities of each party are defined, the
price and terms of payment are agreed upon and the mode of transport is
determined. As far as possible, the terms and conditions of the DC should
also be agreed at this stage.

⚫ Each element of the contract needs to be accurately reflected in the

subsequent documentary credit to ensure that the transaction can be
7 completed successfully, without creating undue difficulty for either party.
 B. The role of the International Chamber of
Commerce (ICC)

There are strict requirements that govern the formulation of documentary

credit. The International Chamber of Commerce is the organization which
has developed the most extensive and most commonly applied rules, models, and
materials related to documentary credit.

The International Chamber of Commerce (ICC) is a non-governmental

organization which was founded in 1919 with the aim of facilitating and helping
the world's businesses, by promoting trade, investment, and open markets for
goods and services, as well as the free flow of capital.

Among the most well-known ICC products in relation to international trade

practices are the Incoterms and the ICC Uniform Customs and Practice for
Documentary credit (UCP). Their objective is to facilitate trade, increase the
efficiency and decrease the cost of international transactions by promoting the
standardization of international banking and commercial practices and procedures.

http://www.iccwbo.org/

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 (1) Incoterms (International Commerce terms)

Incoterms are uniform sales and shipping terms used in foreign trade and are
accepted by the banks as legal terminology for letter of credit transactions.

The ICC published in 1936 the first set of rules specifying contract obligations
and assigning the responsibilities of buyers and sellers involved in international
trade. These Incoterms have been updated regularly since, most recently in
2000 (with 13 standardized foreign sales terms) to reflect new techniques of
international trade.

➔ Incoterms provide generally three basic pieces of information:

• Information on the transfer of risk: it defines at which place the risks of cargo
loss and damage is transferred from the seller to the buyer during transport
operations.
• Information on the division of costs: it defines how costs resulting from the
transport operation are shared between the buyer and seller (i.e. cost of
dispatch, carriage and delivery; customs clearance for export and import;
service or assistance rendered by one party to the other; and insurance).
• Information on the documents: it defines who will provide the required
documents (i.e. transport document, proof of delivery, certificate of
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inspection, insurance, etc.).
 (1) Incoterms (International Commerce terms)

EXAMPLE:

 Ex Works (named place): where the seller make available the

goods to the buyer at his premises. The seller here does not bear
any risk.
Ex Works - XYZ International,Geneva, Switzerland.

 CIF - Cost, Insurance, and Freight (named port of

destination): where the seller bear the risk of the main transport
cost but not the risks after shipment.
CIF - Port of Kaohsiung, Taiwan

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 (2) UCP (Uniform Customs and Practices for
Documentary Credit)

ICC has established a set of standard rules and practices called the "Uniform
Customs and Practices for Documentary Credits" (UCP) to govern trade
transactions.

The UCP describes customary practices and standard performance for letters of credit and
provides a comprehensive and practical aid to bankers, lawyers, and all businesses
involved in international trade. The UCP lays down a code of practice for the issuing of
documentary credits. For many years most documentary credit transactions have been
carried out in accordance with the "Uniform Customs and Practice for Documentary
Credits". (the UCP had been modified 5 times with the latest in1993 - UCP 500)

The objective of the new UCP is to enhance international trade and facilitate the use
of letters of credit by reducing the level of discrepancies and disputes. It should be
noted that not all banks in the world conform to the UCP rules but, in principle, it is
clearly stated in Article 1 of UCP 500 that UCP rules apply to a documentary credit when
they are included in the contract. Therefore, it is always preferable to refer to the UCP
when setting up a contract.

Letters of credit are reviewed by all banks according to these rules, and
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persons dealing in letters of credit should be well-aware of them.
 (2) UCP (Uniform Customs and Practices for
Documentary Credit)

§ The UCP of 1993 (ICC publication no. 500) contains 49 articles

under seven headings:

1. General Provisions and Definitions

2. Forms and Notification of Credit (provides consistent standards
in connection with the issuance, amendment, advisement,
payment and confirmation of letters of credit)
3. Liabilities and Responsibilities
4. Documents (defines the elements of acceptability and content of
each type of transport document)
5. Miscellaneous Provisions
6. Transferable Credit
7. Assignment of Proceeds.

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III. International Trade Payment Instruments

Introduction

DCs are one of the most widely used methods of settlement for international
trade transactions because the security they offer is well balanced between the
two commercial parties. Various payment instruments have been designed to
take into account, not only the payment risk of the buyers, but also the risks
inherent in their countries of domicile. The overall aim is to ensure that the
buyer receives the consignments of the right quantity, quality at the right price
and time, and on the other hand it ensures also that the seller receives due
payments.

The are four principal payment mechanisms for settling international trade
transactions. These are: Open Account, Advance Payment, Documentary
Collections and Documentary Credits.

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 Risk Perspective

Least secured for Exporter/Seller Most secured for Importer/Buyer

Open account

Documentary collections

Documentary credits

Payment/cash in advance

Most secured for Exporter/Seller Least secured for Importer/Buyer

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 Payment mechanisms

Open Payment in Documentary Documentary

Account Advance Collections Credit

Irrevocable
D/C

Document Document
against against
Payment Acceptance

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 A. Open Account
Open account means exporter selling on credit terms to the buyer

This is the most secure method of payment for the importer. It allows the
importer to make payments at some specific date in the future and without the
buyer issuing any negotiable instrument evidencing his legal commitment to
pay at the appointed time. On the part of the seller, it is therefore the most
risky payment mechanism the buyer bears the cost of financing and the
credit risk of the buyer

Open account does not involve the bank very much except in moving the
funds from buyer to seller, in due course. This mechanism offers the seller no
protection in case of non-payment. However, an exporter can structure his
open account sale transaction to minimize the risk of non-payment; for
example, reducing the repayment period and retaining title to the goods until
payment is made. Even then, it is difficult to enforce this especially if the
goods have been either resold by the buyer or consumed in some other
processing activity.

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 ➔ When Open account should be used?

1. This payment mechanism is used when the exporter has a well-established

commercial relationship with a credit-worthy importer and when the importing
country enjoys reasonable political and economic stability.

2. When the exporter is shipping goods to a parent or subsidiary company.

3. When the exporter is faced with excessive inventory. In this case, he seeks
markets desperately and would take the risk of delivering even to a seller
without excellent credit records. This is more relevant for items with short
expiration dates, which could go bad, any way.

4. A seller faced with a very strong competition may also decide to ship goods
on open account as a way to squarely face the challenges posed by the
competitors. It is a way of making his products visible in the international
market.

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 Open Accounts - summary

Informal arrangement whereby goods are shipped and the importer is

billed later (Invoice sent with or after shipment).
Provides great flexibility.
Useful when customers are well known good credit risks and common
with longstanding good customer-supplier relationships

Typical risks include:

– Customer refuses to take possession
– Customer unable or unwilling to pay
– Customer restricted from paying by its central bank

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 B. Payment/Cash in Advance
In contrast to open account, payment against documents is the most secure
payment method for the exporter but most risky for the buyer since
goods are not shipped until payments are received in part or full.

In this arrangement, the seller retains total control over the transaction and
there is no guarantee that goods paid for will even be delivered in good
time. There is very limited bank involvement in this method of payment
since the seller sends the documents directly to the buyer. The bank only
comes in to effect payment which is usually wired from the buyer’s bank to
the seller’s bank.

Cash in advance can be expensive to the exporter since buyers who are
forced to pay in advance may ask for a discount on the value of the exports.

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 ➔ When is Payment in Advance used?

1. This method of payment is usually used only for small purchases.

2. Essentially, sellers request payment in advance when foreign buyer's

credit status is doubtful and unsatisfactory and/or the country political and
economic risks are very high. In this circumstance, the seller does not
want his funds to be trapped in a foreign land on grounds of buyer failure
or difficulties in remittance due to exchange restrictions by the
government.

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 Cash in Advance - summary
Occurs when exporter is in strong bargaining position relative to importer

Relationship between parties unestablished

Typical Risks include:

– Supplier may not ship
– Supplier may ship late, low grade or less than agreed
– Supplier may not be permitted to export by authorities

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 C. Documentary Collections
This is a method of payment by which the sale transaction is settled
through an exchange of documents, thus enabling simultaneous payment
and transfer of title. The principal obligations of parties to a documentary
collection arrangement are set out in the guidelines of the ``Uniform Rules
for Collection’’ (URC) drafted by the Paris-based International Chamber
of Commerce.

This method makes use of Bill of Exchange or Draft supported with other
shipping documents.

Documentary collections offer a middle-of-the road approach to satisfying

both the exporter and importer. In the arrangement, the importer is not
obliged to pay for goods prior to shipment and the exporter retains title to
the goods until the importer either pays for the value of the draft upon
presentation (sight draft) or accept to pay at a later date and time (term
draft).

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 Role of Banks in Documentary Collections
Banks play essential roles in transactions adopting documentary
collections. Two major banks come into the scene:

Remitting Bank: This is the exporter’s bank and acts as the exporter’s
agent in collecting payment from the importer. It basically transmits the
exporter’s instructions along with the terms of the draft to the importer’s
bank. The bank does not assume any risks and does not undertake to pay
the exporter but can influence to obtain settlement of a bill.

Collecting Bank: This is the importer’s bank and takes up the role of
ensuring that the buyer pays (or accept to pay) for the goods before
shipping documents are released to him.

Generally, the banks in the transaction control the flow and transfer of
documents and regulate the timing of the transaction. They must ensure
the safety of the documents in their possession but are not responsible for
their validity and accuracy.

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 Flow of Transaction in a Documentary Collections Deal
1. Exporter/drawer and Importer/drawee agree on a sales contract, including
payment to be made under a Documentary Collection.

2. The Exporter ships the merchandise to the foreign buyer and receives in
exchange the shipping documents.

3. Immediately thereafter, the Exporter presents the shipping documents with

detailed instructions for obtaining payment to his bank (Remitting bank).

4. The Remitting bank sends the documents along with the Exporter’s
instructions to a designated bank in the importing country (Collecting Bank).

5. Depending on the terms of the sales contract, the Collecting Bank would
release the documents to the importer only upon receipt of payment or
acceptance of draft from the buyer. (The importer will then present the
shipping documents to the carrier in exchange for the goods).

6. Having received payment, the collecting bank forwards proceeds to the

Remitting bank for the exporter’s account.

7. Once payment is received, the Remitting bank credits the Exporter’s

24 account, less its charges.
 Documentary Collections Flow Chart
1. Contract of sale

2. Delivery of goods
Importer Exporter
(Drawee) (Drawer)

5.
Presentation
of documents
and receipt of
payment

Collecting/ Remitting
6. Payment
Presenting Bank
Bank
4. Documents and collection order
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 Variations of Documentary Collections

• Cash against documents/Sight Drafts:

In a transaction on documents against payment, the exporter releases the
shipping documents to the importer only on payment for the goods. In
this arrangement, the exporter retains title to goods on board and may
decide to refuse their discharge if payments are not received. This
arrangement which demands the buyer’s immediate payment of the
exporter relies on the a sight draft drawn on the buyer.

• Document against Acceptance/Term Drafts:

An exporter may decide to release shipping documents to a buyer on
acceptance of the exporter’s drafts. In this case, the importer is under an
obligation to pay at a future date. This method satisfies both parties
since the importer is able to receive the goods before payment and the
exporter has a firm assurance that payment will come at a future date.

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 Risks in Documentary Collections
• To the Exporter
If it is a sight draft, the exporter will reduce the risk of non-payment
but will not eliminate it totally since the importer may not be in a
position to pay for the goods or may not be able to procure sufficient
foreign exchange to make the payment. In this case the exporter
may be forced to either call back the goods or negotiate sale to some
other interested party, may be at a reduced rate.
In the case of term draft, the risk to the exporter is higher since the
foreign buyer will take possession of the goods and may not pay at
due date, forcing therefore the exporter to try and collect payment
from the foreign buyer in the foreign buyer's home country.

• To the Importer
The importer faces the risk of paying for goods of sub-standard
quality or even with shortages. In such a circumstance, it would take
some time to get refunds from the exporter. It could also happen that
the exporter refuses to make refunds, leading the importer to lengthy
legal proceedings.

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 ➔ When to use Documentary Collections?

Since Documentary Credit transactions entail some measure of differed

payment it advisable to use when the following conditions apply:

 when the exporter and importer have a well established

relationship

 when there is little or no threat of a total loss resulting from the

buyer’s inability or refusal to pay

 when the foreign political and economic situation is stable and

when a letter of credit is too expensive or not allowed.

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 D. Documentary Credits

Documentary credit is for an exporter the next best thing after Payment
in Advance.

Compared to other payment forms, the role of banks is substantial in

documentary credit transactions.

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 Role of Banks in Documentary Credits

• The banks provide additional security for both parties in a trade transaction
by playing the role of intermediaries. The issuing bank working for the
importer and the advising bank working for the exporter.

• The banks assure the seller that he would be paid if he provides the
necessary documents to the issuing bank through the advising bank.

• On the other hand, the banks also assure the buyer that his money would
not be released unless the shipping documents evidencing proper and
accurate shipment of goods are presented.

• On the basis of these roles, it can be properly said that banks are the
beacon which guide parties in an international trade transaction, without
which, pitfalls would abound.

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 (1) Types of L/C - 1

Irrevocable L/C
Such a letter of credit cannot be changed unless both buyer and seller agree
to make changes. Usually an L/C is regarded as irrevocable unless otherwise
specified. Therefore, in effect, all the parties to the letter of credit
transaction, i.e. the issuing bank, the seller and the buyer, must agree to any
amendment to or cancellation of the letter of credit. Irrevocable letters of
credit are attractive to both the seller and the buyer because of the high
degree of involvement and commitment by the bank(s). By the 1993
revision of the UCP, credits are deemed irrevocable, unless there is an
indication to the contrary.

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 (1) Types of L/C - 2
A letter of credit may be of two forms: Confirmed or Unconfirmed

Confirmed L/C
If the exporter is uncomfortable with the credit risk of the issuing bank or if the
country where the issuing bank is situated is less developed or politically
unstable, then as an extra measure, the exporter can request that the L/C to be
confirmed. This would add further comfort to the transaction, an exporter may
request that the L/C be confirmed. This is generally by a first class
international bank, typically the advising bank (now the Confirming Bank).
This bank now takes the responsibility of making payments if no remittance is
received from the issuing bank on due date.

Unconfirmed L/C
In contrast, an unconfirmed credit does not require the advising bank to add its
own payment undertaking. It therefore leaves the liability seller with the
issuing bank. The advising bank merely as a channel of transmission of
documents and payment.

NOTE  The lowest risk form to the exporter is a confirmed and

32 irrevocable letter of credit.
 (1) Documents associated with an L/C

Documents are the key issue in a letter of credit transaction. Banks deal
in documents, not in goods. They decide on the basis of documents
alone whether payment, negotiation, or acceptance is to be effected.

Bill of Lading
– Contract with carrier, shipper’s receipt and control
Commercial Invoice
– Authoritative description of product
Insurance
– Under a floating policy for all cargoes
Certificate of inspection
– Attesting the specification of the goods shipped
Consular Invoice
– To allow items to enter country

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 (3) Methods of Settlement

The documentary letters of credit can be opened in two ways:

1. Sight Letter of Credit: A Sight Letter of Credit is a credit in which the

seller obtains payment upon presentation of documents in compliance
with the terms and conditions.

2. Timer or Usance Letter of Credit: A Time or Usance Letter of Credit

is a credit in which the seller will be paid a fixed or determinable future
time. A time or usance letter of credit calls for time or usance drafts to be
drawn on an accepted by the buyer, provided that documents are
presented in good order. The buyer is obligated to pay the face amount at
maturity. However, the issuing bank¹s obligation to the seller remains in
force until and unless the draft is paid.

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 Special Note on Documentary Credits

Documentary credits hinge much on the appropriateness of documents.

Banks involved in the transaction do not need to know about the
physical state of the goods in question but concern themselves only with
documents. If proper documents are presented, banks will make payment
whether or not the actual goods shipped comply with the sales contract.

Thus, special care needs to be taken in preparation of the documents

since a slight omission or discrepancy between required and actual
documents may cause additional costs, delays and seizures or even total
abortion of the entire deal.

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 Letter of credit Summary

Provides exporter the greatest degree of safety when extending credit

Useful when importer is not well known
Useful when exchange restrictions exist or are possible

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 III. Basic Sources Of Finance

In this section we will see how exporters and importers can obtain
finance on the back of a simple trade transaction, first with the
intervention of an L/C and second without necessary intervention of
an L/C.

Importers may need financing to be able to carry out their trade

activities.

Exporters may need liquidity to cover the financing requirements for

the period before and/or after shipment of goods and until payment is
received. Financing the period prior to shipment is referred to as
pre-shipment financing and that for the period following shipment
is the post-shipment financing.

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 (A) Financing Importers
(1) Letter of Credit (financing with the use of an L/C)

While the L/C can be used as payment mechanism, it can also be used to
provide financing to the applicant (importer).

a. Deferred and Acceptance credits (i.e. term credits) are

considered to be financing instruments for the buyer, since during deferred
payment the buyer can often sell the goods and pay the amount due with the
proceeds.

– By Deferred Payment
Payment is made to the seller at a specified future date, for example 60 days
after presentation of the documents or after the date of shipment (i.e. the
date of the bill of lading).

– By Acceptance
This type of credit requires the exporter to draw a draft (bill of exchange)
either on the issuing or confirming bank. The draft is accepted by the bank
for payment at a fixed date. For example, payment date under an
acceptance credit may be at sight or after 90 days from presentation of the
documents or from the shipment of goods.
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 (A) Financing Importers
(2) Bills of Exchange (financing without the use of an L/C)

In the absence of a letter of credit, the exporter (beneficiary) can also

grant extended payment terms directly to the importer and generally
would issue bills of exchange addressed to, and accepted by, the
importer (drawee and acceptor) who commits to pay on demand, or at a
fixed or determinable future time, a certain sum to the exporter (drawer
and, generally, payee).

Bills of exchange are similar to invoices: the exporter issues a demand

for payment to an importer (or to a guarantor). This is a trade bill, drawn
by one commercial party on another. Once it has been accepted or
endorsed by the importer, it becomes a trade acceptance, which, with a
bank guarantee, becomes negotiable.

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 (B) Financing Exporters
(1) Special Type of L/C
While L/Cs can be used strictly as a tool to ensure safe payment
procedures, they are often also used to provide financing to the
beneficiary (exporter).

a. Red Clause L/C

Red-clause letters of credit enable an exporter to obtain pre-shipment
finance (a percentage of the L/C amount) from the advising or
confirming bank. The loan can be made by the advising bank against
either a simple written statement of purpose form the exporter,
guaranteeing that the advance will be used for the purpose stated
(clean red-clause) or against an undertaking to provide certain
specified documents (e.g., warehouse receipts) and to deliver shipping
documents in accordance with the terms of the L/C (documentary or
secured red-clause L/C).

Under a red clause L/C, the importer is actually granting an unsecured

loan to the exporter and is therefore incurring risks for all advanced
credits. He is made liable for repayment of the advance and interest.
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 Red Clause L/C Flowchart

Opens a red-clause L/C and forwards details

OPENING/ISSUING 3 to exporter through the advising bank ADVISING/
CONFIRMING

Payment (net of the loan and related interest and fees)

BANK
After examining documents and BANK
clearing up any discrepancies,
Negotiating bank presents
8 documents to Opening banks for
payment 4
9
Exporter requests loan
from advising bank
NEGOTIATING against either clean
red-clause L/C or for
BANK secured (or
documentary) L/C
Requests to open a red-clause L/C by Makes
completing application form specifying terms loan
and conditions of L/C (details of the parties, Present
2 sum of transaction, time limit, delivery dates
and terms of goods, and list of required
documents for
negotiation and
7 5
documents) payment
10
IMPORTER 6 Exports commodity EXPORTER
(Applicant) (Beneficiary)
1
Sales contract agreement (specifying goods, quantity,
41 payment, and documents required)
 (B) Financing Exporters
b. Green Clause L/C
Green-clause letters of credit serve the same purpose as red-clause credits
but differ in that the exporter can only obtain advance payments against
actual production not just undertaking to produce, certain documents.

The loan is made available by the advising bank against production of

certain documents (e.g., warehouse receipts) evidencing that goods are
held to the order of the bank.

From the perspective of banks, green-clause L/Cs are more secure than
red-clause L/Cs because the loan is also with full recourse to the goods.
From the perspective of exporters, green-clause L/Cs are more attractive
than red-clause L/Cs because the amount of the advance can be much
higher, say typically up to 85% of the L/C amount.

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 (B) Financing Exporters
b. Green Clause L/C
The transaction flow can be summarized as follows:

1. Buyer issues green-clause L/C in favor of Exporter (Beneficiary)

2. L/C is issued by Issuing Bank
3. L/C is advised (and may be also confirmed) by Advising Bank
4. Exporter request Loan from Advising Bank
5. Advising Bank makes Loan to Exporter (provided that the required
documents are submitted)
6. Commodity is exported
7. Documents are presented by Exporter for negotiation and payment to
Advising Bank
8. Payment (net of the Loan and related interest and fees) is made to
Exporter by Advising Bank which claims reimbursement on Issuing
Bank

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 (B) Financing Exporters
c. Revolving L/C
A Revolving Letter of Credit is one where, under the terms and
conditions thereof, the amount is renewed or reinstated without
specific amendment to the credit being needed. It can revolve in
relation to time or value.

In the case of a credit that revolves in relation to time, the amount

available per month during a fixed period of time, say, six months, the
credit is automatically available for the same amount each month
irrespective of whether any sum was drawn during the previous
month. A credit of this nature can be cumulative (i.e. any sum not
utilized during the first period carries over and may be utilized during
a subsequent period) or non-cumulative (i.e. any sum not utilized in a
period ceases to be available, that is, it is not carried over to a
subsequent period).

In the case of a credit that revolves in relation to value, the amount of

the credit is reinstated upon utilization, within a given overall period
of validity. It is a commitment on the part of the issuing bank to make
the L/C available in the original amount whenever it has been used or
44 drawn down.
 (B) Financing Exporters
c. Revolving L/C

Revolving L/Cs cover multiple/continuous shipments of merchandise,

i.e. the buyer anticipating regular flow of goods from same seller.

Revolving L/Cs enable borrowers (sellers) to rely on ongoing sources

of short-term financing. When a buyer and seller have arranged for
goods to be shipped on a continuing basis over a designated period, it
may be suitable to establish a revolving L/C to handle the shipments
as they occur, rather than having an individual L/C for each shipment.
This would avoid the fixed costs of entering each time.

The credit will contain instructions allowing the seller (beneficiary) to

draw designated amounts over specified periods and may also restrict
the amount available for each shipment or control the frequency of
shipments during a specified period.

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 (B) Financing Exporters
d. Transferable L/C

A letter of credit may also be transferred by the original (first) beneficiary

to one or more second beneficiaries under various circumstances. For an
L/C to be transferable, the first beneficiary must arrange for the (ultimate)
buyer to have an L/C opened expressly stipulating that it is transferable.

It is normally used when the first beneficiary does not supply the
merchandise himself, but is a middleman (or a trading company) and thus
wishes to transfer part, or all of his rights and obligations to the actual
exporter(s)/supplier(s) as second beneficiary(ies). The advising bank will
then make the L/C available in whole or in part, to one or more other
beneficiaries. This type of credit can only be transferred once, i.e. the
second beneficiary(ies) cannot transfer to a third beneficiary.

46
 Transferable L/C Flowchart
The transaction flow can be summarized as follows :
1. Ultimate Buyer issues L/C in favor of Trading Company (Beneficiary No 1)
2. L/C is issued by Issuing Bank
3. L/C is advised (and maybe confirmed) by Advising Bank
4. Trading Company instructs Advising Bank to transfer the L/C to Exporter (Beneficiary No 2).
The respective rights under the L/C are transferred to Beneficiary No 2 (transferee) who must
comply with the terms and conditions of the transferred L/C in order to receive payment
5. Commodity is exported
6. Documents are presented by Exporter for negotiation and payment to Advising Bank
7. Advising Bank informs Trading Company that it is holding the Exporter's documents
8. Trading Company may substitute its own invoice and documents
9. Payment is made to Exporter by Advising Bank which claims reimbursement on Issuing Bank
10. Buyers pays Issuing Bank.

PRODUCT PRODUCT
TRADER
BUYER SELLER
CONTRACT (AGENT) CONTRACT
Beneficiary 1 Beneficiary 2

ADVISING/
ISSUING
CONFIRMING
BANK
47 BANK
 (B) Financing Exporters
e. Back-to-Back L/C

Back-to-back L/Cs are an alternative to Transferable letters of credit as a

method of facilitating transactions arranged by a trading company.

Back-to-back L/Cs can be used in similar circumstances than those

supporting Transferable L/Cs, i.e. back-to-back L/Cs are often used when
the beneficiary is not the ultimate supplier of merchandise but the
middleman between the seller and a buyer.

This also would be the case if the exporter (ultimate supplier) insists on a
letter of credit or wants to be paid before the trading company receives
payment from the ultimate buyer. This is because the credit rating of
trading companies is often weak and banks would be unwilling to make an
advance or issue a letter of credit on behalf of the trading company without
the security of another letter of credit issued by another bank for the
beneficiary of the trading company. The steps taken in effecting a payment
under a back-to-back credit and a substitution of invoices under a
transferable letter of credit are similar.
48
 Back to back L/C Flowchart
Trading company

BUYER SELLER
(Ultimate
buyer)
CONTRACT SELLER = BUYER CONTRACT (Ultimate
seller)

L/C 1 Back-to-Back L/C 2

ISSUING ADVISING ISSUING ADVISING

BANK 1 BANK 1 = BANK 2 BANK 2

payment payment
49
 (B) Financing Exporters
e. Back-to-Back L/C
However, there are inherent risks associated with every back-to-back
credit arrangement since performance under the original L/C is
conditional upon the perfect and timely execution of the second L/C.
The original L/C which is used as a collateral to issue the back-to-back
L/C may not be a good security for payment because a problem or
discrepancy with the documents under the first L/C can lead the issuing
bank of the first L/C to refuse payment and therefore to the issuing bank
(of the back-to-back L/C) to be reluctant in paying the back-to-back L/C.
That is basically why, sometimes, banks would prefer to issue an L/C for
a creditworthy and reliable enough trading company rather than to rely
on a backing L/C opened in favor of this trading company. Alternatively
banks advise trading companies to conduct their trade transactions under
a transferable letter of credit . The main reason for the banks' reluctance
to arrange back-to-back L/Cs is that there isn't any provision in the
UCP for this type of L/C (unlike in the case of transferable L/Cs)
which, therefore, makes it more difficult for banks to deal with it; banks
are not clear and certain about their rights and responsibilities in the
back-to-back letter of credit system. However, only one thing is certain
and that is the two L/Cs are two separate independent instruments; they
are in no way legally connected although they both are part of the same
50 transaction.
 Comparaison between back-to-back and transferable L/C

Back-to-back credits can be used as an alternative to transferable credits when the

buyers refused a transferable credit, the importing bank does not allow transferable
credits, or when the beneficiary is buying and selling on different terms.
Back-To-Back LCs are used when the seller/trader needs funds to purchase
merchandise from his supplier but does not qualify for an unsecured bank credit.
Back-to-back L/Cs are usually requested by trading companies which do not have
sufficient credit in their accounts to open their own L/Cs in favor of the ultimate
exporter (or supplier).
Transferable L/Cs are more transparent and more secure, from a credit standpoint,
than back-to-back L/Cs. The relative advantage of transferable L/Cs is that they are
governed by the rules and regulations of UCP 500 (Article 48 and 49). The UPC
offers legitimate ways of safeguarding the interest of trading companies as
beneficiaries under transferable L/Cs.
Both forms of L/C typically provide payment or short-term financing to a trading
company for a relatively small, one-off transaction. However, traders in many cases
may not wish to use what banks advise them to use, i.e. transferable L/C. One of
the main reasons is the disclosure of the original exporter (or supplier) to the
ultimate buyer; traders in general may not wish to reveal the identity of their
suppliers. Another reason would be the limited ability of the trader to prevent
delays in shipment and presentation of documents from the exporter (supplier) side.

51
 (B) Financing Exporters
(2) Forfaiting

Forfaiting is post-shipment finance instrument. It is the term generally

used to denote the purchase at a discount (LIBOR +) by a forfaitor of
obligations (i.e. trade debt or receivables) falling due at some future date,
which arise from deliveries of goods and services, without recourse to the
exporter or any previous holder of the obligation if the negotiable
instrument evidencing the debt is not paid at maturity by the obligor or
guarantor. The forfaitor then takes over the responsibility of collecting
the invoices from the importer, and bearing the risks and losses of unpaid
credits.

The term forfait originated from the French word forfait which means to
give up. In this circumstance, it means to give up one’s rights to receive
payments under the underlying transaction. i.e. the seller giving up his
rights to receive future payments to the forfaiter in consideration for a
discounted value received immediately. In this arrangement, the face
value of the Notes is discounted at an agreed rate from the date of
purchase until a future maturity or due date.

52
 Forfaiting Flowchart
2. Sales Contract

Exporter 3. Shipment of the goods Buyer

5. Hands over avalized
documents

notes, etc.) for avalization.

4.(a) Presents documents (or
6. Delivers documents

against the documents

4.(b) Provides avalization

7. Discounts and pays

9. Repays at maturity
1. Binding
agreement
on the
forfaiting
terms

9. Repay at maturity Buyer’s bank/

International
Guaranteeing
bank/forfaiter 8. Presents documents for
payment at maturity bank
53
 Fundamentals of forfaiting
1. Forfaiting aims at creating a source of finance by the purchase from a seller/exporter
of receivables due from a buyer at a future date.
2. Forfaiting maximizes cash flow, reduce transaction risks, and may enhance
competitiveness by offering flexible payments terms to the buyer.
3. The risk of delivery of satisfactory goods or services and the fulfillment of the
underlying contract remains with the seller, while the buyer of receivables (the
forfaitor) assumes the commercial, political and economy risks of the buyer's country.
4. Forfaiting deals with one single existing and known transaction
5. In forfaiting finance can be provided to 100% of the present value (future value minus
the interest discount) is always disbursed.
6. Forfaiting is mostly used for medium- and long-term deals involving cross-border
transactions. However, nowadays forfaitors are discounting short-term deals mainly
in commodity transactions.
7. Forfaiting deals with negotiable instruments, like bills of exchange, letter of credit,
and mainly promissory notes. The Promissory note has the following characteristics:
· An unconditional (an irrevocable) promise in writing,
· Made by one person to another,
· Engaging to pay: at a fixed future dated;
a certain sum in money;
to or to the order of a specified person or to the
bearer/order .
54
 FORFAITING - CASE STUDY
The Transaction: Tesco/Fox Fresh Export Zimbabwe

Exporter : Fox Fresh Exports

Zimbabwe
Client : Tesco Supermarket, U.K.
Export Value : USD 1,000,000
Discounting Bank : Rabobank
Discount Rate : 5% flat
Days to Payment (Maturity) : 90 days
Value to Exporter : USD 950,000

55
 (1) Flowchart
2. Airfreights its
Procedures flowers or fresh
a- Fox Fresh Exports Zimbabwe vegetables
receives confirmation of value of
Tesco
Fox Fresh Exports 4. Issues avalized Supermakets
their exports and settlement dates tenored promissory
from Tesco. Zimbabwe United
Kingdom
b- Fox Fresh Exports Zimbabwe
instructs Tesco to issue promissory

bank for avalization

3.1 Presents notes to his
notes to be paid through its bank to

5. Submit the notes

pays against the notes

Rabobank.

6. Discount (5%) and

8. Repayment
1. Binding
c- Tesco issues avalized promissory agreement on
notes to the exporter (this is the the forfaiting
traditional way, nowadays it is done terms
more on a bank to bank basis where
the buyer's bank issue notes to the
exporter bank directly).
7. In 90 days, presents
notes for payment
d- Rabobank pays Fox Fresh Guaranteeing
Exports Zimbabwe less the discount
Rabobank
8. Repayment bank
(5%).

e- In 90 days Tesco's bankers make

final settlement with Rabobank.
56
 (2) Advantages in the Tesco/Fox Fresh Export
Zimbabwe Transaction
1. To the exporter (Fox Fresh Exports Zimbabwe):

a. Fox Fresh Exports Zimbabwe is paid within 7 days of exporting. Once the aval is
added, the exporter, instead of waiting for 30 to 180 days for payment and/or borrowing
money on the local market to finance his working capital needs, can approach a bank
for immediate payment in foreign currency less a discount rate. The exporter would
then use the confirmed receivables backed by the aval of the bank as security and
would thus receive payment within 7 days days after exporting. In this way, he is able
to effectively borrow off-shore without any exchange rate risks, and benefiting also
from all interest rates advantages - hence, borrowing costs are reduced dramatically.

b. This facility does not require any rigorous credit rating for F. F. Exports Zimbabwe
and all the inconveniencing procedures an exporter usually has to go through to obtain
an off-shore facility (to obtain for working capital purposes). In this case, all that is
required is a promissory note or equivalent guarantee on the part of the foreign buyer
unequivocally indicating through his bank that he will pay within the agreed period.

c. Fox Fresh Exports Zimbabwe's competitiveness is enhanced as he can afford to give

good credit terms to its foreign clients without worrying about cashflow. 
57
 (2) Advantages in the Tesco/Fox Fresh Export
Zimbabwe Transaction
1. To the exporter (Fox Fresh Exports Zimbabwe):

Now that Fox Fresh Exports Zimbabwe will be getting their payment earlier than
before, they can:

◆ Invest any idle portion of their foreign currency (after repatriating what is
immediately needed for working capital) for a period of 60 days, in the case
of Zimbabwe, before liquidation into Zimbabwe dollars as per the RBZ
requirements. This in effect means that Fox Fresh Exports Zimbabwe can
recover some of the costs or charges made in the attempt to obtain prompt
payment
◆ Fox Fresh Exports Zimbabwe can repay some of their loans (local loans),
thus avoiding further crippling interest accruals particularly if the loans are
denominated in Zimbabwe dollar terms.
◆ Fox Fresh Exports Zimbabwe can now increase their export turnover and
plant efficiency because payment for sales is now on a cash basis.

58
 (2) Advantages in the Tesco/Fox Fresh Export
Zimbabwe Transaction
2. To the buyer (Tesco):
a. The buyer (Tesco) will enjoy a bit of credit terms and as such will not be under too
much pressure to pay immediately.
b. The buyer can now get the product, sell, receive money and invest it before final
settlement in 90 - 180 days.

3. To the bank (Rabobank):

a. Rabobank (the forfaiter) does not need to worry about country risk (Zimbabwe
risk).
b. The facility is based on a transaction basis and the risk that Rabobank is taking is
with the foreign buyer Tesco, and not with Fox Fresh Exports Zimbabwe.

4. To the country (Zimbabwe):

a. The country, in this case, Zimbabwe, is now collecting its foreign currency receipts
faster than before, thereby improving on its balance of payments or foreign currency
reserves.

59