The following information is only intended to provide an overview of some of the trade finance alternatives available to prospective exporters. It is not intended to provide detailed information or recommendations as they may apply to your specific transaction. Financing an export is an important process. You are advised to seek expert advice as it pertains to the financing of your individual transaction.

How Do I Get Started?

What Trade Financing Tools Are Available?

• Letters of Credit 

• Other forms of international trade financing

How Do I Get Started?

Where can I learn more about import/export and trade finance?

Who do I need on my team?

All importers and exporters should have a good team to work with. This will include:

· an international banker,
· a freight forwarder,
· an export insurance broker,
· an accountant

What special terminology will I need to know?

Letters of Credit

Why the Letter of Credit and When Should I Use It?

Definition: Letters of Credit assure certainty of payment to exporters and address the importer's wishes that they pay only for the goods and/or services they contracted to purchase from the exporter.

A Letter of Credit is a written financial document, issued by the buyer's bank, authorizing the seller to request payment in accordance with certain terms and conditions. The document guarantees payment if the seller requests payment and if the seller can present documents that absolutely conform to the requirements imposed by the Letter of Credit.

Purpose: The purpose of the Letter of Credit is to assure sellers of payment for their goods and services, through the reassurance of an independent financial third party to the transaction. It acts like an insurance contract for both buyers and sellers.

Compare the following example: When we want to buy a T.V., we can go to our local retailer and see and touch what we want to buy. We then hand over the cash or use our credit card to settle the purchase. However, how do the wheels of commerce turn when the buyer and seller are in different countries? No longer can the buyer see and touch the merchandise he wishes to buy. Furthermore, how does the seller (exporter) ensure that he is going to be paid?

To address the concerns of the buyer (importer) and seller (exporter) engaged in international trade, a mechanism must exist to address the concerns of both of the parties involved.

The Letter of Credit ensures certainty of payment to the exporter, provided certain conditions are met, and addresses the importer's concern that he receive the merchandise he contracted to purchase.

In short, a Letter of Credit is a written undertaking given by a bank on behalf of the importer, usually their customer, to pay an exporter, the beneficiary of the Letter of Credit, an amount of money within the time frame described in the Letter of Credit, provided the exporter presents documents which comply with the terms outlined in the Letter of Credit.

Types of Letters of Credit

Letters of Credit may be Revocable or Irrevocable.

Revocable Credits are rarely used because the terms outline in the Letter of Credit can be amended or canceled at any time, without the exporter's (seller/beneficiary) consent. As this would pose considerable risk to the exporter, they are rarely accepted.

Contrary to a revocable credit, an irrevocable credit can only be amended or canceled with the consent of the issuing bank and the beneficiary (exporter). Terms are irrevocably laid down, and the exporters is assured of payment provided the documents comply with the terms of the Letter of Credit. Changes must have the consent given by the beneficiary/issuing bank in order to amend the terms.

An Irrevocable Letter of Credit can take the following forms:

Under a Confirmed Letter of Credit, a second guarantee is added to the Letter of Credit by another bank. The advising bank, the branch or the correspondent through which the issuing bank routes the Letter of Credit, adds its undertaking and commitment to pay to the Letter of Credit. This confirmation means that the seller/beneficiary may look additionally to the credit worthiness of the confirming bank for payment assurance.

Caution: The beneficiary of the Letter of Credit who has requested a confirmation should note who is confirming the Letter of Credit and be satisfied that it is in reality an additional and acceptable financial institution.

Note: Definition of a Confirming Bank - A Confirming Bank is a separate financial institution requested by the issuing bank to add their guarantee of payment or acceptance to the credit instrument. It is necessary for this bank to establish a credit line or facility for the issuing bank in order to agree with this request. The bank who is requested to add their confirmation is usually, but not necessary, the advising or drawee bank. The beneficiary on his own cannot request a bank to confirm a Letter of Credit. The request must come through the issuing bank. Therefore, a seller should request that the buyer authorize the issuing bank to request a Confirmation.

Irrevocable Credit may also be Unconfirmed. An Unconfirmed Letter of Credit means that it bears the guarantee of the issuing bank alone. The advising bank merely informs the exporter of the terms and conditions of the Letter of Credit, without adding its obligation to pay.

Cautions/Limitations: In an Unconfirmed Letter of Credit, the exporter is assuming the payment risk of the issuing bank, which is typically located in a foreign country.

An Irrevocable Letter of Credit may also be Transferable. A Transferable Letter of Credit allows the first beneficiary to request that the paying bank (or negotiating bank) make the credit available in whole, or in part, to one or more other parties (second beneficiary). Transferable credits are used when the first beneficiary is a middleman and not the actual supplier of the goods being purchased. Though he has secured a contract with the buyer, he depends upon another party to produce the goods. A credit may only be transferred when it is expressly designated as transferable by the issuing bank. Additionally, credits can only be transferred once.

Other forms of irrevocable letters of credits, though not widely used, are back-to-back, red-clause, and revolving.

Back-to-Back Letters of Credit are similar to transferable credits. The beneficiary is not the actual supplier of the goods. In a back-to-back letter of credit, a broker or middleman seeks to open a second credit in favor of the producer of the goods. The second credit is separate and distinct from the first credit. This mechanism must be employed because the first credit is not transferable. The broker has requested the bank to issue a second credit in favor of the supplier, using the first credit as collateral. Hence, the name "back-to-back". Because back-to-back letters of credit involve two separate transactions, it is likely that several participating banks will be involved.

Cautions/Limitations: In such a scenario, the likelihood of a dispute is considerable.

It is best for importers and exporters to meet with their banking officer to determine which type of credit best suits their needs.

Other forms of international trade financing


Letters of credit are not the only means available for settling import and export transactions. Other alternatives are:

• cash in advance

• open account

• sending bills or related trade documents for collection

The exporter would prefer to be paid in advance, but only in rare instances will the buyer grant credit to the seller before he receives the goods. Likewise, the exporter would rarely ship his goods without having received payment from the buyer.

Documentary Collections: Definition: The collections department of a bank assists its clients with payment settlement for foreign sales and purchases. The collection method is employed when either cash in advance is not acceptable to the buyer, or an open account is not acceptable to the seller. In such cases, the exporter ships the goods and draws a draft or bill of exchanger on the importer. This draft, the demand for payment by the seller on the buyer, together with shipping documents, are presented to the exporter's bank for collection. When the draft is paid, the title documents are released to the exporter so he can obtain possession of the goods.

In the typical collection described above, the exporter draws a draft, or bill of exchange, on the buyer and presents it to his bank, so the bank in turn can forward it to the buyer through a collecting bank located in the buyer's country. If the exporter and importer have agreed that payment should be made immediately upon receipt of the draft and/or shipping documents by the buyer's bank, the draft is said to be drawn at sight. In such cases where the exporter has provided credit terms to the buyer, thereby allowing the merchandise to be released before payment is received, the exporter wants a written promise from the buyer that payment will be made at a specific future date. This is accomplished by drawing the draft at some specific future date after receipt of the collection by the buyer's bank. For instance, 120 days after sight.

As previously described, a collection may be payable either at sight or some specific future date. When payable at sight, the collection procedure is known as documents against payment. When a bank receives time drafts, the bank is requested to only deliver documents against acceptance by the buyer. The buyer's acceptance of the draft is his agreement to pay at the agreed upon future date.

Cautions/Limitations: Nothing prevents the buyer from refusing a draft (bill of exchange) for payment. In such cases, the exporter, who has already shipped the goods, faces the problem of getting his merchandise back, which may involve warehousing or insuring the goods or even disposing of the merchandise at auction.

Summary: In reviewing the means of payment for import/export transactions, the method of settlement which gives the exporter the least security is open account. Although this may be preferred by the buyer (importer), the exporter faces a variety of risks in receiving payment, including political or economic country risk or insufficient buyer funds.

Cash in advance is the preferred settlement method for the exporter, but the buyer will rarely put cash down up front before he reasonably assures himself that the goods will be shipped and that the type of goods ordered will be delivered.

Documentary Collections fall between the two, but nothing prevents the buyer from refusing a draft (bill of exchange) for payment. In such cases, the exporter, who has already shipped the goods, faces the problem of getting his merchandise back, which may involve warehousing or insuring the goods or even disposing of the merchandise at auction.

The Letter of Credit, therefore, is the safest, most certain and most convenient settlement method for import/export transactions. Once an Irrevocable Letter of Credit is Confirmed by a bank in the exporter's locale, the political and economic country risk and the buyer's ability to pay are removed. The confirming bank is obliged to pay, provided the documents comply to the terms of the Letter of Credit, even if the buyer goes bankrupt.

Discounting of Trade Acceptances (with recourse) In cases where a draft (bill of exchange) drawn by an exporter on a foreign importer is payable at a specific future date, the draft may be discounted by a bank so that the exporter may receive funds before the maturity of the acceptance date. The exporter receives less than the full face amount of the draft (trade acceptance) and the bank will present the trade acceptance to the importer's bank for full payment at maturity. Often, banks will discount the trade acceptance with recourse to the exporter. In such a case, the bank retains the right to demand payment from the exporter should the importer fail to honor the trade acceptance.

Forfaiting: When the bank discounts the trade acceptance without recourse, thereby relying on the credit capacity of the importer, the trade acceptance is often guaranteed by the government export agency or commercial bank in the importer's country. In such a case, the exporter can sell the debt, represented by the trade acceptance, a forfait. This means of financing is performed by banks and specialized finance companies that buy the trade obligations of importers without recourse to the exporter. The guarantee of the financial entity in the importer's country is evidenced by endorsing the note by aval.

Avals

Definition: An Aval is a form of guarantee of the repayment of an obligation. Typically, the Aval is given by a bank, which adds its promise to pay to the promissory note, draft, or other debt obligation, as if the bank were the co-maker. This promise takes the form of the addition, after the signature of the maker of the obligation, of an authorized bank signature, under the words "POR AVAL". No separate guarantee agreement or other documentation is normally provided with the Aval.

When to Use: As with any form of third-party guarantee, an aval can make an otherwise non-bankable transaction creditworthy. An exporter, if planning to finance the sale, would be wise to contact his/her bank prior to accepting the avaled note, as requirements of the financing of promissory notes with Avals vary greatly within the banking industry. If not planning to finance the sale, an exporter can still derive comfort from a proper Aval. The exporter should , however, engage the services of a professional (banker, attorney, etc.) , to determine the validity of the Aval.

Cautions/Limitations: Avals are easily forged, resulting in false comfort to an exporter. Additionally, some countries allow the Aval to be issued by a bank as an off-balance-sheet "obligation", not registered with the Central Bank of the country. In this case, the availability of U.S. dollars, should the Aval be called upon, can be compromised. Again, the exporter should seek help before accepted an Aval.

Export Finance Insurance/Guarantees
Definition: Export finance insurance, like other types of credit insurance, is sold by private and government entities. This insurance will pay, subject to the terms of the policy, a percentage of the buyer's unpaid obligation under a promissory note or other obligation.

When to Use: Export credit insurance is typically purchased for two reasons: risk mitigation and as an aid to financing. Normally, the insurance is purchased through political risk insurance brokers or directly from the providers, like ExIm Bank.

Advantages: An exporter not wishing to finance (discount, advance against) a foreign obligation can still derive comfort from the fact that the obligation is insured by a third party. As a financing tool, the insurance mitigates, to an extent, the risk associated with the foreign buyer (and his country) to a financing institution. This normally makes it possible for the exporter to borrow, and at more reasonable rates than without the insurance.

Cautions/Limitations: As with an insurance product, care must be given to the following criteria:

1) Strength of insurer/guarantor - will it be there to pay a claim? In the case of private insurance companies, independent ratings are available from the company itself or from the rating agency. Governmental entities carry the creditworthiness of the government behind them.

2) Coverage/Limitations to Coverage - will the policy be paid in the event of a loss? As with any insurance company, credit insurers are cautious in paying claims, and typically adhere very closely to the terms of the policy. Professional help, from a banker, attorney, etc., should be secured prior to purchasing coverage. Typical reasons for non-payment of policies are: faulty paperwork, contract disputes, acts of war, terrorism, etc.

3) Price - does the policy price, when added to the other costs, allow the transaction to work? An exporter should price policies prior to quoting sales prices, as the credit insurance cost is normally passed on to the buyer.

Where to go for more information? While not comprehensive, the following is a partial list of credit insurers/guarantors.

1) Export-Import Bank of the United States (ExIm Bank) - an arm of the U.S. government. Can be reached at (305) 526 7425 in Miami.
2) Foreign Credit Insurance Association (FCIA) - a private company.
3) American International Group (AIG). A private company.
Many other companies can be reached through insurance brokers