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Professional Banker

STUDY TEXT
International Trade Finance

In this first edition

 A user-friendly format for easy navigation
 A chapter review at the end of each chapter
 A full index
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ii
CONTENTS

Page

I n t r o d u c t i o n v

C h a p t e r 1 1
Introduction to International Trade

C h a p t e r 2 33
Methods of Payment in International Trade

C h a p t e r 3 47
Documentary Collections

C h a p t e r 4 69
Documentary Credits

C h a p t e r 5 111
Guarantees and Standby Letters of Credit

C h a p t e r 6 135
Foreign Exchange and Exchange Controls

C h a p t e r 7 163
Trade Finance

C h a p t e r 8 193
Trade Support from Government Agencies

C h a p t e r 9 207
International Trade Finance and Islamic Banking

G l o s s a r y o f K e y T e r m s 219

I n d e x 225

R e v i e w f o r m

iii
iv
INTRODUCTION

This module provides an introduction to the role of banks in trade finance and the assistance provided by
banks to exporting and importing businesses. It deals with the methods of payment in international
trade, and the ways in which banks provide finance, guarantees and assistance with foreign exchange.

Learning Outcomes
Covered
Learning Outcome - the learner will: Learning Objective - the learner can: in
chapter
1. Appraise the benefits and risks of 1.1 Analyse the differences between domestic 1
international trade and international trade and international trade
trade finance
1.2 Examine the benefits of international trade 1
and trade agreements

1.3 Distinguish and classify the various risks in 1

international trade

1.4 Demonstrate the roles of participants in 1

international trade

2. Analyse the documents used in 2.1 Describe the contents and purpose of the 1
international trade and the roles of various documents used in international
international trade participants and trade
organisations
2.2 Examine the role of the International 1
Chamber of Commerce (ICC)

2.3 Analyse the purpose and nature of Incoterms 1

2.4 Differentiate between the various Incoterms 1

and the responsibilities and costs of seller
and buyer with each term

3. Examine the payment methods used in 3.1 Describe the concept of 'open account' and 2
international trade and the systems, the payment obligations of buyers and sellers
mechanics and risks of those methods in international trade

3.2 Compare and contrast the different methods 2

of payment in international trade

3.3 Analyse the role of banks with each method 2

of payment and in the transfer of payments

3.4 Describe the role of SWIFT in the 2

international messaging and payments
system

3.5 Appraise the use of foreign currency 2

accounts for international payments

3.6 Appraise the use of cheques and bank drafts 2

as methods of payment in international trade

v
 Covered
Learning Outcome - the learner will: Learning Objective - the learner can: in
chapter
4. Analyse the uses and limitations of 4.1 Demonstrate the purpose and nature of 2
countertrade countertrade

4.2 Compare the advantages and disadvantages 2

of countertrade

5. Analyse the purpose, advantages and 5.1 Analyse the nature of collections and the 3
risks of documentary collections and difference between clean and documentary
bills of exchange collections

5.2 Identify the parties to a collection 3

5.3 Analyse the stages in the documentary 3

collection process and the role of banks in
the process

5.4 Distinguish the nature and features of bills of 3

exchange

5.5 Distinguish between documents against 3

payment and documents against acceptance

5.6 Describe the information included on a 3

collection instruction

6. Appraise the role of the International 6.1 Demonstrate the application of the rules in 3
Chamber of Commerce and the the Uniform Rules for Collections (ICC
application of the Uniform Rules for Publication Number 522)
Collections
6.2 Describe the advantages and practical 3
problems with documentary collections

6.3 Examine the main rules in the Uniform Rules 3

for Collections (URC 522)

7. Analyse the purpose, contents, 7.1 Examine the nature of a documentary credit 4
advantages and risks of documentary (letter of credit)
credits or letters of credit
7.2 Identify the participants in a documentary 4
credit

7.3 Describe the documentary credit process 4

7.4 Distinguish between sight payment, deferred 4

payment and acceptance letters of credit and
letters of credit available by negotiation
7.5 Distinguish between negotiation with and 4
without recourse and how banks honour
guarantees in a letter of credit
7.6 Examine the contents of a letter of credit 4
7.7 Describe the features of a letter of credit 4
7.8 Analyse the nature and purpose of 4
confirmation of a letter of credit and silent
confirmation
7.9 Appraise the different levels of security 4
offered by various letter of credit
arrangements
7.10 Describe the different roles banks play in a 4
documentary credit arrangement
7.11 Describe the letter of credit application 4
process
7.12 Demonstrate the role of the seller and third 4
parties in the presentation of documents
7.13 Examine the role of the issuing bank in the 4
presentation of documents

vi
 Covered
Learning Outcome - the learner will: Learning Objective - the learner can: in
chapter
7.14 Examine the settlement process for a letter 4
of credit

7.15 Describe the purpose and use of a 4

transferable letter of credit, a back-to-back
credit, a red clause letter of credit, a green
clause letter of credit and a revolving letter
of credit

8. Examine the role of the International 8.1 Examine the role of the International 4
Chamber of Commerce including the Chamber of Commerce
application and benefits of the Uniform
Customs and Practices for Documentary 8.2 Appraise the rules in ICC Uniform Customs 4
Credits and Practice UCP 600

9. Analyse the legal and regulatory issues 9.1 Explain the purpose of anti-money 4
involved in documentary credits, laundering procedures for international trade
particularly in the context of money transactions
laundering
9.2 Explain the purpose of the Wolfsberg Trade 4
Finance Principles

9.3 Examine trade-based money-laundering 4

methods and AML risk-based control
measures

9.4 Describe the nature of anti-money 4

laundering procedures for documentary
credit and documentary collection
transactions

10. Analyse the purpose, form, uses and 10.1 Describe the nature of bank guarantees and 5
limitations of guarantees and standby the main parties to a guarantee
letters of credit
10.2 Differentiate between direct and indirect 5
guarantees

10.3 Analyse the nature of a conditional 5

guarantee and a demand guarantee

10.4 Explain the risks for the principal with a 5

demand guarantee

10.5 Analyse the purpose of guarantees or bonds 5

issued by a commercial bank

10.6 Describe the different types of guarantees or 5

bonds that may be issued by a bank

10.7 Examine the rules that apply to the 5

examination of a demand for payment under
the terms of a bank guarantee

10.8 Examine the nature and use of a standby 5

letter of credit

10.9 Explain the difference between a guarantee 5

and standby letter of credit

10.10 Analyse the nature and purpose of a shipping

guarantee issued by a bank

11. Examine the role of the International 11.1 Examine the uses and limitations of URCG 5
Chamber of Commerce and the 325
application and benefits of their
Uniform Rules in relation to guarantees 11.2 Apply the rules in URDG 758 for demand 5
guarantees

11.3 Apply the rules in ISP98 for international 5

standby letters of credit

vii
 Covered
Learning Outcome - the learner will: Learning Objective - the learner can: in
chapter
12. Analyse the role of the systems and 12.1 Demonstrate how foreign currency (FX) 6
arrangements for making foreign payments are made
currency settlements
12.2 Contrast the nature of nostro and vostro 6
accounts

12.3 Describe the main participants in the foreign 6

currency markets

12.4 Examine the nature of spot FX transactions, 6

spot rates, margins and the spread between
bid and ask rates

12.5 Apply a spot rate to calculate an amount 6

payable or receivable in a spot transaction

12.6 Calculate a cross rate 6

12.7 Analyse the reasons for exchange rate 6

volatility

13. Analyse the functioning of foreign 13.1 Describe the nature of currency risk 6
exchange markets, exchange rate risk 6
and methods available for hedging or 13.2 Appraise the nature of forward FX contracts
limiting that risk and the use of these contracts to hedge
exposures to currency risk

13.3 Apply a forward rate to calculate an amount 6

payable or receivable at settlement of a
forward FX contract

13.4 Demonstrate how forward FX rates are 6

derived

13.5 Compare a fixed forward FX contract and an 6

option forward FX contract

13.6 Describe how forward FX contracts may be 6

closed out or extended

13.7 Calculate the settlement amount on close-out 6

of a forward contract

13.8 Appraise methods of hedging exposures to 6

currency risk, other than forward FX
contracts

13.9 Describe the features of currency options 6

and how these options may be used to
hedge exposures to currency risk

13.10 Compare over the counter and exchange 6

traded currency options

13.11 Analyse the nature and features of a range 6

forward option and a participating forward
contract

13.12 Explain how to decide whether to hedge FX 6

exposure and what hedging method to use

13.13 Compare economic FX exposure and 6

translational FX exposure

14. Examine the use of exchange controls 14.1 Analyse the purpose and effectiveness of 6
exchange controls

14.2 Examine the impact of exchange controls on 6

international trade

15. Examine the uses and limitations of the 15.1 Analyse the stages of the working capital 7
various forms of trade finance cycle

viii
 Covered
Learning Outcome - the learner will: Learning Objective - the learner can: in
chapter
15.2 Explain the negotiation and discounting of 7
bills

15.3 Distinguish between structured trade finance 7

and conventional banking finance

15.4 Appraise the nature of structured trade 7

finance and structured trade commodities
finance

16. Analyse the characteristics, discounting, 16.1 Describe methods of import financing, 7
risks and regulations applicable to bills including trust receipts and banker’s
of exchange and banker’s acceptances acceptances

16.2 Analyse the advantages and risks of trust 7

receipt financing for a bank

16.3 Describe methods of export financing, 7

including banker’s acceptances, export
factoring, invoice discounting and forfaiting

16.4 Calculate amount receivable from a 7

discounted BA

16.5 Calculate the amount payable for early 7

redemption of a BA

16.6 Examine methods of structured trade 7

commodities financing, including escrow
accounts, off-balance sheet financing, asset-
backed financing and tolling finance

16.7 Analyse the nature of structured trade 7

commodity financing models, including
export receivables-backed finance, pre-
payment financing and warehouse receipt
financing

17. Analyse the services offered by 17.1 Describe the banking and insurance services 8
government agencies in facilitating and provided by government agencies to support
controlling the risk inherent in exports and foreign trade
international trade
17.2 Explain the difference between the different 8
types of export credit risk

17.3 Compare the costs and benefits of export 8

credit insurance

17.4 Analyse the purpose and benefits of the 8

Bilateral Payments Arrangement (BPA)
Agreement

18. Examine the principles and products of 18.1 Analyse the nature of Shariah-compliant 9
Islamic trade finance and banking arrangements for export and import
financing

18.2 Compare Islamic and conventional trade 9

finance and banking products

19. Differentiate between conventional and 19.1 Analyse the nature of Shariah-compliant 9
Islamic financial systems and forward foreign exchange transactions and
arrangements bank guarantees

19.2 Compare Islamic and conventional financial 9

systems and arrangements

ix
 Assessment Structure
Your exam will comprise of 80 multiple-choice questions (MCQs) to be answered in two and a half hours,
as follows:

Question Format Total number Distribution of Questions Marks per Marks

of questions question
Independent MCQs 60 1 mark 60
Case-based MCQs 20 4 Case studies with 5 MCQs 2 marks 40
per case
80 100

x
chapter 1

INTRODUCTION TO INTERNATIONAL
TRADE

Contents
1 Differences between domestic trade and international trade.............................................2
2 Risks in international trade...........................................................................................8
3 International trade and its participants ........................................................................ 10
4 Documentation in international trade: transport documents ........................................... 12
5 Documentation in international trade: other documents ................................................. 19
6 Costs of transportation: who pays for what?................................................................. 23
7 International Chamber of Commerce (ICC) and Incoterms 2010...................................... 24
8 Incoterm definitions .................................................................................................. 25
Chapter roundup............................................................................................................ 32

1
 INTERNATIONAL TRADE FINANCE

Learning outcomes
On completion of this chapter you should be able to:
 Appraise of the benefits and risks of international trade and international trade finance.
 Analyse the documents used in international trade and the roles of international trade participants
and organisations.

Learning objectives
While working through this chapter you will learn how to:
 Analyse the differences between domestic trade and international trade.
 Examine the benefits of international trade and trade agreements.
 Distinguish and classify the various risks in international trade.
 Demonstrate the roles of participants in international trade.
 Describe the contents and purpose of the various documents used in international trade.
 Examine the role of the International Chamber of Commerce (ICC).
 Analyse the purpose and nature of Incoterms.
 Differentiate between the various Incoterms and the responsibilities and costs of seller and buyer
with each term.

Introduction
Many customers of banks engage in international trade, buying goods from foreign suppliers or selling
goods to foreign customers. Banks are involved as they support their customers with receipts and
payments of money, and by providing finance.
To provide services to their customers, banks should understand the rules of international trade, and
how it differs from domestic trade. Banks are involved with some methods of payment, and should
understand the documentation for transactions between a seller (exporter) and a buyer (importer).

1 Differences between domestic trade and international

trade
International trade differs from domestic trade in a number of ways, meaning that exporting and
importing is more risky than simply by selling and buying in the domestic market.

1.1 Limited knowledge of foreign markets and customers: competition

For an exporter, selling to other countries can be difficult because foreign markets operate in different
ways. An exporter needs to find buyers in other countries, where selling and marketing can be difficult,
and may need to use an agent to help with this. Alternatively, a company may send its own salesmen to
other countries to find new customers and make sales.

Exporters face competition in foreign markets, both from domestic products, and exporters’ from other
countries. In a competitive market, only the most efficient or innovative companies succeed.

Requirements for success in exporting include:

 Production capacity to meet export demand.

 Access to an adequate supply of raw materials.

 A skilled work force with some employees having multi-lingual skills.

2
 1: INTRODUCTION TO INTERNATIONAL TRADE

 Sufficient cash flow or access to finance to support the export business.

 An understanding of sources of trade finance, including structured trade finance methods.

 The ability to sell directly to foreign buyers, through personal contacts or agents in foreign
countries.

 Knowledge of the targeted foreign markets.

1.2 Law: resolution of disputes

When a seller and a buyer have a good long-term business relationship, there is likely to be a high level
of trust between them. They may have occasional problems with a business transaction, but any such
problems are likely to be resolved amicably due to the business relationship therefore, the commercial
risks in their dealings with each other will be low.

However, with many international business transactions the seller and buyer may not be familiar with the
other, and when problems occur, they may have difficulty in reaching a resolution. If a buyer complains
about faulty, or poor-quality goods, that have been supplied by the exporter, there must be
arrangements in place for dealing with the complaint.

With domestic trade agreements, the complaint can be resolved easily, either by supplying new goods, or
refunding some of the money paid by the buyer. With foreign trade, resolving problems and obtaining
redress can take longer and be more difficult to arrange.

When a buyer and seller in the same country enter into a trading agreement, the agreement is covered
by the laws of their country. However, when an exporter sells to a foreign buyer, the agreement cannot
be covered by the laws of both countries. The exporter or the buyer must accept that the trade
agreement will be subject to the laws of the other country – or even a third country.

If there is a legal dispute between the buyer and the seller, one of them will have to hire lawyers in the
country whose law applies to the agreement and, if necessary, take the dispute to the courts of that
country.

It may be possible to resolve disputes through arbitration.

Key term
Arbitration, a form of alternative dispute resolution (ADR), is a technique for the resolution of disputes
outside the courts, where the parties to a dispute refer it to one or more persons, by whose decision
they agree to be bound.

It is possible for a seller and buyer to agree that their transaction should be subject to internationally-
accepted rules. Nevertheless, the problems with resolving a commercial dispute are often greater with
international trade transactions than with domestic trade.

1.3 Time and distance

With international trading transactions, shipment of the goods can pose a greater problem than with
domestic trade.

 Goods are transported internationally by one or more different methods: by air, sea, rail, or road.

 Costs of ‘carriage’ (transportation) may be significantly higher than for domestic trade.

 For goods shipped by sea (and long distances by road) there is a risk of loss or damage to the
goods, and the goods should therefore be insured against loss or damage during shipment.

 This raises problems regarding who should pay for the insurance, and what risks the insurance
policy should cover.

 International piracy is common in some parts of the world, with the risk to sea shipments being
particularly high.

3
 INTERNATIONAL TRADE FINANCE

With many international trading transactions, the seller and buyer are located in different countries,
meaning that the goods have to be transported to the buyer’s country. Having dispatched the goods to
another country, the seller would not wish them returned, if the buyer refuses to accept them.

A further problem can arise with commercial disputes in international trade, which is what to do with the
goods, if they have already arrived in the buyer’s country:

 The buyer may refuse to accept the goods, which means that the seller must decide what to do
with them. The immediate problem will be to ensure that the goods are stored securely until a
decision is made about them.

 The seller may try to find another buyer for the goods in the buyer’s country, but this may be
difficult, or even impossible, depending on the nature of the goods.

 The seller may decide to recover the goods and have them shipped back to his own country, but
he may need an agent in the buyer’s country to arrange the shipment, and the seller must bear
the cost of transportation and insurance for the goods.

In most international trade transactions, the seller will allow the buyer to take possession of the goods
before paying for them, and will trust the buyer to make the payment after an agreed period of credit.
Conversely, although the buyer may be prepared to accept the transported goods, the seller may want
payment before allowing the buyer to take possession of the goods.

1.4 Finance for operations

Where an exporter has spent a considerable amount of money producing goods for shipment, and the
actual shipment of the goods to a foreign buyer is lengthy, as the exporter usually allows the buyer some
time (credit) before making the payment, it means that export trade often requires substantial
financing, to cover the period between the cost of production and shipment, to receiving payment from
the buyer.

Small businesses often have difficulty obtaining finance to support their export operations because:

 Banks may be unwilling to provide conventional loans or finance, due to their size.

 Export transactions may be quite large in relation to the size of the business, so the company may
need finance to provide working capital (to pay for producing the goods, and to cover the credit
period between shipment and eventual payment by the foreign buyer).

 Export transactions often take longer to settle, therefore a company may need working capital
finance for a longer period than with a domestic transaction.

1.5 Credit risk

Credit risk – the risk for a seller that the buyer will not pay for the goods that have been delivered – is
a serious risk in domestic trade but it can be an even greater risk in international trade. If a buyer
defaults when the goods have been shipped to the buyer’s country, the exporter has a problem with:

 Pursuing the buyer for payment, and if this is not possible,

 Disposing of the goods.

1.6 Currency risk

When goods are traded in a domestic market, they are usually priced in the domestic currency. In
international trade transactions, the buyer and seller must pay or accept a foreign currency. The
exporter may sell goods priced in a foreign currency, or the importer may buy the goods in a foreign
currency. Sometimes an international trading agreement is transacted in a third currency, such as the US
dollar, which is not the domestic currency of either the seller or the buyer.

4
 1: INTRODUCTION TO INTERNATIONAL TRADE

When a business buys goods in a foreign currency, it has to obtain the currency to make the payment.
When an exporter sells goods in a foreign currency, it will need to exchange its receipts for domestic
currency when the buyer pays.

During the period between making the trade agreement and receiving payment for the goods after
delivery, the value of a foreign currency may rise or fall. This creates currency risk. Adverse
movements in foreign exchange rates can affect the profitability of export or import transactions.

1.7 Government policy on foreign trade

The government may impose regulations on foreign trade, usually to protect domestic industries against
foreign competition but sometimes to restrict the export of goods that are needed in the domestic
economy. International trade is therefore subject to official requirements that do not apply to domestic
trade:

 Imported goods may be subject to the payment of import duties, or there may be import
restrictions on the goods.

 Imports from particular countries may be prohibited by a government.

 There may be restrictions on the export of goods from the seller’s country or to the buyer’s
country.

Goods may therefore be allowed out of the seller’s country and into the buyer’s country only if
appropriate:

 Import duties have been paid.

 Export documentation has been provided, as evidence that the goods may be exported.

 Import documentation has been provided, as evidence that the goods may be imported and have
obtained import clearance.

Exporters and importers may therefore have to deal with:

 Export licences, for permission to export goods.

 Import licences, for permission to import goods.
 Import duties/import tariffs on goods entering a country.
 A ban or quota limit on the permitted total amount of exports or imports of particular goods.
 Providing evidence to the authorities of the country of origin of the goods.

An exporter should be aware of goods that cannot be exported due to a government ban on their export,
or goods that can be exported only with government approval and an export licence, such as livestock,
grains and minerals. Other types of product can be subject to regulations on carriage, such as perishable
food products that require refrigerated transport. Some types of goods may be subject to import
restrictions, where they may require an import licence to allow the goods into a country.

In some countries, exchange controls may restrict the movement of currency, so that sellers and
buyers have to find an alternative arrangement for payment, permitted by the exchange controls.

Information about export regulations can be obtained from the Ministry of International Trade and
Industry (MITI).

1.8 Political events

In some instances, international trade may be disrupted by war or civil unrest. For example, unrest may
close flights to the country’s airports, bringing international air shipments to a halt.

5
 INTERNATIONAL TRADE FINANCE

1.9 Benefits of international trade

Although international trade can involve higher risk for businesses, than domestic trade, exporters are
able to grow their business and profitability by selling in foreign markets. The potential rewards often
justify the risks.

International trade is also beneficial for national economies. Countries are able to export goods that they
do not need or want in their domestic markets, and import goods that they cannot grow, make or
provide themselves. International trade increases the volume of global trade, and, generally, all countries
that engage in international trade find that their national wealth increases, leading to growth in their
national economy.

For this reason, most governments support the principle of free trade between countries. The absence of
restrictions on international trade, such as import duties and import quotas, should encourage more
trade and greater increase in wealth.

In practice, however, most countries agree with the principle of free trade between countries – but
cannot fully agree on how international trade should be conducted.

 Developing countries – and sometimes developed countries – seek to protect their domestic
industries against foreign competition, by imposing high duties on imports or setting a quota limit
on the quantity of imports of certain goods.

 Countries are reluctant to remove import duties entirely, because they provide revenue to the
government as well as provide some protection to domestic industries.

 Countries may be involved in disputes about ‘unfair trading practices’, with the result that they
take retaliatory measures against each other, and impose an import ban or raise import duties on
goods produced by the other country.

Malaysia has entered into bilateral trade agreements with other countries. These agreements aim to
improve investment, trade and economic co-operation. Malaysia currently has bilateral free trade
agreements with Japan, Pakistan, New Zealand, India, Chile and Australia. Further details of these
agreements can be found here:

http://www.miti.gov.my/cms/content.jsp?id=com.tms.cms.section.Section_8ab55693-7f000010-
72f772f7-46d4f042

1.10 World Trade Organisation (WTO)

Governments have been seeking ways of reducing barriers to international trade since 1947, when the
General Agreement on Trade and Tariffs (GATT) was established. Its aim was to obtain
international agreement between member states on measures to reduce trading barriers. (International
agreements on trade between the governments of several countries are called ‘multilateral trading
agreements’.)

The stated aim of GbATT was a ‘substantial reduction of tariffs and other trade barriers and the
elimination of preferences, on a reciprocal and mutually advantageous basis’.

GATT existed from 1947 to 1994, and was replaced by the World Trade Organisation (WTO).

The WTO is an international body that supervises international trade and encourages governments to
reach multilateral agreements for the removal of trade barriers. It has achieved some success in its
negotiations with governments.

6
 1: INTRODUCTION TO INTERNATIONAL TRADE

There are WTO agreements in goods, services and intellectual property. These have been negotiated
and signed by most countries in the world, including Malaysia. The WTO agreements set ground rules for
international trade, and member countries agree to keep their trade policies within limits permitted by
the WTO agreements. Although they are signed by governments, the aim of the WTO agreements is to
help exporters and importers to conduct international trade more easily, whilst allowing governments to
meet their social and environmental objectives.

The WTO agreements are based on certain fundamental principles.

Key term
Most-favoured-nation (MFN) principle is the principle of treating countries equally.

Member countries should not discriminate between their trading partner countries, for example by
charging lower import tariffs on goods from a favoured country. If a country imposes import tariffs on a
product, it should impose the same rate of tariff on all imports of the product, regardless of its country of
origin. (However, exceptions are allowed, such as when one country accuses another of unfair trading
practices to exports of its goods.)

Key term
National treatment is the principle that countries should treat imported goods and domestically-
produced goods equally.

This principle applies only when the imported goods have entered the country. The principle of national
treatment does not prevent countries from imposing tariffs on imported goods when they come into the
country.

The WTO agreements are not described in detail here, but the main ‘rules’ are:

 Countries may impose tariffs on imported goods to protect domestic industries, and countries may
decide on the level of tariffs to charge. However, member states should publish their import tariffs
so that exporters from other countries know what their cost will be. Countries have also agreed to
set limits on the tariffs they will charge on goods. As stated earlier, the same tariff should be
charged on a product, regardless of its country of origin, under the MFN principle.

 The WTO agreements generally prohibit quantitative restrictions on imports or exports (quotas).

 ‘Dumping’ of unwanted products is also prohibited. Dumping is the sale of unwanted goods
(excess production) on a foreign market at prices substantially below those of domestic
producers.

The WTO recognises that member countries are at different stages of economic development. WTO
agreements therefore give differential treatment to developing countries, such as allowing them time to
implement the WTO agreements fully.

The WTO also acts as a forum where governments can negotiate trading agreements. It is also a body
that can be used to help with the resolution of trading disputes between countries. WTO has written:
‘Essentially, the WTO is a place where member governments go, to try to sort out the trade problems
they face with each other.’

Since it negotiated the ‘Uruguay Round’ of agreements (1986 – 1994), the WTO has made only limited
progress in promoting international fair trade through multilateral trading agreements between member
countries.

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2 Risks in international trade

Most of the risks in international trade relate to the problems in international trade, described earlier. The
main risks may be classified as follows:

 Performance risk
 Credit risk/payment risk
 Financing risk
 Currency risk
 Regulatory and political risk

For banks, there is also a risk that they may become involved in money laundering.

2.1 Performance risk

Performance risk is the risk for an importer that the supplier will fail to carry out its obligations under
the terms of the trading transaction:

 The seller may fail to deliver the goods.

 The seller may deliver the goods, but these may not be produced to the required specification.
 The goods may be delivered, but much later than promised.

There is risk with the transportation of goods. As explained earlier, the shipment of goods in international
trade can be expensive and the shipment may take a long time when the goods are shipped by sea. The
risk of loss or damage to the goods in transit can be high. This risk can be covered by insurance, but
the buyer and seller must agree which of them should pay for the cost of the insurance.

2.2 Credit risk/payment risk

If the seller is required to deliver goods to the buyer’s country before obtaining any payment, there is a
risk that the buyer will refuse to accept the goods when they arrive in the buyer’s country. If this
happens, the seller faces the problem of having goods in another country, and they must either be
returned or disposed of (perhaps through sale to another buyer).

There is also the risk that if a buyer is allowed to take possession of the goods before paying for them, it
will be unable or unwilling to pay on settlement date.

As indicated earlier, credit risk exists in domestic trade as well as international trade, but the risk in
international trade can be much greater.

2.3 Financing risk

Key term
Financing risk is the risk that an exporter or importer may be unable to finance their transactions.

As indicated earlier, exporters may have a long cash cycle: the period between the time they pay for the
production of goods and the time that the buyer eventually pays after shipment. An exporter needs to
finance this working capital/cash cycle. It may have insufficient capital of its own and there is a risk that
it may be unable to find a bank that is willing to provide financial support.

Importers may also have insufficient capital of their own, and may need financial assistance to pay for
imported goods until they can re-sell them, and obtain cash to make the payment.

2.4 Currency risk

Key term
Currency risk is a form of risk that arises from the change in price of one currency against another.
Whenever investors or companies have assets or business operations across national borders, they face
currency risk.

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The risk exists between the time that a liability to make a payment arises and the time that the liability
originates and payment is made for the transaction.

For example, suppose that an Australian company sells goods to a buyer in Hong Kong, and agrees to:

 Accept payment in Hong Kong dollars

 Allow the Hong Kong buyer 60 days’ credit from the time the goods are delivered in Hong Kong.

The Australian company will be exposed to the risk that the value of the Hong Kong dollar will fall against
the Australian dollar between the time that the sale transaction is agreed and the time that the customer
pays.

Currency risk is explained in more detail in a later chapter.

2.5 Regulatory and political risks

International trade transactions must comply with export regulations in the seller’s country and import
regulations in the buyer’s country. There may also be export taxes and import taxes to pay.

Key term
Regulatory risk is the risk that:

 The seller or the buyer fails to comply with regulatory requirements.

 New regulations may be introduced that make international trade more difficult or more
expensive.

Failure to comply with regulations could have the following consequences:

 If the exporter fails to obtain the necessary export documentation and approval, the goods will
not be allowed out of the country.

 If the buyer fails to obtain the necessary import documentation, the goods will not be allowed into
the buyer’s country.

 If the required import taxes are not paid, the goods will not be allowed into the country.

 When there are regulatory restrictions on imports of goods from particular countries, it may be
necessary to provide documentary proof of the country of origin of the goods. Without this, the
goods will not be allowed into the country.

Key term
Political risk is the risk that political events, such as war, may disrupt international trade, making it
impossible for exporters to deliver goods to buyers in a country where the events occur.

2.6 Money laundering risk

The settlement of payments in international trade usually involves the transfer of money between
countries. This is a function of banks. A significant amount of international money transfers are money
laundering transactions by criminals and their associates. Banks have a legal requirement to report (to
the relevant authorities) transactions that they suspect of involving money laundering. Failure to report
suspicions, as well as involvement in money laundering transactions, exposes a bank to the risk of
criminal prosecution. For banks, international payments normally involve higher money laundering risks
than domestic money transfers.

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2.7 Bribery and corruption risk

Bribery is the act of giving an individual money, hospitality or gifts in order to influence their behaviour.
For example, an exporter could pay for a holiday, for the CEO of a potential customer, to help persuade
them to sign a sales contract. Bribery is a complicated area in international trade, because behaviour that
could be classified as bribery in one country may be considered who legal in another country. Therefore
companies must ensure that their actions comply with anti-bribery regulations both domestically and
abroad.

Corruption involves an individual using their official capacity for their own gain. For example, a
government official could use government funds to buy medical supplies from an exporter who charges
more than other exporters supplying the same products, but who provides the government official with
lavish hospitality. Any involvement in corruption can have severe adverse consequences for companies,
from a financial and reputational perspective.

3 International trade and its participants

There are ways of reducing risks or sharing risks in international trade. Some of these involve banks to a
certain degree, and bankers should understand:

 How international trade is conducted (including how goods are transported between countries).
 How banks are involved.
 What the risks may be, for the bank and its customers.

The rest of this chapter provides an explanation of some of the features of international trade
transactions.

Participants: International trade in goods involves a seller (exporter or shipper) and a buyer (importer),
but other organisations are also involved. These include:

 Carriers
 Freight forwarders
 Banks

When an exporter sells goods to a buyer in another country, arrangements have to be made to transport
the goods from the seller’s premises, to the buyer’s chosen destination.

The seller or exporter has to make the goods available for shipment. The seller may also be called the
‘shipper’ of the goods. The shipper (seller) or the buyer is responsible for arranging the transportation,
but they also use the services of:

 A carrier
 (Possibly) a freight forwarder

3.1 Carrier
A carrier is a firm that agrees to transport goods from one destination to another, or to undertake to
procure the transportation of the goods. The agreement is made in the form of a contract of carriage,
and transport may be by road, rail, air, sea or inland waterway. Carriers include:

 Road transport companies

 Shipping companies
 Airline companies

The method of transportation may be multi-modal, which means that the contract of carriage
provides for the goods to be transported by a combination of methods – for example by rail for part of
the journey and by road for the rest of the journey.

Transportation of goods may involve more than one carrier. When this happens, one carrier will
usually accept the overall responsibility for the carriage of the goods to their final destination, but will
sub-contract the carriage for part of the journey, to another carrier.

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When goods are shipped in containers from a container yard in one country to a container yard in
another country, the carriers may include the container firm and a shipping company. ‘Roll on, roll off’
(RORO) transportation is a term for the use of container lorries to transport the goods by road and
sea: the lorries are driven on to a ship in the exporter’s country and driven off at a port in the country of
destination: the goods do not leave their container, but they are transported by both road and sea (or
possibly rail).

3.2 Freight forwarder

An international freight forwarder is a firm that acts as agent for the exporter/shipper or the
buyer, and arranges the transportation of the goods. The freight forwarder then makes sure that the
goods are delivered to their destination. They can provide a variety of services for the client, including:

 Providing advice about freight costs, port charges, insurance costs, handling fees and other
expenses.

 Reserving space for the goods on transportation vessels, in accordance with instructions from the
shipper or buyer.

 If required, arranging for goods to be containerised (put into containers) at the port from which
they are to be shipped.

 Preparing the export documentation for the goods, including a bill of lading (if required).

 Arranging for the goods to clear customs.

International freight forwarders have extensive knowledge and experience in the transportation of
goods for export, and their services can be invaluable to small firms that do not export regularly or in
large quantities.

3.3 Banks
The seller and the buyer each have their own bank, usually in their own countries.

3.3.1 The buyer’s bank

When a buyer wants to pay for purchased goods it will ask its bank to make the payment. The payment
may be made in the buyer’s own domestic currency, or it may be in a foreign currency (for example, the
seller’s currency).

If payment is to be made in a foreign currency and the buyer does not have a foreign currency account
of that denomination, the bank will buy the required amount of currency for the payment (it will sell the
currency to the buyer) and make the payment transfer.

3.3.2 The seller’s bank

When a buyer makes a payment through its bank, the payment is made to the bank nominated by the
seller – the seller’s bank.

 If the payment is in the seller’s own currency, the money is credited to the seller’s current
account with the bank.

 If the payment is in a foreign currency and the seller does not have an account with the bank in
that currency, the bank will sell the currency in exchange for domestic currency, and credit the
seller’s current account with the domestic currency obtained from the sale.

3.3.3 Correspondent banks

With most payments for international trade transactions, money can be transferred directly from the
buyer’s bank to the seller’s bank.

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In some situations, however, the buyer will ask its bank to make an arrangement in the seller’s country
or the seller will ask its bank to make an arrangement in the buyer’s country.

A bank may ask for assistance from a bank in the other country with which it has an established business
relationship. This bank may be called a correspondent bank – although it may also be known by other
names (depending on the nature of the transaction with which it assists).

A correspondent bank is also a bank in another country, which holds its deposits in the currency of that
country. For example, an African company may hold its Hong Kong dollars in an account with a
correspondent bank in Hong Kong and may hold its Singapore dollars in an account with a correspondent
bank in Singapore. (This is because currency ultimately resides in the country where it has been issued.)

4 Documentation in international trade: transport documents

4.1 Why do bankers need to know about documentation in international
trade?
Bankers should understand the documentation used in international trade, as this makes it easier to
communicate with their business customers. More specifically however, a seller and buyer sometimes
agree on a method of payment that involves the banks handling commercial documents for their trading
transaction.

When the method of payment is a letter of credit (documentary credit), a bank will guarantee to pay the
seller for the goods on behalf of the buyer. From the seller’s perspective, they are transferring the credit
risk of the transaction to the bank issuing the letter of credit. The documentation is important as it will
be used to ensure that the seller has performed their duties and that the goods meet the required
standard as specified in the letter of credit.

Bankers should therefore understand the nature of the commercial documents used by sellers, buyers,
carriers and freight forwarders in international trade. Some documents are used as evidence that the
seller or the buyer has complied with certain requirements of their transaction, and should be checked to
ensure that everything is in order and accurate.

Transport documents (or shipping documents) can be particularly important. A transport document is
issued by a carrier, and provides evidence that the carrier has taken possession of the goods itemised
in the document. Sometimes, a freight forwarder will combine the shipments of several clients into a
single large shipment; when this happens, the freight forwarder will issue a transport document to each
of the clients with goods in the shipment.

There are different forms of transport document. The most commonly used are a bill of lading and a
waybill. These are both multi-part documents. In the past, they were produced and transferred in paper
form. There is now widespread use of electronic documents.

4.2 Bill of lading

Key term
A Bill of Lading is a legal document between an exporter and the carrier detailing the type, quantity
and destination of the goods being carried. It also serves as a receipt of shipment when the goods are
delivered to a pre-determined destination, and must be signed by an authorised representative of the
exporter, carrier, and receiver.

Most commonly, a bill of lading is used when transportation is by sea. A bill of lading serves several
purposes.

 It is a receipt of goods for shipment, issued by the carrier to the shipper and provides a list of
the goods in the shipment. It identifies the carrier who will deliver the goods to their destination.

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 It is also an acknowledgement of a contract between the carrier and the shipper, for the
transportation of the goods listed in the bill of lading, from and to the places indicated in the
document. The contract actually begins when the space is booked on the carrier’s transport, and
the bill of lading (or waybill) confirms this. The bill of lading is signed evidence of the contract.

 A negotiable bill of lading is a document that gives its holder legal title to the goods. The
buyer cannot obtain possession of the goods that have been shipped under a bill of lading,
without first getting possession of the negotiable bill of lading.

Since a negotiable bill of lading is a document of title to the goods, the exporter can prevent the
buyer from taking the goods that have been shipped, by retaining control over the bill of
lading, until the buyer has paid or until the seller can be assured of eventual payment.

4.2.1 Straight and negotiable bills of lading

Most bills of lading are negotiable, but some are not.

A straight bill of lading states that the goods are being sent (consigned) to a specified person: it is a
non-negotiable bill of lading and is not a document of title to the goods.

An order bill of lading includes words that make the bill negotiable, by stating that the goods
will be delivered to the consignee ‘or to order’. The effect of this wording is that the exporter can
transfer legal title to the goods, and the right to take possession of the goods, by endorsing the bill of
lading and delivering it to the buyer.

 ‘Endorsing’ a bill of lading is achieved by stamping and signing the document.

 ‘Negotiation’ of a bill of lading means endorsing the document and delivering it to another
person, so that the person receiving the document obtains legal title to the goods.

 A person presenting an endorsed order bill of lading to the carrier at the destination for the goods
can therefore take possession of the goods.

 An endorsed order bill of lading can be used as security (collateral) against the obligation of the
buyer to pay for the goods. This will be explained in more detail later.

 A bill of lading must be an ‘order bill of lading’ in order for it to be negotiable, and give its
holder title to the goods and control over the goods that are delivered by the carrier.

A bill of lading is usually issued with several copies of the original. When the bill of lading is
negotiable, any one of the original copies must be surrendered to the carrier (duly endorsed/signed by
the person who surrenders it). The carrier will then release the goods against this endorsed original
copy. The other copies of the original then become void.

The bill of lading indicates how many copies of the original there are, and a ‘full set’ of the bills of
lading means all the original copies.

4.2.2 Clean and foul bills of lading

A clean bill of lading shows that the goods have been received by the carrier and are apparently in
good condition and without evidence of damage. The bill of lading normally acknowledges that the goods
have been received for shipment in good order. However, a ‘clean’ bill of lading does not need to
contain words to the effect that there is no visible defect in the goods. The absence of wording to
indicate a possible defect is sufficient to indicate that the bill of lading is ‘clean’.

 A clean bill of lading can be taken by the buyer (the ‘consignee’) as a representation that the
carrier has made a reasonable inspection of the goods, as far as this has been practicable, and
they do not have any visible defect.

 A clean bill of lading also provides evidence that the seller (shipper) has complied with the terms
of the contract requiring him to ship the goods.

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 If the goods subsequently arrive at their destination in damaged condition, the clean bill of lading
provides evidence that the carrier is responsible or accountable for the damage.

In contrast, a ‘foul’ bill of lading includes a statement that the goods have been received by the carrier
in damaged condition. When a letter of credit is used as the method of payment, only a clean bill of
lading will normally be acceptable. (Letters of credit are described in a later chapter.)

4.2.3 On board bill of lading and received for shipment bill of lading
When goods are shipped by sea, an on board bill of lading acknowledges that the carrier has received
the goods and they have been loaded on to the ship named in the bill of lading. A ‘clean on board’ bill
of lading indicates that they have been loaded on board ship and are apparently in good condition.

An on board bill of lading therefore provides evidence for the buyer that the goods have been loaded on
board ship.

In contrast, a ‘received for shipment’ bill of lading indicates that the goods have been delivered in
to the custody of the carrier for shipment. It does not indicate that the goods have been loaded on board
ship. They may still be on land waiting shipment, stored under control of the carrier.

The wording on a ‘received for shipment’ bill of lading may be: ‘received in apparent good order and
condition for shipment on [name of ship] or the next following vessel’. The buyer cannot be certain of
the actual vessel that will be used to transport the goods.

4.2.4 Bill of lading and method of transport

An ocean bill of lading or a port-to-port bill of lading is a bill of lading for the carriage of goods by
sea from one port to another.

A multimodal bill of lading covers the shipment of goods by more than one method of transportation,
but including an ocean ‘leg’ in the journey. There are two types of multimodal bill of lading:

 A combined transport bill of lading is a bill of lading issued and signed by a single carrier (the
‘contractual carrier’) although this carrier may subcontract various legs of the journey to other
carriers. The contractual carrier accepts responsibility for the delivery of the goods to their final
destination and for any damage to the goods during any leg of the journey.

 A through bill of lading is a bill of lading issued by a carrier for just one part of the journey, to
a named place of delivery in the document. This carrier will then pass responsibility to another
carrier for onward carriage from the place of delivery to the final destination for the goods. The
through bill of lading is issued by one carrier, but this carrier acts as principal in the contract for
carriage only for its own leg of the journey, and acts only as agent for the shipper in handing the
goods over to the next carrier for onward carriage.

 When a bill of lading is issued for containerised shipments of goods, a multimodal bill of lading
should be used rather than a port-to-port bill of lading, where the place of delivery is somewhere
inland in the buyer’s country.

4.2.5 Charter party bill of lading

Sometimes the seller or buyer will charter a ship to transport the goods. A charter party agreement is a
contract for the hire of a vessel that sets out the obligations and rights of the vessel owner and the hirer.

A charter party bill of lading is a bill of lading issued for a shipment on a chartered vessel.

As a general rule, when a letter of credit is used as the method of payment, a bank will not accept a
charter party bill of lading unless the letter of credit specifically states that this transport document will
be used.

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4.2.6 Freight prepaid and freight to collect

A bill of lading should also indicate the arrangements for payment of the freight charges.

 Freight prepaid means that freight charges have been paid by the shipper (exporter) in advance
of shipment.

 Freight to collect means that the freight charges must be paid at the port of destination before
the carrier will release them.

4.2.7 Stale bill of lading

There may be a requirement that the original full set of the bill of lading should be presented to a bank
or the buyer/consignee within a stated period of time. For example, with letters of credit and
documentary collections, the general requirement is that the bill of lading (or waybill) should be
presented no later than 21 days after the day of shipment, or not later than the final date for
presentation of the documents as stated in the letter of credit, if this is sooner.

A stale bill of lading is a bill of lading that is presented after the latest permitted time.

The consequences of presenting a stale bill of lading will depend on the circumstances of the
arrangement between the buyer and the seller.

4.2.8 Contents of a bill of lading

An ocean bill of lading contains the following information:

 Identity number.

 Name and address of the carrier.

 Name and address of the shipper/exporter.

 Name and reference number of the freight forwarding agent, if there is one.

 Name and address of the consignee (the buyer).

 Name and address of the ‘notify party’: this is the person who must be informed when the goods
arrive at their port of destination. The notify party is often the buyer/consignee, but may be the
buyer’s agent.

 Port of loading.

 Port of destination.

 Name of vessel, if the bill of lading is an on board bill of lading.

 The words ‘shipped on board’ and date, for an on board bill of lading.

 The words ‘freight prepaid’ if the cost of the freight has been prepaid, or ‘freight to collect’ if
freight charges will be paid at the port of destination.

 Brief description of the goods: their identification marks, number of packages or containers, a
description of what the packages are said to contain and what their weight is said to be.

 For a clean on board bill of lading, words to the effect that the goods have been taken in charge
by the carrier in apparent good order.

 The number of original copies of the bill of lading that have been issued.

 Date of issue of the bill of lading.

An example of an ocean bill of lading is shown in the following page.

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Shipper/Exporter (Complete Name and Address) Bill of Lading No. TNKL099112365

Final Leathers Forwarding Agent Name & Ref
123 Rama Salal
T Nagar 555 666
Tamil Nadu, India

Consignee's Name and Address

DRAGON NET LINE
To Order of HSBC Bank Australia
158-1 Arjunaa Salai, T Nagar 555 661, Tamil Nadu, India
Tel 991 123456789, Fax 991 987654321
Notify Party (Complete Name and Address)
Received in apparent good order and condition except as otherwise noted the total number of
SLE Marketing Agency containers or the packages or units enumerated below for transportation from the place of receipt
to the place of delivery subject to the terms hereof. One of the signed Bill of Lading must be
11 Providence Place surrendered duly endorsed in exchange for the goods or delivery order on presentation of this
Adelaide document (duly endorsed) to the Carrier by or on behalf of the Holder the rights and liabilities
arising in accordance with the terms hereof shall (without prejudice to any rule of common law or
statue rendering them binding on the Merchant) become binding in all respects between the
Carrier and the Holder as though the contract evidenced hereby had been made between them.

Place of Loading Port of Discharge Freight Payable at

Chennai Port of Adelaide Chennai

Australia
Vessel/Voyage Final Destination No. of Original Bills of Lading

Sinar Bon Port of Adelaide, Three (3)

Australia
Marks & Numbers Number and kind of packages description of goods gross Weight in Kgs Measurement CBM
Said to contain Said to weigh/measure

INDIA 15 SHEEP NAPI GRWT 32,000 2.005

POCH PORT ROLL FINISHED LEATHER KGS NET WT CBM
KLANG FOR LINING USE 300.00 KGS
447/366
WE NO 7890

SHIPPED ON BOARD:
16/09/2XXX
FREIGHT PREPAID
The goods and instructions are accepted and dealt with subject to the Standard Conditions printed overleaf.

Taken in charge in apparent good order and condition, unless otherwise noted herein, at the place of receipt for transport and delivery as mentioned above.

One of these Bills of Lading must be surrendered duly endorsed in exchange for the goods. In witness whereof the original Bills of this tenor and date have been signed in the
number stated above, one of which being accomplished the other(s) to be void.

Freight Amount Stamp and authorised signature

Prepaid as per arranged

DRAGON NET LINE
Freight Prepaid At

Chennai
Date of Issue: Sinapa Murugesu
16 Sep 2XXX Carrier

Place of Issue Laden on Board

Chennai Chennai

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4.3 Waybill

Key term
A waybill is a receipt for goods and a contract for carriage of the goods. It is used for the purpose of
transporting the goods and is not a document of title to the goods.

A waybill is a transport document that may be used instead of a bill of lading. Waybills are commonly
used for carriage by air, from airport to airport, and are known as air waybills. A waybill is issued by
the carrier, and serves most of the same purposes as a bill of lading.

 It is a receipt from the carrier, to acknowledge that the goods have been received for
transportation.

 It is evidence of a contract of carriage between the carrier and the shipper, for delivery of the
goods from a named place of shipment to a named place of delivery.

However, unlike a bill of lading, it is not negotiable and possession of a waybill does not give the holder
of the document legal title to the goods or control over the goods.

With a waybill, the goods are delivered to the person named in the waybill (the ‘consignee’) at the place
of delivery.

When goods are shipped by air, a freight forwarder may arrange for the consolidation of shipment by a
number of different shippers into a single large consignment. When this happens, the carrier issues a
master air waybill to the freight forwarder, and the freight forwarder then issues its own ‘house’ air
waybills to each of its clients who have goods in the consignment.

An example of an air waybill is shown on the following page.

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Shipper's Name and Address Not Negotiable

JPN Exports Ltd, 109 Metro Plaza, Osaka, Japan Air Waybill
Issued by
DN Logistics Ltd, 86, Nagoya Avenue, Tokyo Japan
Shipper's Account Number:
Copies 1,2 and 3 of the Air Waybill are originals and have the same validity

Consignee's Name and Address It is agreed that the goods described herein are accepted in apparent good order
and condition (except as noted) for carriage SUBJECT TO THE CONDITIONS OF
ABC Trading Bukit Tima Plaza
CONTRACT ON THE REVERSE HEREOF. ALL GOODS MAY BE CARRIED BY ANY
Singapore OTHER MEANS INCLUDING ROAD OR ANY OTHER CARRIER UNLESS SPECIFIC
Consignee’s Account Number: CONTRARY INSTRUCTIONS ARE GIVEN HEREON BY THE SHIPPER, AND SHIPPER
AGREES THAT THE SHIPMENT MAY BE CARRIED VIA INTERMEDIATE STOPPING
Issuing Carrier's Agent Name and City PLACES WHICH THE CARRIER DEEMS APPROPRIATE. THE SHIPPER'S ATTENTION
IS DRAWN TO THE NOTICE CONCERNING CARRIER'S LIMITATION OF LIABILITY.
Shipper may increase such limitation of liability by declaring a higher value for
Account No.
carriage and paying a supplemental charge if required.

Airport of Departure (Add of first Carrier) and requested Routing

TYO
To Br first Carrier To By To By Currency CHGS Declared Value for Carriage Declared Value for Customs
Code
C
Airport of Destination Flight/Date Amount of Insurance INSURANCE : If Carrier offers insurance, and such
insurance is requested in accordance with conditions on
SIN 1209XX QQ123 reverse hereof, indicate amount to be insured in figures
in box marked ‘amount’.
Handling Information
Notify Accountee: ABC Trading Singapore
No.of Pieces RCP Gross Weight kg lb Rate Class Chargeable Weight Rate / Charge Total Nature and Quantity of Goods

100 cartons motor amplifiers and controllers 1 1250 kgs.

Audio Japan

ON BOARD

Carrier: SIN
Date: 14.09.200X
Signature: Simon

Prepaid Weight Charge Collect Other Charges

USD2,480.00
Valuation Charge Transhipment at Singapore Airport
Tax Shipper certifies that the particulars on the face hereof are correct and that
Total other Charges Due Agent insofar as any part of the consignment contains dangerous goods, such
part is properly described by name and is in proper condition for
carriage by air according to the applicable Dangerous Goods
Total other Charges Due Carrier Regulations.

Signature of Shipper or his Agent

Total Prepaid Total Collect 12 Sept 2XXX Tokyo

Executed on (date) at (Place) Signature of Issuing Carrier or its Agent
For Carrier's Use only at Charges at Destination Charges at Destination
Destination

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4.4 The significance of ‘negotiable’ and ‘not negotiable’ transport

documents
An order bill of lading is a negotiable document. This means that it is not just a transport document,
but is also a document of title. With a bill of lading, the shipper can retain control over the goods by
keeping possession of the bill of lading, and can give the bill of lading to the buyer only when the buyer
has paid for the goods or made arrangements for payment of the goods.

Because a bill of lading is negotiable, it can be sold/bought whilst the goods are in transit to their
destination. This means that goods can be sold whilst they are still being shipped, and delivered to the
holder of the bill of lading at the place of delivery for the goods.

A bill of lading can be an important document when the method of payment for the goods is by letter of
credit.

Although a waybill is not a negotiable instrument, it can be used as a means of payment, but
only through the assistance of a bank and only when the method of payment is a documentary collection
or a letter of credit. Methods of payment for goods are explained in a later chapter.

4.5 Electronic transport documents

A bill of lading or a waybill may be issued in either paper form or electronic form.

Since a waybill is simply a transport document, and not a document of title, a carrier can issue a waybill
to the shipper in digital form.

Since a negotiable bill of lading is a document of title, there must be arrangements that enable the
shipper to transfer ownership of title to the goods. There are international rules for electronic bills of
lading, which apply when the parties agree.

 The carrier issues a bill of lading to the shipper in electronic form, by means of Electronic Data
Interchange. The message includes a private key for the shipper, as holder of the bill of lading,
which secures the authenticity of the transmission.

 The shipper confirms receipt of the message to the carrier, and with this confirmation the shipper
becomes the holder of the bill of lading.

 When the shipper, as holder of the bill of lading, wants to transfer the right of control over the
goods, it notifies the carrier of its intention.

 The carrier transmits this information electronically to the proposed new holder of the bill of
lading, who acknowledges his acceptance. The carrier then cancels the private key of the shipper
and gives a new private key to the new holder of the bill of lading.

 This has the same effect as transferring the rights to the goods by handing over possession of a
paper bill of lading.

5 Documentation in international trade: other documents

Some other documents used in international trading transactions are described below.

5.1 Invoices
A commercial invoice is a normal invoice, and is a statement of the payment due from the buyer to
the seller. It also lists the goods in the shipment (and their prices). When a commercial invoice is a
document in a letter of credit arrangement, the details of the goods, and the currency of payment, must
be the same as those specified in the letter of credit.

A consular invoice is an invoice that has been authenticated by the consulate of the importer’s country
in the country of the exporter. It is usually produced on a special form and includes all the details on the
commercial invoice. It provides a statement by the exporter of the value of the goods in the shipment.

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A consular invoice is often required by the customs authorities in the importer’s country, to ensure that
the goods in the shipment have been priced fairly and to prevent an under-declaration of the value of
the goods.

5.2 Insurance policy or certificate

It is normal practice in international trade for the goods to be insured by either the seller or the buyer,
depending on the terms of the sale.

An insurance policy document provides evidence of a contract of insurance, and indicates all the risks
covered by the contract.

An insurance certificate is a much shorter document, providing evidence that insurance has been
taken out under a standard or ‘open’ policy. Whereas an insurance policy provides details of all the risks
covered, an insurance certificate gives only brief details of the risks covered.

An insurance policy or certificate is issued by an insurance company, or an insurance underwriter or their

agent. The date from which the insurance policy/cover takes effect is very important, because this must
be the same date as, or earlier than, the date of issue of the transport document.

It is usual practice in international trade for the amount of the insurance cover for the goods to be
their cost, insurance and freight value (CIF) or carriage and insurance paid to (CIP) value plus 10%.

 CIF and CIP are international shipping terms, which are explained later.

 The extra 10% is to cover additional expenditure that might be incurred in the event of loss or
damage to the goods.

The type or extent of insurance cover required is often specified in the agreement between the seller and
buyer as Institute Cargo Clauses ‘A’, ‘B’ or ‘C’. The insurance policy or certificate may need to be checked
to ensure that the appropriate insurance cover has been obtained.

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5.3 Certificate of origin

A certificate of origin is a document issued by the Chamber of Commerce, or another government-
approved body, in the exporter’s country. It certifies the country of origin of the goods.

This document is often required by the customs authorities in the importer’s country.

 Special import duty may be payable, depending on the country of origin of the goods.

 It may provide an indication that the goods did not originate from a country whose goods are
banned from import into the country.

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5.4 Certificate of inspection

A certificate of inspection is a document issued after the goods have been inspected before shipment,
which certifies the nature and condition of the goods in the shipment.

The inspectors are normally an independent inspection agency, used by the buyer to check the condition
of the goods and to ensure that the seller is sending goods of the correct quality, condition and quantity,
in accordance with the trading contract they have.

5.5 Packing list

A packing list is a document that lists in detail the goods in the shipment. This is sometimes required
by:

 An insurance company, to determine the most appropriate amount of insurance cover required for
the goods.

 The carrier, to determine where the goods should be held during shipment.

 The buyer, as a check that the goods have been packed properly for shipment.

Other documents may be used for an international trading contract. With the exception of finance
documents, which are described in later chapters, the most common documents have been described
here.

(Note on the language of documentation. A problem with international trade is that sellers and
buyers may speak different languages. Documents can be produced in more than one language, but
English is most often used as the international language of commerce. Where a letter of credit is used,
the language of documents should be in the same language as the letter of credit.)

6 Costs of transportation: who pays for what?

The contract of sale of goods by an exporter to a foreign buyer should define the responsibilities of both
the seller and the buyer with regard to:

 The goods themselves, their price and how they will be paid for.
 Their transportation method and cost of transportation.

An exporter and foreign buyer have a number of different choices about:

 Who should pay for the transportation.

 How the responsibilities for transportation should be divided between them.

6.1 What are the costs of transportation?

There are several costs involved in transporting goods.

Freight cost is the cost of moving the goods. It may include the costs of packing, loading and
unloading, cost of documentation, in addition to the costs of carriage.

The carriage costs are the fees charged by the carrier for moving the goods from one location to another
by the contracted method of transport. In international trade, the total costs of carriage can be divided
into three elements:

 Pre-carriage. This is the cost of transportation from the exporter’s location to the point or port
from where the goods will leave the exporter’s country. The exporter’s country may be called ‘the
seller’s side’. An inland carrier may be contracted to make the delivery from the exporter to a port
or airport.

 Main carriage. This is the transportation of the goods from the exporter’s country to a port or
airport in the buyer’s country. (This is the carriage from the ‘seller’s side’ to the ‘buyer’s side’.)
With exports, the main carriage is usually by air or sea (‘ocean carriage’).

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 On-carriage. This is the carriage of the goods from the point of arrival on the buyer’s side to the
final designated destination in the contract for carriage. This part of the carriage is undertaken by
an inland carrier in the buyer’s country (on the buyer’s side).

Other costs that may be involved in the transportation of exported goods are:

 Costs of keeping goods stored in a warehouse at a port or airport.

 Handling costs at a port or airport.

 Customs duties and import duties.

 Cost of insurance or takaful for the goods during transportation: goods may be insured against
damage or loss.

 Costs of inspecting goods, where inspection is required.

6.2 Agreement on payment of transportation costs

The division of responsibilities for transportation and payment of transportation costs should be included
in a contract for the export of goods. The specifications in the contract should be clear, so that there is
no possibility of misunderstanding or disagreement between the shipper and the buyer.

With international trade, there is a high risk of misunderstanding. Fortunately, it is common practice to
use standard terms for shipment which specify exactly the responsibilities of buyer and seller, and who
pays the costs. These standard terms are internationally accepted.

These standard terms of shipment are known as International Commercial Terms or Incoterms, which
are published by the International Chamber of Commerce (ICC).

7 International Chamber of Commerce (ICC) and Incoterms

2010
The International Chamber of Commerce or ICC is an international voluntary organisation based in
Paris. Its membership includes companies in most countries of the world, although membership of the
ICC is usually through national committees or chambers of commerce.

The ICC makes policies and rules for some aspects of international trade. These are accepted voluntarily
by its membership and therefore have widespread acceptance. One aspect of the ICC’s work is the
publication of Incoterms.

Incoterms are internationally accepted terms for shipments of goods which define:

 The responsibilities of buyer and seller for arranging shipments.

 The procedure where control over the goods passes from seller to buyer.
 The situation where the liability for the goods and insurance cover passes from seller to buyer.
 Responsibilities for costs.
An Incoterm is included in the export contract between seller and buyer. Because they are internationally
accepted, Incoterms provide an international language for the shipment of goods.
The first Incoterms were published in 1936. They are now reviewed and revised every ten years, to
make sure that they reflect common practice in international trade and shipments. The most recent
version of Incoterms, Incoterms 2010, became effective in January 2011. (The previous version was
Incoterms 2000, which stated that an export contract should specify the version of Incoterms that
applies to the shipment, [Incoterms 2010 or Incoterms 2000] to avoid any disagreement or
misunderstanding.)

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8 Incoterm definitions
There are 11 Incoterms in Incoterms 2010. (There were 13 Incoterms in Incoterms 2000.) Each
Incoterm consists of a three-letter code, beginning with the letter E, F, C or D.
 Term beginning with letter E. This indicates that the shipper’s responsibilities for
transportation and costs end as soon as the goods are ready for transportation at the shipper’s
premises.
 Term beginning with letter F. This indicates that the costs of the main carriage is arranged
and paid for by the buyer, not the seller.
 Term beginning with letter C. This indicates that the costs of the main carriage is arranged
and paid for by the seller, not the buyer.
 Term beginning with the letter D. This indicates that the seller is responsible for
transportation to a named destination in the buyer’s country. This destination not usually the port
or airport, at where the goods arrive in the country, often being the buyer’s premises. This means
that the seller has to arrange for carriage on the buyer’s side, and the services of a freight
forwarder may be used for this purpose.

In Incoterms beginning with the letter D, the responsibilities and obligations of the shipper are greater
than with other Incoterms, but it also means that the seller retains control over the goods for longer
during the transportation process.

The 11 Incoterms can be divided between seven terms that are used for transportation by any mode of
transport and four terms that apply specifically to transportation by sea or inland waterway.

Terms for any mode of transport Terms for sea and inland waterways

EXW Ex works FAS Free alongside ship …

FCA Free carrier … FOB Free on board …

CIP Carriage and insurance paid to … CFR Cost and freight to …

CPT Carriage paid to … CIF Cost, insurance and freight to …

DAT Delivered at terminal …

DAP Delivered at place …

DDP Delivered duty paid …

Incoterms beginning with the letter F must specify a port of shipment on the seller’s side.

Incoterms beginning with a letter C must specify a port of destination on the buyer’s side.

Incoterms beginning with a letter D must specify a destination.

E X A M P L E

If an agreement for the sale of goods includes the Incoterm DAT Johor (Incoterms 2010), this means
that a foreign shipper undertakes to ship the goods to Johor and that the terms and conditions for
shipment will be DAT.

If an agreement for the sale of goods includes the Incoterm FOB Brisbane (Incoterms 2010) this means
that an Australian exporter undertakes to deliver the goods to a foreign buyer at the seaport in Brisbane,
and that the terms and conditions for shipment will be FOB.

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If an agreement for the sale of goods includes the Incoterm CIF Manila (Incoterms 2010) this means that
an Australian exporter undertakes to deliver the goods to a foreign buyer at the seaport in Manila
(Philippines), and that the terms and conditions for shipment will be CIF.

8.1 Delivery
‘Delivery’ means the point at which the seller has fulfilled all his obligations for transportation under the
terms of the export contract. Responsibility passes to the buyer at the point of delivery.

It is important to understand that ‘delivery’ does not mean the physical delivery of the goods to the
buyer. Delivery can take place at some distance from the buyer, and in some cases delivery occurs in the
exporter’s country.

8.2 Other points to note about Incoterms

Incoterms are concerned with responsibilities for transportation, and the following points should be
noted:

 They are not contractual terms that deal with ownership of the goods or payment for the goods
by the buyer. They do not specify, for example, when the buyer must pay for the goods.

 They apply to the shipment of goods and do not apply to the provision of services to a client in a
different country.

 Incoterms do not specify the details of how the goods will be transported and delivered.

 Where goods are shipped by container, the goods must be loaded into the container at some
point. Incoterms do not specify who is responsible for loading the container and paying for this.
Loading containers should be included as a separate item in the contract between the seller and
the buyer.

 Incoterms are used voluntarily and there is no legal requirement that they must be used.

8.3 Incoterm specifications

The meaning of each Incoterm is explained in the following table.

Terms for transport by sea or inland waterway

FAS: Free Alongside Ship This term is commonly used where a ship is chartered by the buyer.

The seller has an obligation to deliver the goods alongside a ship at

a named port of shipment and is responsible for the clearance of the
goods for export.

The buyer is responsible for the costs and the risks of loading the
goods on to the ship and transporting them to their destination in
the buyer’s country. The buyer has responsibility for import
clearance for the goods.

FOB: Free On Board The seller has an obligation to deliver the goods on board a ship at a
named port of shipment and is responsible for the clearance of the
goods for export and for loading the goods on to the ship.

The buyer is responsible for the subsequent costs and the risks of
transporting the goods to their destination in the buyer’s country.
The buyer has responsibility for main carriage, on-carriage, any
insurance of the goods and import clearance for the goods.

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Terms for transport by sea or inland waterway

FOB is similar to FAS, with the exception that the seller has
responsibility for loading the goods on to the ship.

CFR: Cost and Freight The seller’s responsibility for the condition of the goods ends when
the goods are delivered on board the ship at the port of shipment.
Any insurance costs are the responsibility of the buyer from this
point.

However, the seller must pay all transportation costs from the port
of shipment to the named port of destination on the buyer’s side.

The seller is therefore responsible for pre-carriage and main carriage

costs and for export clearance for the goods.

The buyer is responsible for import clearance.

The seller’s responsibilities (by including main carriage) go one step

further than FOB.

CIF: Cost, Insurance and The seller’s responsibility for the condition of the goods ends when
Freight the goods are delivered on board the ship at the port of shipment.
The seller is therefore responsible for pre-carriage and main carriage
costs and for export clearance for the goods. This is the same as
with CFR.
In addition, even though the buyer has the risk for the insurance of
the goods from the time they are placed on board ship, the seller
pays for their insurance to the named port on the buyer’s side. In
comparison with CFR, CIF therefore adds insurance costs during the
main carriage to the seller’s responsibilities.

The buyer is responsible for import clearance.

CIF obliges the seller to provide a minimum level of insurance for the
goods during their shipment to the buyer’s country; the buyer may
therefore obtain additional insurance cover, to bring the level of
cover up to a level that the buyer wants.

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Terms for any mode of transport

EXW: Ex Works The seller has very little responsibility. The seller’s obligations are
fulfilled when the buyer has been notified that the goods, packed for
transportation, are available for the buyer’s carrier to collect from
the seller’s premises (a named place) within the time specified by
the sale contract. Where the buyer uses a freight forwarder, the
goods come under the control/supervision of the freight forwarder
from this point.
The buyer is responsible for all costs and bears all risks from that
point. The buyer is also responsible for loading the goods on to their
mode of transport at the seller’s premises. If the goods are to be put
into a container for shipment, this is a responsibility of the buyer,
because ‘packing’ does not include containerisation.
The buyer therefore pays for pre-carriage, main carriage and on-
carriage and is responsible for export clearance for the goods as well
as for import clearance. (However, the seller is responsible for
ensuring that the goods comply with any export requirements.)
EXW should be the preferred Incoterm for a company that is
inexperienced in exporting, and is unfamiliar with the processes and
risks involved.

FCA: Free Carrier The seller is responsible for delivering the goods to a carrier
nominated by the buyer at the named place. The carrier is located in
the seller’s country. The seller is responsible for obtaining export
clearance for the goods (for example, payment of export duty or
export tax).
If the named place for delivery to the carrier is at the seller’s
premises, the seller is responsible for loading the goods.
The buyer is responsible for carriage and other costs from this point,
and is also responsible for import clearance for the goods.
FCA may be used for containerised cargo, where the goods are
driven onto and off a ship for the main carriage.

CPT: Carriage Paid to… The seller’s risk and responsibility for the goods ends when they are
delivered to the first carrier (on the seller’s side) and the buyer has
the risk of any loss or damage to the goods from that point.
However, the seller is responsible for carriage of the goods to the
named destination in the buyer’s country, and is also responsible for
export clearance for the goods.
The buyer is responsible for import clearance.

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Terms for any mode of transport

CIP: Carriage and Insurance This is similar to CPT, with the exception that the seller is
Paid to… responsible for insurance of the goods to the named destination in
the buyer’s country (cargo insurance).
In comparison with CPT, CIP therefore adds cargo insurance costs
during the main carriage to the seller’s responsibilities.
The buyer is responsible for import clearance for the goods.
CIP obliges the seller to provide a minimum level of insurance for
the goods during their shipment to the buyer’s country; the buyer
may obtain additional insurance cover, to bring the level of cover up
to a level that the buyer wants.

DAT: Delivered At Terminal The seller is responsible for delivery of the goods to a named
terminal on the buyer’s side and making the goods available to the
buyer.
The seller is therefore responsible for main carriage and export
clearance for the goods. The seller’s responsibility also includes
unloading the goods from the carrier.
The buyer is responsible for import clearance for the goods.
‘Terminal’ includes a place, which may or may not be covered, such
as a warehouse, container terminal, quay or road, rail or air cargo
terminal.
If the contractual agreement is for the seller to deliver the goods
past the terminal to another place in the buyer’s country, DAT
should not be used. The Incoterm DAP or DDP would be more
appropriate.

DAP: Delivered At Place The seller is responsible for delivery of the goods to a named place
on the buyer’s side and bears all the risks of delivering the goods to
that place.
DAP does not specify whether the buyer or seller is responsible for
unloading the goods from the carrier, so this should be specified as
an additional item in the contract.
The seller is therefore responsible for pre-carriage, main carriage
and on-carriage for the goods, and for export clearance for the
goods.
However the buyer is responsible for obtaining import clearance for
the goods, even though on-carriage is the responsibility of the seller.

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Terms for any mode of transport

DDP: Delivered Duty Paid The seller is responsible for delivery of the goods to a named place
on the buyer’s side, and is also responsible for import clearance
(including payment of customs duties and taxes) as well as export
clearance for the goods.
The seller therefore has responsibility for pre-carriage, main carriage
and on-carriage.
The only responsibility of the buyer, with regard to shipment
arrangements, is to take delivery of the goods at the named place of
destination. The buyer is responsible for unloading the goods from
the carrier.

8.4 Choice of Incoterm

The choice of Incoterm for the sale of goods by an exporter to a foreign buyer is a matter for
negotiation.
 The price charged by the seller will include an amount to cover the costs of carriage and other
costs that the seller will have to pay.
 Often exporters like to retain control over the goods as long as possible during shipment, and
may therefore want to negotiate a term that makes them responsible for costs and risks up to at
least a port or destination in the buyer’s country.
 On the other hand, the buyer may wish to take control over the goods at an early stage and may
therefore ask for FOB or FCA.

8.5 Incoterms: summary of responsibilities and costs

Sea/Inland waterway Any mode of transport

transport

Cost item FAS FOB CFR CIF EXW FCA CPT CIP DAT DAP DDP

Packaging S S S S S S S S S S S
Loading at seller S S S S B x* S S S S S
Pre-carriage S S S S B S S S S S S
Export duty/taxes S S S S B S S S S S S
Terminal charges S S S S B B S S S S S
at place of
shipment
Loading on to S S S B B S S S S S
main carriage
Main carriage S S B B S S S S S
Cargo insurance S S B B B S S S S
Destination B B B B B B B S S S S
terminal charges
On-carriage B B B B B B B B B S S
Import duty/taxes B B B B B B B B B B S

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Key
S Responsibility of the seller
B Responsibility of the buyer

x* If FCA states that the carrier picks up from the seller's premises, seller is responsible for loading
charges

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Chapter roundup

 Risks in international trade are generally greater than domestic trade.

 Risks include commercial risks, such as credit risk and risks arising from the geographical distance
between seller and buyer, risks of transporting goods over long distances, and linguistic and cultural
differences between seller and buyer.

 There are also economic risks (such as foreign exchange or currency risk), regulatory risks and political
risks.

 The role of intermediaries (carriers and freight forwarders) is important in international trade. In
particular, carriers or freight forwarders issue transport documents.

 Documentation is important in international trade, as a means of checking that the exporter has
complied with the terms and conditions of the trading transaction.

 Transport documents are particularly important, as evidence of receipt of the goods by the carrier,
acknowledgement of a contract of carriage and, in the case of a negotiable bill of lading, as a document
of legal title to the goods for its holder.

 Traditionally, transport documents have been ‘physical’ paper documents, but there is now increasing
use of electronic documentation.

 Significant costs in international trade may be costs of insurance for the goods, freight costs and other
costs such as the cost of obtaining export and/or import clearance. The exporter and importer must
agree in advance how these costs will be shared between them.

 Incoterms are internationally-recognised terms that specify the responsibilities of both exporter and
importer when engaging in international trade transactions for matters such as delivery and protection of
the goods, export and import clearance, and responsibilities for costs such as freight and insurance.

 There are currently eleven Incoterms: four for transportation by sea or inland waterway, and seven for
transportation by any method.

 Although the use of Incoterms is voluntary, they are widely accepted and used in international trade.

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chapter 2

METHODS OF PAYMENT IN
INTERNATIONAL TRADE

Contents
1 Methods of payment.................................................................................................. 34
2 Bank transfers .......................................................................................................... 37
3 Cheques and banker’s drafts ...................................................................................... 40
4 Countertrade ............................................................................................................ 42
Chapter roundup............................................................................................................ 45

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Learning outcomes
On completion of this chapter you should be able to:
 Examine the payment methods used in international trade and the systems, mechanics and risks
of those methods.
 Analyse the uses and limitations of countertrade.

Learning objectives
While working through this chapter you will learn how to:
 Describe the concept of 'open account' and the payment obligations of buyers and sellers in
international trade.
 Compare and contrast the different methods of payment in international trade.
 Analyse the role of banks with each method of payment and in the transfer of payments.
 Describe the role of SWIFT in the international messaging and payments system.
 Appraise the use of foreign currency accounts for international payments.
 Appraise the use of cheques and bank drafts as methods of payment in international trade.
 Demonstrate the purpose and nature of countertrade.
 Compare the advantages and disadvantages of countertrade.

Introduction
The method of payment is the way in which settlement will be made between the buyer and seller in
international trade. Each method of payment places different obligations on the seller and the buyer. The
role of the bank also differs with each method of payment.

1 Methods of payment
All methods of payment involve the transfer of money from buyer to seller.

Key term
Open account is a method of settling payment for trade transactions. The supplier ships the required
goods to the buyer who, after receiving and checking the related shipping documents, credits the
supplier's account in their books with the invoice amount. Over 80% of global trade is now conducted on
‘open account’. This is the same method of conducting trade as in domestic trading.
 The seller delivers goods to the buyer.
 The payment terms usually provide for the buyer to pay within a specified number of days. In
other words, the sale is on normal credit terms, and there is no formal guarantee of payment
from the buyer to the seller.
 The buyer arranges a ‘clean payment’ through the banking system.

These arrangements between seller and buyer are called ‘open account terms’, and the seller accepts a
credit risk that the buyer will not pay or will be late with payment.

As an alternative to open account the seller could request for the transaction to occur on an advance
payment basis. In this case all, or part of the payment is made to the seller prior to the goods being
shipped. This eliminates or reduces the credit risk for the seller, and transfers it to the buyer who has
paid and bears the risk that the goods are not delivered. Thus advance payment terms are less attractive
to the buyer.

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When making clean payments, the buyer will choose a payment method based on how quickly they need
to make the payment and the cost of making the payment.

The method used to make a ‘clean payment’ when trade is on open account terms may be either of:

 An electronic transfer of funds from the buyer’s bank to the seller’s bank (a ‘bank transfer’ or
‘bank remittance’).

 A cheque, which may be a corporate cheque or a bank cheque (a banker’s draft).

Cheques are now rarely used as the method of payment in international trade. Most settlement is
by means of bank transfer.

Banks are involved in open account settlements simply because they facilitate the transfer of money
between buyer and seller.

Other methods of payment, which are not ‘clean payments’, call for greater involvement – and more fees
– for banks. These are:

 Documentary collection.
 Documentary letter of credit (also known as ‘documentary credit’ and ‘letter of credit’).

With both these methods of payment, banks are required to handle documents connected with the
shipment of goods from seller to buyer. With documentary credits, one or more banks are also required
to give a guarantee of payment.

Payments by bank transfer and cheque are called ‘clean payments’, whereas payments by
documentary collection and documentary credit are called ‘documentary payments’.

Documentary collections and documentary credits are described in detail in the following chapters.

In some cases, the method of payment in international trade does not involve a transfer of money.
Instead, the payment is arranged by means of exchange of goods. This is known as countertrade.

However, the most common methods of payment are bank transfer, cheque (or banker’s draft),
documentary collection and documentary credit.

The terms of trading between seller and buyer, which affect the method of payment, are:

 Payment in advance (by bank transfer or cheque).

 Open account trading (payment by bank transfer, or possibly by cheque).
 Documentary collection.
 Documentary credit.

The obligations of the seller, buyer and banks with each method of payment (excluding barter or
countertrade) are as follows:

Method of Obligation of the Obligation of the Role of banks

payment seller buyer

Money Document Payment

transfer handling guarantee

Bank transfer To provide the buyer To arrange for Yes No No

with an invoice payment of the
invoice

Cheque To provide the buyer To arrange for a Yes No No

with an invoice cheque or bank
draft to be sent to
the seller

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Method of Obligation of the Obligation of the Role of banks

payment seller buyer

Money Document Payment

transfer handling guarantee

Documentary After delivery of the Pay (or accept a bill Yes Yes No
collection goods, to arrange of exchange) at the
for agreed bank against the
documents to be documents
provided to the presented
buyer’s bank

Documentary After delivery of the To arrange for a Yes Yes Yes

credit goods, to arrange letter of credit to
for agreed be issued, in
documents to be accordance with
provided to the bank the contract

In the case of clean payments, bank transfers offer more efficient and quicker means of payment for
both parties, hence cheques are now rarely used. The fees charged by a bank for a simple bank transfer
will be modest.

Documentary payments offer advantages for importers and exporters summarised in the tables below.
Set against this is the higher levels of fees charged by banks for their involvement in the payment
process.

Advantages of using documentary collection

For importers For exporters

Collection allows importer to reduce risk Ensures that buyer will not receive goods before
associated with default on the seller’s delivery payment is made, since documents remain with
obligation the collecting bank until payment received

Documents can be reviewed and analysed before Lower expenses than those under an documentary
making decision on payments credit

Lower expenses than those for an documentary

credit

Advantages of using documentary credit

For importers For exporters

Documentary credit helps the importer reduce the Guaranteed payment upon presentation of the
risk connected with the seller not meeting documents specified in the terms of the letter of
delivery obligations credit

Letters of credit ensure certainty that the Reducing the production risk, first of all, for the
payment will be made only upon presentation of situations when the buyer cancels or changes his
the documents confirming shipment of the goods order

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 2: METHODS OF PAYMENT IN INTERNATIONAL TRADE

Advantages of using documentary credit

For importers For exporters

Having opened a letter of credit, the importer The buyer cannot refuse to pay due to a complaint
proves his ability to pay and can count on more about the goods. The buyer must raise any
favourable payment terms in the future complaints/claims about the delivered goods
separately from the letter of credit

As the use of open account trading grows, banks are looking for ways of providing more effective
intermediary services. A fairly recent initiative, which has not yet become widely established, is the
SWIFTnet Trade Services Utility (TSU).

The role of SWIFT in international trade, including the possible use of SWIFTnet TSU, is explained later
in this chapter.

1.1 Bank charges

Banks charge for the services they provide, and the charges must be paid by either the seller or the
buyer, or both. The most convenient arrangement is for the seller and buyer to agree to pay the bank
charges in their own country, and include this arrangement in the contract between them. This
arrangement avoids problems with exchange rate fluctuations when making payments to a foreign bank.

Bank charges may consist of:

 Standard fees for specified services, such as bank transfers or issuing and clearing cheques.
 Handling charges for handling and checking documents.
 Commission for services such as issuing a guarantee or confirming a letter of credit.

2 Bank transfers
As stated earlier, most international trade is based on open account payment terms. The seller delivers
the goods to the buyer without receiving payment or a guarantee of payment at the time of delivery. The
seller provides an invoice after delivery, and the invoice may be accompanied by a shipping document
(for example, a copy of a waybill) that verifies the shipment and the shipment date.

The buyer is required to pay the invoice within the time specified on the invoice, which will usually
provide for a short period of credit. The usual arrangement is for the buyer to instruct its bank to make a
bank transfer (also known as credit transfers) to a bank chosen by the seller.
The seller has no guarantee of payment, and is exposed to the risk of non-payment or late payment.
However, some international trade is between countries that are close to each other geographically and
commercially, where commercial risk is considered low. When sellers and buyers trade with each other
regularly, a business relationship built on trust can develop, so that open account payment terms can be
used with relatively little risk. Having a good business relationship is particularly important where there
are delays in the bank transfer from buyer to seller. This relationship will develop some understanding by
the seller and allow for a slight delay of payment in the event of a bank transfer issue. However, it is
important for the buyer to have a contingency payment procedure in place (such as cheques or banker’s
drafts) should there be a long delay with a bank transfers.

The following diagram summarises how payments by bank transfer are made when payment is on open
account terms.

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 INTERNATIONAL TRADE FINANCE

Figure 2.1: Open account bank transfers

Invoice (note 1)
Seller Buyer

Payment (note 4) Payment (note 2)

Seller’s bank Buyer’s bank

Bank transfer (note 3)

Notes

1 The seller sends an invoice to the buyer when the goods have been delivered.

2 The buyer makes the payment instruction to its bank. The payment is usually made from the
buyer’s current account, in its own currency. However payment may be made from a foreign
currency account.

3 The buyer’s bank arranges a bank transfer to the seller’s bank. The payment instruction is
transacted through the SWIFT system.

4 The seller’s bank forwards the payment to the seller, by crediting the seller’s account. Payment
may be made in the seller’s domestic currency or in a foreign currency, in accordance with the
currency identified in the invoice, and the seller’s instructions to its bank.

2.1 Card payments

Bank transfers are the most common method of making international payments by electronic means, for
a business transaction. Individuals and businesses are also able to make payments using a credit card or
debit card. For example, an importer can arrange to pay for goods by credit card provided that the
foreign supplier has a merchant bank card processing account (with an independent sales organisation,
acting as agent for card issuing companies) and is willing to accept international payments by this
method. The advantage of using card payments is that they are quick and simple to make. However,
credit cards often incur fees and charges, as well as the exchange rate fluctuations. Both credit and debit
cards have maximum payment limits, that may not be large enough to cover all payments.

International payments by credit card or debit card are similar to credit transfers, with the exception
that:

 The credit card holder has a period of credit before having to settle the account: with corporate
credit cards, unlike personal credit cards, the card holder is required to settle the account in full
each month.

 The actual transfer of funds is arranged through the card processing systems: a card holder
making a payment in a foreign currency will receive a statement showing the amount of the
payment in the card holder’s own currency.

2.2 SWIFT
The Society for Worldwide Interbank Financial Telecommunication (SWIFT) is a global association of
thousands of financial institutions, owned by its participating banks.

It operates a communication system and network, for the transfer of messages and instructions,
including payment instructions, between participating institutions.

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 The SWIFT system transfers messages and instructions using a common ‘language’ of codes.
Each bank has a unique identity code, so that secure messages can be sent within the system,
from one bank to another.

The SWIFT messaging system supports a large number of clearing and settlement systems, including
multi-currency settlements, and instructions for bank transfers between banks in the system are sent by
SWIFT message.

The SWIFT system provides for a fast settlement of transfers between banks. When a buyer’s bank
inputs instructions to the system for the transfer of a payment, the money is usually available at the
seller’s bank two working days later. Urgent SWIFT messages are processed more quickly, to enable the
funds to be made available to the seller sooner, but there is a higher fee for sending them.

2.3 SWIFTnet Trade Services Utility (TSU)

Key term
The SWIFTnet Trade Service Utility (TSU) provides a service that will allow the financial supply
chain to mirror the physical supply chain.

SWIFT has developed a new system, known as the SWIFTnet Trade Services Utility (TSU), which banks
may use to increase their intermediary role for trading conducted on open account. The system has been
in development since 2005 and currently only a limited number of banks use it, although its use is likely
to increase in the future if it proves to be successful.

The TSU system enables the buyer and the seller to monitor the progress of their transaction, when
trading is operated on open account terms. When their contract is agreed, the seller and the buyer both
submit confirmation of their transaction to their own banks using a standardised format. The banks then
input this information into a SWIFT database, where they are then matched.

As the trading transaction progresses, the seller submits updating information to its bank, such as
information about transportation and the invoice presentation. The bank then inputs the information into
the TSU system, which is then transmitted to the buyer’s bank and forwarded to the buyer.

SWIFT considers that its TSU system provides opportunities for banks to offer more services to
customers who are engaged in international trade on open account terms, by making information
available about the progress of the transaction. For example, it may enable banks to offer trade finance
for the transaction at an earlier stage in the process.

2.4 Foreign currency accounts

When a company buys and sells regularly in a particular foreign currency, it may choose to open a
currency account in that particular currency. An account can be opened with a branch of the seller’s own
bank in that country of trading, or it may be set up in cooperation with a banking partner of the seller’s
bank. This type of account is sometimes called a collection account).

 When a seller has a bank account in the buyer’s country, payments by the buyer can be paid into
the seller’s local account, meaning that the payment will be domestic rather than international
(and thus cheaper).

 Similarly, when a buyer has an account in the seller’s country, a domestic payment can be made
to pay the invoice.

In Malaysia, many businesses have foreign currency accounts with their local bank. They can arrange
for payments in the currency to a foreign seller to be made from the currency account and can arrange
for receipts in that currency to be made into the currency account.

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 INTERNATIONAL TRADE FINANCE

2.5 Responsibility of banks for late payments

When international trade is conducted on open account terms, there may be occasions where the buyer
is late making the payment to the seller. When this problem occurs, it is a matter for the seller and buyer
to resolve, as the banks are not affected. The only responsibility of the banks is to make bank transfers
as and when instructed to do so.

However, with documentary collections and documentary credits, banks are involved more closely in the
payment process and in some situations may have responsibility for late settlement.

3 Cheques and banker’s drafts

Electronic payments are now more common than paper-based payments, but there remains some
international trade transactions where payment is made in the form of a cheque or bank draft.

3.1 Payment by cheque

A normal cheque instructs the bank on which it is drawn to transfer a sum of money from the drawer's
account to the payee's account. The cheque is delivered to the payee. When the payee deposits the
cheque into their account, the transfer of the payment is made through the clearing process. Cheques
are easy to issue and do not require any IT infrastructure to administer. However, due to their long
clearing period, it can result in late or failed payments.

If the drawer of the cheque does not have sufficient funds in their current account, the cheque is
dishonoured and the payment is not made. There may be a delay in informing the payee that the cheque
has been dishonoured, which makes payment by cheque more risky than electronic payment methods
(where the availability of funds to make the payment is established quickly).

In international trade, when the seller and buyer do not have a foreign currency bank account with their
bank, payment by cheque is further complicated by the fact that the buyer’s currency of payment is
different from the seller’s domestic currency. If the buyer sends a cheque in their own domestic
currency, the seller will have to arrange with their bank for the payment to be collected (or negotiated)
and for the seller’s account to be credited in the seller’s own domestic currency.

 However, if the seller has a foreign currency account in the buyer’s currency (a ‘collection
account’), a payment (by bank transfer or cheque) can be made by means of a domestic
settlement between banks in the buyer’s country.

 If the buyer has a foreign currency account in the seller’s currency, and the invoice is
denominated in the seller’s currency, the buyer can make a payment (by bank transfer or cheque)
through their foreign currency account.

There is no international (cross-border) cheque clearing system. A foreign cheque is a cheque

issued in a foreign currency and payable at a foreign bank: for example if an Australian company paid a
Malaysian exporter by cheque, in Australian dollars and payable in Australia, this would be a foreign
cheque. For payment purposes, a foreign cheque payable to an exporter is sent abroad to the foreign
bank on which the cheque has been drawn.

3.2 Banker’s draft

Key term
A banker’s draft is a bank cheque where the funds are taken directly from the financial institution
rather than the individual drawer's account.

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 2: METHODS OF PAYMENT IN INTERNATIONAL TRADE

It is a method of payment whereby the credit risk of the seller (known as the payee or beneficiary) is
transferred from the buyer (the payer) to the buyer’s bank. Payment is taken directly from the bank, not
the buyer’s current account. When a banker’s draft is used to make a payment in international trade, the
buyer must ask the bank to arrange payment by banker’s draft. The bank will take the money (including
any applicable fees and charges) from the buyer’s current account before it issues a draft to the buyer.
The buyer then delivers the banker’s draft to the seller, who then arranges with their bank for the
payment to be settled.

A bank only issues a banker’s draft after it has taken the money from the buyer’s bank account. This
means that with this payment method, there is no risk that the buyer will not have sufficient funds in
their current account.

Banker’s drafts are more secure for sellers because payment is guaranteed by the buyer’s bank issuing
the banker’s draft. The only credit risk for the seller is that the buyer’s bank itself will be unable to make
the payment. This risk is usually extremely low, although it may be higher in some countries than in
others.

A banker’s draft can be issued in any currency. If the draft is denominated in the local currency of the
seller, sufficient funds are taken from the buyer’s bank account to purchase the currency required. When
the seller receives the draft from the buyer and pays it into their bank account, the funds are cleared
quickly.

However if the draft is in the seller’s currency, the process of collecting the payment and converting it
into the seller’s currency will take longer.

3.3 Receipt of payment by cheque or banker’s draft in a foreign currency:

negotiation and collection
When an exporter receives payment by banker’s draft or cheque in a foreign currency, its bank arranges
settlement. Drafts and cheques from another country, denominated in a foreign currency, are handled
either by negotiation or collection).

3.3.1 Payment by negotiation, purchased with recourse

Payment by negotiation can only be used if the draft or cheque is issued in the local currency of the
country on which it is drawn (for example, a cheque for US dollars payable in the USA). The foreign
currency draft or cheque is credited to the payee’s account, in local currency. This may take 4 – 5
working days after the payee has agreed to negotiation of the draft or cheque.

The bank will pay the value of the draft or cheque, less charges, using the current currency exchange
rate.

The bank then sends the cheque or banker’s draft to the buyer’s bank, for collection of the payment.

‘With recourse’ means that if the cheque or draft is dishonoured, the bank will recover the money from
the exporter by debiting their account with the amount previously credited, plus further charges. So if
the payment is not honoured by the buyer’s bank, the seller’s bank will debit the seller’s account the
value of the draft or cheque (the amount previously credited to the account for the draft or cheque) plus
a handling fee.

3.3.2 Payment by collection

Sometimes a bank will not negotiate a foreign currency banker’s draft or cheque, for example:

 If the payment is coming from a high-risk country (for example, an unstable economic or political
environment);

 If it is not issued in the local currency of the sender's country (eg Australian dollars payable in
Singapore).

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 INTERNATIONAL TRADE FINANCE

In these situations, the seller’s bank sends the banker’s draft or cheque to the bank on which it is drawn
and will not credit the seller’s account until the payment has been collected and the bank has physically
received the money.

This can take some time, depending on the country the payment is coming from and the bank clearing
the payment.

The process of international payment by cheque is summarised in the following diagram.

Figure 2.2: Payments by cheque

Invoice (1)
Seller Buyer

Cheque (2a)

Payment (5) Cheque (2b) Payment (3)

Cheque (2c)
Seller’s bank Buyer’s bank

Payment (4)

Notes
1 The seller submits an invoice to the buyer.
2a The buyer pays by cheque in the buyer’s currency and sends the cheque to the seller.
2b The seller pays the cheque into his bank.
2c The seller’s bank sends the cheque to the buyer’s bank, for collection of the payment.
3 The buyer’s bank takes the payment from the buyer, plus charges.
4 The payment is collected by the seller’s bank from the buyer’s bank. Payment is made through
the appropriate inter-bank settlement system.
5 The seller’s bank credits the seller’s account with the payment, in the seller’s currency (less
charges). The payment may not be made until after the money has been collected from the
buyer’s bank. Alternatively, the bank may negotiate the cheque and pay the funds (with recourse)
to the seller before payment has been collected from the buyer’s bank. The seller will receive the
money sooner, but must pay a negotiation fee to the bank.

6 The procedure is slightly different with a banker’s draft. The buyer purchases the draft from the
bank and sends this to the seller. The seller then presents the banker’s draft to its bank for
payment.

4 Countertrade
Countertrade is a term used in international trade where goods are exchanged for other goods (in
whole or in part) instead of for payment in cash (‘hard currency’).

There are three broad categories of countertrade:

 Barter
 Counter-purchase
 Offset

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4.1 Barter
This is the direct exchange of goods between two parties. This occurs when a buyer in one country is
unable to pay in currency, and therefore arranges payment in the form of goods, that the other party
can readily sell for cash on the world market.

For example, one party may supply scientific equipment to the other party, in exchange for payment in
oil. The company supplying the scientific equipment may can then sell the oil on the world market for a
cash payment of a major exchangeable currency such as US dollars. This can then be exchanged for the
currency of the original company selling the scientific equipment.

4.2 Counter-purchase
This is an arrangement in which a foreign seller supplies goods to the buyer and, as part of the deal,
agrees to buy goods (or services) in the buyer’s country to the value of the goods that it has sold. For
example, if an American exporter arranges to sell electronic equipment to a buyer in the Philippines, it
may agree as part of the deal to buy goods from suppliers in the Philippines up to the value of its sale.
The goods that it buys may or may not be related to the goods that it sells.

With a counter-purchase agreement, the exporter agrees to buy a specific total value of goods from a
nominated list, but it cannot buy goods produced with the technology that the exporter is selling to the
buyer. This means that the exporter is likely to buy goods for which it has no use in its own business,
therefore, it may use a trading firm to market the goods.

Alternatively, a trading firm may:

 Purchase goods from a manufacturer in its own country.

 Sell the goods under a counter-purchase agreement to a foreign buyer.
 Sell the goods independently.

For example, an import-export company in China may purchase soya bean meal from local producers
and enter into a counter-purchase arrangement with a European company to exchange soya bean meal
for wheat. The Chinese company would sell the wheat palm oil in the market. Similarly, the European
seller of wheat may need to arrange the sale of the soya bean meal through a trading organisation.

Counter-purchase arrangements may be negotiated where the foreign buyer is the government of the
country, or where the government is involved in the arrangement. An example of counter-purchase in
the past has been the provision of infrastructure construction work to the African Democratic Republic of
Congo by Chinese construction firms, in return for the purchase of metals from the African Democratic
Republic of Congo by the Chinese companies.

4.3 Offset
In an offset arrangement, a foreign seller supplies manufactured products to a buyer and, as part of the
deal, agrees either to:

 Buy raw materials or components from the buyer’s country, to go into the manufacture of the
goods that it produces.

 Supply the components for the products and arrange for these to be assembled into the finished
product in the buyer’s country.

This type of arrangement may occur, for example, in the aerospace industry.

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4.4 Benefits and disadvantages of countertrade

A major benefit of countertrade for the buyer is that it may operate in a country where buyers find it
difficult to pay in foreign currency. For example:

 The currency of the buyer’s country may be non-convertible into other currencies.

 There may be a general lack of foreign exchange in the country due to the strict controls over
foreign payments, or that foreign currency is difficult to obtain.

This may be the situation, for example, when the buyer is located within a developing country.

For the government of the buyer’s country, countertrade may be beneficial by providing work and
employment to the country.

For the seller, a benefit of countertrade is that this type of arrangement may be necessary to win export
business.

The main disadvantages of countertrade are that:

 It may be difficult to establish an agreed value for the goods that are exchanged, especially if the
products have a volatile market price (for example, commodities such as agricultural produce or
oil).

 The negotiation of countertrade arrangements may be time-consuming, and therefore only viable
for large transactions.

In barter arrangements it is essential that the party to the transaction that does not really require the
goods that it receives, must be able to sell the goods easily and for a fair price on the open market. For
example, if a supplier of optical equipment is paid in cashew nuts by the other party, it is essential that
the cashew nuts can be sold on the world markets where the market is liquid and the price is fairly
stable.

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Chapter roundup

 Most international trade is conducted on open account terms, especially between sellers and buyers in
developed countries. Trading on open account is trading on normal credit (deferred payment) terms.

 Other methods of payment are payment in advance (not common), documentary collections and
documentary credits (letters of credit).

 When trading is on open account, the method of payment is often electronic funds transfer, although
cheques and bank drafts are sometimes used.

 With open account trading, the role of banks is limited to making the payments. Banks have a bigger role
in documentary collections and an even bigger role in documentary credits.

 Banks use the SWIFT messaging system. The SWIFT messaging system supports a large number of
clearing and settlement systems, including multi-currency settlements. Instructions for making bank
transfers are sent by SWIFT message.

 SWIFTnet Trade Services Utility (TSU) has been developed as a system for monitoring the progress of
international trading transactions on open account.

 Foreign currency accounts can be used by importers to pay for goods and by exporters for receiving
payments, avoiding the need for an exchange of currencies to make the settlement.

 When payment is by cheque or bank draft, a bank in the exporter’s country may agree to negotiate the
cheque or draft (with recourse in the event of dishonour), so that the exporter receives funds sooner.

 Alternatively, cheques or drafts require collection from the payer, and the money is not paid to the
exporter until the funds have been received. This can be a slow process.

 Some international trade is conducted by countertrade. This is the exchange of goods rather than a
purchase/sale for cash. Countertrade involves barter, counter-purchase or offset agreements.

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46
chapter 3

DOCUMENTARY COLLECTIONS

Contents
1 Definition of collection ............................................................................................... 48
2 The parties to a collection .......................................................................................... 49
3 Outline of the documentary collection process .............................................................. 49
4 Bill of exchange ........................................................................................................ 54
5 Documents against payment and documents against acceptance .................................... 56
6 The collection instruction ........................................................................................... 57
7 Uniform Rules for Collections (URC 522) ...................................................................... 58
8 Practical problems with documentary collections ........................................................... 63
9 Summary: advantages of documentary collection .......................................................... 64
10 Summary of URC 522 ................................................................................................ 65
Chapter roundup............................................................................................................ 68

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Learning outcomes
On completion of this chapter you should be able to:

 Analyse the purpose, advantages and risks of documentary collections and bills of exchange.
 Appraise the role of the International Chamber of Commerce and the application and benefits of
the Uniform Rules for Collections.

Learning objectives
While working through this chapter you will learn how to:
 Analyse the nature of collections and the difference between clean and documentary
collections.
 Identify the parties to a collection.
 Analyse the stages in the documentary collection process and the role of banks in the process.
 Distinguish the nature and features of bills of exchange.
 Distinguish between documents against payment and documents against acceptance.
 Describe the information included on a collection instruction.
 Demonstrate the application of the rules in the Uniform Rules for Collections (ICC
Publication Number 522).
 Describe the advantages and practical problems with documentary collections.
 Examine the main rules in the Uniform Rules for Collections (URC 522).

Introduction
Most international trade is conducted on open account terms, but for some, a different method of
payment is used giving greater security to the seller. There are two such methods of payment:
documentary collections and documentary credits. This chapter explains the nature of documentary
collections, followed by an overview of the standard internationally-accepted Uniform Rules for
Collections, which are published by the International Chamber of Commerce (ICC).
Documentary collections may be appropriate for a transaction where the goods take a long time to ship
to the buyer, with a bill of lading used as the transport document, rather than a waybill. Since the bill of
lading is a document of title to the goods, the buyer cannot take control of the goods without either
having paid, or given reasonable assurance of his intention to pay, by accepting a bill of exchange.
A payment by bank transfer, or cheque, is common for trade on open account terms, whereas a bill of
exchange is used with documentary collections.

1 Definition of collection
The term ‘collection’ in international trade means the handling by banks of documents in accordance
with instructions received. The ‘documents’ may be a financial document, commercial documents or a
combination of both.

1.1 Clean collection

A clean collection is a collection of financial documents by a bank, without any accompanying
commercial documents. A clean collection may therefore involve:

 A bank handling a cheque to obtain payment.

 A bank handing a bill of exchange (or promissory note) to obtain payment.

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 A bank handling a bill of exchange to obtain acceptance.

The most important point about a clean collection, is that there are no commercial documents in the
collection process, only financial documents.

1.2 Documentary collection

A documentary collection is the collection of:

 Financial documents accompanied by commercial documents.

 Commercial documents without any accompanying financial document.
In this chapter, the focus is on documentary collections that involve financial documents accompanied by
commercial documents.
A documentary collection is a method of payment in international trade that provides greater security to
the seller, rather than trading on ‘open account’ terms.

2 The parties to a collection

There are five potential parties involved in a collection:
 Principal. The principal is the person who begins the process by asking a bank to make a
collection. In international trade, the principal is the seller/exporter.
 Remitting bank. This is the bank used by the principal to handle the collection. The remitting
bank is situated in the same country as the exporter/principal, and will usually be the exporter’s
bank. The remitting bank sends a collection instruction to a bank in the buyer’s country.
 Collecting bank. This is a term for any other bank involved in the collection process, other than
the remitting bank. The collecting bank is usually situated in the country of the buyer. The
collecting bank may also be the presenting bank.
 Presenting bank. This is the collecting bank that makes the presentation of the documents to
the drawee, in accordance with the collection instruction. The presenting bank may be the single
collecting bank, receiving the collection instruction direct from the remitting bank. Alternatively,
the first collecting bank may ask another bank to act as the presenting bank.
 Drawee. This is the person to whom the presentation is made by the presenting bank, in
accordance with the collection instruction. In international trade, the drawee is the buyer of the
goods/importer.

3 Outline of the documentary collection process

The documentary collection process is as follows:

1 The exporter and buyer agree a  They specify documentary collection as the method

commercial contract for the sale of payment and the payment terms (D/P or D/A).

and shipment of goods.  They might name the collecting/presenting bank.

There is usually only one collecting bank in the
collecting process, which will be the presenting bank.
This is usually the buyer’s bank.
 They agree a list of documents that must be included
in the collection and the number of copies of each
document. These usually include a bill of exchange
(financial document) and a bill of lading (as one of the
commercial documents).

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2 The exporter ships the goods to the

buyer and obtains a negotiable
transport document (a bill of
lading) from the shipping firm.

3 The exporter gathers the The commercial documents include the bill of lading.
documents required for the
The financial document is usually a bill of exchange,
collection and gives these (‘remits’
which may be payable either ‘at sight’ or at a later date.
the documents) to the remitting
bank, together with a collection
order. This collection order sets out
the terms and conditions under
which the bank should hand the
documents to the buyer.

4 The remitting bank sends the The remitting bank instructs the collecting/presenting
collection order and the documents bank to present the documents to the drawee, in
to the collecting/presenting bank in exchange for either payment (‘documents against
the buyer’s country. payment’) or acceptance of a bill of exchange
(‘documents against acceptance’).

5 The collecting/presenting bank The presenting bank:

checks that the documents are in
 Notifies the drawee about the terms and conditions
order and in accordance with the
of the collection order.
collection order, and presents them
to the drawee.  Releases the documents to the drawee when these
terms and conditions have been met (payment or
acceptance).

If the commercial documents include a negotiable bill of

lading, which is a document giving legal title to the
goods, the buyer obtains the document of title and so
can take control and possession of the goods.

6 The buyer either pays immediately When documents are released against acceptance of a
for the goods when the documents bill of exchange, payment of the accepted bill must be
are released (documents against collected at the due date for payment. This payment
payment) or accepts a bill of will be collected at the appropriate future time in a
exchange, promising to pay at a clean collection.
future date (documents against
acceptance)

7 When payment is received, the

collecting/presenting bank remits
the payment (less fees) to the
remitting bank.

8 When payment is received, the

remitting bank pays the exporter.

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This process can be shown diagrammatically.

Figure 3.1: Documentary collection process

Goods
Seller Buyer

Presentation of
Payment/ Collection documents Payment/
Acceptance order Acceptance

Collection order
Remitting bank Collecting/Presenting bank
(Seller’s bank) (Buyer’s bank)
Payment/Acceptance

Notes:

1 The collection order is accompanied by the appropriate documents, as specified in the collection
order.

2 When the first collecting bank is not also acting as the presenting bank, the collection order with
documents is sent by the first collecting bank to the presentation bank, and payment or
acceptance flows in the other direction, from the presenting bank to the first collecting bank and
then to the remitting bank.

3 When the collecting bank is not also acting as the presenting bank, this may be because the
principal has not specified the buyer’s bank as the presenting bank, and the remitting bank has
selected its correspondent bank in the buyer’s country as the collecting bank. This correspondent
bank might then ask the buyer’s bank to act as the presenting bank for the collection.

Illustrative copies of collecting instructions are shown on the following page.

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Trust
Address:

Trust Bank Telex

SWIFT
Fax

Dear Sirs, Date 12/09/200X

We enclose the following draft(s)/documents as specified

hereunder which please collect in accordance with the Our Reference: TBL/6670980091209200X
instructions indicated herein

Mail to:

Standard Chartered Bank

1095 Avenue of the Americas
New York

Drawer: Drawee:

JPNO Industry Ltd ABC Manufacturing

89 Metro Plaza 200 Park Avenue
Nagoya East 45th Street
Japan New York 10166

Tel No.1-677-695-0789, Fax No 1-677-695-0790

Deliver documents against Payment Due date/Tenor At Sight

Drawer's Reference SLK 5678910 Amount USD15,333.30

Documents:

Draft Inv Packing Weight BL Ins Quality Bene Cert Air GSP Analysis Halal Others
List List Policy Cert Cert of Waybill Form Cert Cert
Origin

2 2 2 2 2 2 2 1 1 1

Special Instructions:

Please acknowledge receipt of this Collection.

All your charges are to be borne by the drawee, do not waive charges.

In case of a time bill, please advise us of acceptance giving maturity date.

In case of dishonour, please do not protest but advise us of non-payment/non-acceptance by SWIFT, giving
reasons.

Please collect interest at 9% p.a. from date of first presentation till date of payment. Do not waive.

Disposal instructions upon collection:

PLS REMIT THE AMOUNT TO BANK OF TRUST, NEW YORK BRANCH NEW YORK N.Y USA FOR CREDIT OF OUR NAGOYA
ACCOUNT WITH THEM UNDER YOUR AND THEIR ADVICE TO US QUOTING OUR REFERENCE NUMBER.

Unless otherwise specified, this collection is subject to Trust Bank Ltd

Uniform Rules for Collections (ICC Brochure No 522)
Simon Veng Elizabeth Veron
Authorised Signatories

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Consignor Name of Remitting Bank & Address

Consignee Terms of Payment

Sight …… days sight

Amount

The documents are for purchase/discount subject The documents are to be sent for collection
to final payment.

Documents are as listed below

hr Packing Weight BL Ins Quality Bene Cert of Air GSP Analysis Halal Others
List List Policy Cert Cert Origin Waybill Form Cert Cert

Document:

Description of Goods:

Sections:
Deliver documents against Do NOT protest Protest for non payment
payment
Deliver documents against Protest for non-acceptance All charges to be paid by us
acceptance
Acceptance may be deferred Waive interest/collection charges if Do not waive
pending arrival of vessel refused by drawee and charge them interest/collection charges if
to us refused by drawee
Interest to be collected from drawee at ………% from date of bill until …….. Your charges to be paid by
drawee
Instructions:

Proceeds disposal instruction:

Credit our A/C No ………………… with you upon purchase/discount of this bill
Credit our A/C No ………………… only upon receipt of collection proceeds
Issues us your Banker’s Cheque
Remit proceeds via Rentas to our A/C No ……………. with …………………. Bank.
Please apply rate against FC Contract No …………………………………….
………………………………………………………………………………………………….
……………………………………………………………………………………………….

Unless otherwise specified, this collection is Drawer’s Name, Stamp & Signature
subject to ICC Uniform Rules for Collections
current version.

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4 Bill of exchange
In a documentary collection, the financial document is commonly a bill of exchange (sometimes called a
draft). Bills are also used with documentary collections, which are describe in the next chapter, and may
also be used when trade is on open account terms.

A bill of exchange has some similarities with a cheque, especially after it has been accepted. However,
whereas a cheque is written by the payer, a bill of exchange is written by the person who will be paid. A
bill of exchange is ‘drawn’ by one person (the drawer) on another (the ‘drawee’), ordering the drawee to
make a payment.

4.1 Definition of a bill of exchange

A bill of exchange is:

 An unconditional order in writing

 Signed by the drawer
 Requiring the drawee to pay on demand (‘at sight’) or at a fixed or determinable future date
 A specified amount of money
 To the order of a specified person
A bill of exchange is ‘drawn’ by the issuer of the bill (the drawer) on the person who is required to make
the payment (the drawee).

4.2 Trade bills and bank bills

Key term
A trade bill is a bill of exchange which is a demand for the payment of a trade debt, where the drawee
is a non-bank organisation. In international trade, a trade bill would be drawn by the exporter on the
importer, as an order to make a payment.

A bank bill is a bill of exchange that is drawn on a bank. In international trade, banks will often allow a
customer to draw a bill on the bank, as an arrangement for providing export or import (buyer) finance.
Bank bills are used with documentary credits, which are described in the next chapter.

4.3 Sight bills and usance bills (time bills)

A bill is either of:

 A sight bill
 A usance bill (also called a term bill or time bill).

Key term
A sight bill is a bill that must be paid immediately on presentation to the drawee. It is payable ‘at sight’.
The drawee demonstrates his willingness to pay the bill by making the immediate payment.

A usance bill (or term bill/time bill) is a bill that is presented to the drawee for payment at a future
date. When it is drawn, a bill is an order to pay, and not a promise by the drawee to make the payment.
The drawee is required to indicate his willingness to make the payment by ‘accepting the bill’.

 A bill is accepted by means of a signature of the drawee (an authorised signatory of the drawee
company) and suitable wording to indicate that the drawee has accepted the bill.

 When a bill of exchange is payable at a future date after acceptance, it is sometimes called a
draft until it has been accepted, and is only called a bill of exchange after it has been
accepted by the drawee.

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 With acceptance, the bill of exchange becomes an undertaking by the drawee to make payment.

The date for payment must be ‘determinable’. There are different ways in which this date (‘maturity’)
may be specified. A bill may be specified as payable:

 A specified number of days after sight of the bill by the drawee, or

 On a specific future date.

At maturity, a usance bill is re-presented to the drawee, who is required to make the payment. The
payment must be either to:

 The person specified in the bill, or

 The holder of the bill, in cases where the bill has been sold by the drawer before maturity to
another person. This holder of the bill may be the drawer’s bank.

4.4 The format of a bill of exchange

A simplified diagram of a trade bill of exchange is shown below.

Figure 3.2: Bills of exchange

Drawer reference number Date of issue Maturity

[date] At sight
Payable at: Pay against this bill of exchange to:

[Bank name and address] [Drawer’s name]

Amount in words and currency Currency and
amount in figures

For:
Value received in goods as shown in invoice [number and date]

Accepted by drawee Drawer’s signature

[Drawee signature, plus full name and address] [Drawer signature, plus full name and address]
Notes:

1 When signed by the buyer, a bill of exchange becomes similar to a cheque – an undertaking by
the drawee to make the payment.

2 The date of issue is usually the date of shipment of the goods or the date of the invoice (or
another date specified in the contract between buyer and seller).

3 A bill of exchange is either paid ‘at sight’ when it is presented to the drawer, or it is accepted by
means of adding the drawee’s signature and payable at a later date. The example above is
payable at sight and is a sight bill.

A bill payable at a future date is called a usance bill or term bill. The maturity for a term bill
may be a specified future date, or after a specified number of days after presentation to the
drawee (for example, ‘at 60 days’ sight’) or at a specified date after the issue date for the bill (for
example, ‘at 60 days’ date’).

4 A bill of exchange for exported goods is normally payable to the exporter. However, a term bill of
exchange may be endorsed (countersigned by the drawer on the reverse side of the bill) in order
to transfer the right to payment to someone else.

5 The place of payment specifies the obligations of the drawee, by indicating where payment should
be made.

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4.5 Bills and collections

In a documentary collection, an accepted bill is given by the drawee to the collecting bank, and the
bill may then either be:

 Held by the collecting bank until payment date.

 Remitted to the remitting bank, in accordance with the instructions in the collection order.

The bill is subsequently paid on the due payment date in a clean collection.

It is important to understand the nature of a bill of exchange, including a bank bill. The use of bills in
collections is explained in the rest of this chapter. The use of bills in documentary collections (‘letters of
credit’) and in providing trade finance for exporters and importers, are described in later chapters.

5 Documents against payment and documents against

acceptance
As indicated earlier, there are two types of documentary collection:

 Documents against payment (D/P)

 Documents against acceptance (D/A)

With documents against payment (D/P), the presenting bank informs the buyer that the documents
have arrived and requests payment of the amount as instructed in the collection order.

When the buyer makes payment against the bill of exchange, the presenting bank gives the buyer the
commercial documents in the collection.

With documents against acceptance (D/A), the presenting bank informs the buyer that the
documents have arrived and requests acceptance of the bill of exchange as instructed in the collection
order. When the buyer accepts the bill of exchange, the presenting bank gives the buyer the commercial
documents in the collection.

The bill is subsequently presented for payment at a later date in a clean collection.

When the collection is D/A, the exporter is giving the buyer a period of credit before requiring
payment.

5.1 The commercial documents in a documentary collection

The collection order should specify how many original copies of each document must be presented. For
some documents, such as a bill of lading or waybill, several original copies are usually required.

The commercial documents in a documentary collection usually include:

 A commercial invoice for the goods.

 A bill of lading (transport document) for the goods, which is also a document of title to the goods,
or a waybill.

The document of title to the goods is given to the buyer only when the buyer has either paid for them or
accepted a bill of exchange, in accordance with the terms of their commercial agreement.

Since the buyer cannot take control and possession of the goods until payment or acceptance, a
documentary collection gives some security to the seller that he will be paid for the goods. D/P
is more secure than D/A, because there is always a risk that the drawee will fail or refuse to pay an
accepted bill on the payment date.

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5.2 Other commercial documents

A potential problem with documentary collection for the buyer is that he does not get an opportunity to
inspect the goods himself before paying for them or accepting a bill of exchange. However, there are
measures that the buyer can take to deal with this problem.

The seller and buyer may agree in the commercial contract that the goods should be inspected at some
point in their transportation by:

 The buyer or the buyer’s agent.

 An independent firm of inspectors.

An independent inspector, having checked the goods, issues a certificate of inspection. This states that
the goods have been checked and:

 They are in good condition, or they are damaged in some way – in which case, the nature of the
damage should be specified.

 The shipment contains the correct quantity of the goods.

The buyer can check the inspection certificate before payment or acceptance.

Other commercial documents that the buyer may ask the seller to supply, as part of the commercial
agreement and arrangement for payment by documentary credit, are:

 A certificate of origin of the goods.

 A packing list and/or weight list for the goods.

 A quality certificate for the goods.

 Other specialised certificates, such as a performance certificate.

 An insurance certificate or an insurance policy, to check that the goods have been insured for
their transportation, as agreed between seller and buyer. (Alternatively, a takaful equivalent.)

 Halal certificate.

6 The collection instruction

A collection instruction or collection order must contain sufficient information to allow the bank receiving
the instruction to act on it. A bank will act only on the instructions in the collection order, and will not
examine any other documents to find additional instructions.

If the collection is subject to the Uniform Rules for Collections (see next section), the collection
instruction must state that these rules apply and must also contain the following items of information, as
appropriate:

 The full name and address of the remitting bank from which the collection instruction comes, plus
contact details and SWIFT address.

 The full name and address of the principal.

 The full name and postal address or domicile of the drawee, and contact details.

 Details of the presenting bank.

 The amount (and currency) to be collected.

 A list of the documents in the collection and with the collection instruction, and the number of
copies of each document.

 For a documentary collection, whether delivery of the documents should be against payment or
acceptance.

 Any charges or interest to be collected, and whether these items may be waived or not.

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 The method of payment and the form of payment advice.

 Instructions in the event of non-payment or non-acceptance by the drawee, or in the event of

non-compliance with any other instructions in the collection instruction.

6.1 Case-of-need
The presenter may also specify a ‘case-of-need’ in the collection instruction. A case-of-need is a person
who the collecting or presenting bank should consult in the event of non-payment or non-acceptance by
the drawee.

The collection order must specify the powers of this case-of-need. In the absence of any such
specification, the banks will not accept any instructions at all from the case-of-need.

For example, a collection order may include a statement:

‘In case of difficulties, the collecting bank is requested to inform our representatives, [name and
address], who will be of assistance. However, our representative may not alter any of this collection
instruction.’

7 Uniform Rules for Collections (URC 522)

The International Chamber of Commerce (ICC) first published its Uniform Rules for Collections in 1956,
although these have been updated several times since then. The current version is the Uniform Rules for
Collections (ICC Publication Number 522) published in 1995.

These are voluntary rules which are agreed between buyer and seller, but they have gained widespread
acceptance as international rules for collections, because they eliminate errors and misunderstandings in
the collection process that would occur if standardised rules did not exist.

When the seller and buyer agree that the method of payment should be documentary collection, and
that the rules in URC 522 should be applied, this is specified in the collection order from the principal
(exporter) to the remitting bank.

When URC 522 is specified in the collection order, all the parties are bound by the Uniform Rules. (A
bank is not obliged to handle a collection, but must inform without delay the party from whom the
collection instruction has been received.) Banks may act only in accordance with the collection instruction
and the Uniform Rules for Collection.

7.1 The presenting bank and collecting bank

The remitting bank should use the bank nominated by the principal as the collecting bank. (The exporter
may nominate the buyer’s bank as the collecting bank, having obtained the details of this bank from the
buyer.)

If the principal does not specify a collecting bank, the remitting bank may use a collecting bank of its
own choice, in the country of payment or acceptance.

If the remitting bank does not nominate a specific presenting bank, the collecting bank may use a
presenting bank of its own choice. (However, as indicated earlier, the collecting bank often acts as the
presenting bank.)

7.2 Release of commercial documents against sight or acceptance

If the collection instruction states that the commercial documents should be released to the drawee
against payment (D/P), the presenting bank must make the presentation for payment without delay.

Similarly, if the collection instruction states that the commercial documents should be released to the
drawee against acceptance (D/A), the presenting bank must make the presentation for acceptance
without delay. (Where payment of a term bill is requested, the presentation for payment should be not
later than the appropriate maturity date for the bill.)

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When a collection includes a bill of exchange that is payable at a future date, the collection instruction
must state whether the commercial documents should be released to the drawee against acceptance
(D/A) or against payment (D/P).

 If the collection order does not specify either method, the documents should be released only
against payment.

 If the collection order states that the documents should be released only against payment of a
term bill, this instruction must be followed, and the documents should only be released at the
future date when the bill is paid.

The rule about the release of documents (Rule 7 in URC 522) is summarised in the following diagram.

Figure 3.3: Release of documents

Collection order

Sight bill Usance/time bill of exchange, payable at a future date.

The collection order instructs:

Delivery against Does not specify Delivery against

payment acceptance

D/P D/P D/P D/A

Release Do not release Do not release Collection instruction
documents commercial commercial may specify that
against documents until documents until acceptance may be
immediate payment payment delayed until the
payment arrival of the vessel in
the port of destination

7.3 Banks and the goods in the commercial contract

A documentary collection is a procedure involving documents only. It does not involve the underlying
goods.

However, there are occasions when the seller may wish to send the goods:

 To a bank, for example the collecting bank, or

 To the order of a bank – for example, putting the goods under the control of a bank when they
are held in storage in the buyer’s country and before release of the document of title to the
buyer.

This may happen when the seller has no other agent in the buyer’s country to take charge of the goods
before they come under the control of the buyer.

Article 10 of URC 522 states that a bank has no obligation to take possession or control of the goods,
but it may choose to do so.

 Goods should not be despatched directly to the address of a bank, or consigned to the order of a
bank, without prior agreement of the bank.
 Even so, the exporter may still decide to dispatch the goods directly to the address of a bank, or
consigned to the order of a bank, without prior agreement of the bank, and with an instruction
that they should be released to the buyer only against payment or acceptance. If this happens,
the bank is under no obligation to take possession or control over the goods, and the goods
remain at the risk and responsibility of the sender (exporter).

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Whenever a bank receives goods or is given control over the goods before presentation for payment or
acceptance, the bank may take action to protect the goods, whether instructed or not. The bank must
notify the person from whom it has received the collection instruction that it has taken this action, and
any charges or costs incurred in connection with this action are for the account of the person from whom
it received the collection instruction.

However, the bank assumes no liability for:

 The condition and fate of the goods, or

 Acts or omissions by a third party entrusted with the custody and protection of the goods (for
example, a warehousing or storage company).

When the buyer subsequently honours the collection by making payment or acceptance, as specified in
the collection instruction, and the collecting bank arranges for release of the goods to the buyer, the
remitting bank is deemed to have authorised the collecting bank to do so.

7.4 Non-liability of banks: disclaimers

The Uniform Rules for Collection state that banks have no liability or responsibility for any of the
following. (This non-liability is referred to as a ‘disclaimer’.)

 A remitting bank using the services of one or more collecting/presenting banks to implement a
collection order from the principal does so for the account of, and at the risk of, the principal. (In
other words, the principal is liable for the cost and for anything that may go wrong.)

 A bank has no responsibility or liability in the event that the collection instructions they sent to
another bank are not carried out by the other bank.

7.4.1 Documents received and their effectiveness

Banks are obliged to check that the documents they have received in a collection appear to be the
documents listed in the collection instruction. They must immediately notify the person from whom the
collection instruction was received, of any missing documents, or any additional documents received that
are not listed in the collection order.

A bank has no other obligation to check the documents.

Banks assume no liability or responsibility for the form, accuracy or sufficiency of the documents they
receive and handle. Banks also have no liability or responsibility for:

 Ensuring that the documents are genuine or false;

 The description, value, quantity, weight, quality or packing of the goods;

 The good faith or acts of any third party, such as a carrier, freight forwarder, consignee of the
goods or insurer of the goods.

Unless the bank has agreed to take possession of the goods, or to have the goods consigned to it, the
bank has no liability or responsibility for delivery of the goods, or whether they exist.

In addition, although the presenting bank is responsible for checking that the form of acceptance of a bill
of exchange appears to be correct, it is not responsible for:

 The legitimacy of the drawee’s signature on the bill, or

 Whether the person who signed the bill in acceptance had authorisation from the drawee to do
so.

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7.4.2 Delays and loss of messages or documents in transit

The URC also states that a bank should not be liable or responsible for the consequences of any delay, or
loss in transit of any:

 Message
 Letter
 Document

Similarly, a bank cannot be held liable or responsible for the consequences of any:

 Delay or mutilation in the transmission of a communication.

 Translation or interpretation of technical terms.

7.4.3 Force majeure

Banks accept no liability or responsibility for consequences that arise from interruption to their business
by ‘force majeure’ – ‘Acts of God, riots, civil commotions, insurrections, wars, or any other causes beyond
their control or by strikes or lockouts’ (Article 15, URC 522).

7.5 Payment
Payments received from the drawee, less charges and any disbursements or expenses, must be
immediately made available, to the party from whom the collection instructions were received.

Unless agreed otherwise, the collecting bank will make the payment in favour of the remitting bank only.

 If the collection instruction states that payment will be made in the local currency of the drawee,
the presenting bank should release the documents against payment in the local currency only if
this currency is immediately available in the manner specified in the collection instruction.

 If the collection instruction states that payment will be made in a foreign currency, the presenting
bank should (unless otherwise instructed in the collection order) release the documents against
payment in the foreign currency only if this can be remitted immediately in accordance with the
collection instruction.

7.5.1 Partial payments

The buyer/drawee may propose to make partial payments, instead of making a single payment of the
entire amount.

 For a clean collection, partial payments may be accepted (provided that they are legally
acceptable in the country of payment).

 For a documentary collection, partial payments should only be accepted if they are specifically
authorised in the collection instruction.

 If partial payments are authorised in the collection instruction for a documentary collection, the
documents should be released to the drawee only after full payment has been received.

7.6 Interest
A collection instruction may specify that the drawee should pay interest. If so, it must specify the:

 Rate of interest

 Interest period (number of days)

 Basis of calculation of the interest (whether the interest should be calculated on the basis of a
360-day or 365-day year).

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If the collection instruction states that interest should be collected, but the drawee refuses to pay the
interest, the presenting bank may deliver the documents against payment or acceptance without
collecting the interest.

An exception to this rule is where the collection instruction states specifically that the payment of interest
must not be waived. In this situation, the presenting bank must not deliver the documents against
payment or acceptance if the drawee refuses to pay the interest, but the presenting bank will not be
responsible for the consequences of any subsequent delay in the collection.

7.7 Charges and expenses

A collection instruction may specify that any charges or expenses should be payable by the drawee
(‘for the account of the drawee’).

If the collection instruction states that charges and expenses should be ‘for the account of the drawee’,
but the drawee refuses to pay them, the presenting bank may deliver the documents against payment or
acceptance, without collecting the charges or expenses.

An exception to this rule is where the collection instruction states specifically that the charges or
expenses must not be waived. In this situation, if the drawee refuses to pay them, the presenting bank
must not deliver the documents to the drawee. The presenting bank must send a telecommunication
immediately to the bank from which the collection instruction was received, but it will not be responsible
for the consequences of any delay in the collection, as a result of the drawee’s refusal to pay the costs.

Alternatively, a collection instruction may specify that any charges or expenses should be payable by
the principal. In this situation:

 The collecting bank is entitled to recover expenses and charges from the bank from which the
collection order was received.

 The remitting bank is entitled to recover all expenses and charges promptly from the principal,
regardless of the fate of the collection.

7.8 Protest
A bill of exchange provides formal documentary evidence that a demand for payment or acceptance has
been made to the buyer/drawee. When the buyer refuses to pay or accept the bill, it may be possible to
take legal action against the drawee. A seller can protect his interests by stating in the collection
instruction that the bill of exchange be either ‘noted’ or ‘protested’ for non-payment or non-acceptance.
When a bill of exchange is not paid or accepted it is said to have be ‘dishonoured’.

7.8.1 Noting a bill

A bill of exchange is ‘noted’ to obtain official evidence that it has been dishonoured. A lawyer (a ‘notary
public’) re-presents the bill to the drawee for acceptance or payment and makes a note on the bill the
reason given by the drawee for dishonouring the bill. Noting is often followed by a formal legal ‘protest’.

7.8.2 Protesting a dishonoured bill

Key term
Protesting is a more formal process than noting. The ‘notary public’ issues a formal deed of protest.
This document provides formal evidence of the presentation of the bill to the drawee and the reason for
dishonouring the bill.

A protest is accepted by a court as evidence that the bill has been dishonoured, and this provides the
basis for legal action against the drawee.

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7.8.3 Collections and protesting a bill

The collection instruction may include specific instructions about protest (or any other legal process) in
the event of non-payment or non-acceptance.

 If the collection instruction does not contain any such instructions, the banks concerned with the
collection are under no obligation to protest the bill.

 Any charges or expenses incurred by a bank in connection with protesting a bill (or any other
legal process) should be for the account of the person from whom the collection instruction was
received.

7.9 Advice
‘Advice’ in the context of collections means ‘advising fate’ and providing information about what has been
done and what has happened. The remitting bank is responsible for specifying in the collection
instruction what form ‘advices’ should take.

Without delay, the collecting bank must send advice of payment to the remitting bank, giving details of
the amount collected and the charges and expenses deducted.

When the collection is D/A, the collecting/presenting bank must (without delay) send advice of non-
payment or non-acceptance to the remitting bank. When the remitting bank receives such a notification
of non-payment or non-acceptance, it must send further instructions about the further handling of the
documents. If it fails to do so within 60 days, the documents may be returned to the remitting bank
without any further responsibility on the part of the collecting/presenting bank.

8 Practical problems with documentary collections

A seller and buyer should only agree to documentary collection if they trust each other.

The buyer needs to be confident that the seller will dispatch the goods and that they will be of the
correct specification, because the buyer must pay for the goods or accept a bill of exchange before being
allowed to take possession of the goods.

The seller needs to trust the buyer to pay for the goods; if the buyer refuses, the goods will be ‘stranded’
in a foreign country. For this reason, it may be advisable that the seller should agree to documentary
collection, only if the goods could be sold easily (in the country of destination) to a different buyer in the
event that the original buyer refuses to pay for them.

A problem for the banks involved in a documentary collection is that the banks should only be involved
with handling documents, and not with the trade transaction between seller and buyer. However, if
something goes wrong with the trade transaction, the buyer and seller may want to involve the bank.

8.1 Matters for the seller to consider

The seller should agree to documentary collection only if he trusts the ability and the willingness of the
buyer to pay for the goods, and only if the buyer’s country is politically, legally and economically stable.

The main problem for the seller with documentary collection is that the buyer is not required to pay for
the goods until after they have been shipped to the buyer’s country.

 The buyer may take possession of the goods (in a D/A arrangement) and then fail to pay the
accepted bill. When this happens, the seller (not the bank) must seek a remedy through the
courts for breach of contract, because the documentary collection process is separate from the
underlying trade transaction.

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 The seller also faces the risk that the buyer will refuse to pay or accept a bill of exchange, and so
will not take possession of the goods when they arrive in the buyer’s country. If the buyer refuses
payment (D/P terms) or acceptance (D/A terms), the goods then remain in the ownership of the
seller, who must then take measures to store and protect the goods, insure them, and source
another buyer for them.

8.2 Matters for the buyer to consider

In a documentary collection, the buyer may inspect the documents before payment or acceptance, but
does not inspect the goods themselves (although inspection of the goods before shipment, by an
independent inspectorate or by an agent of the buyer, may be agreed between seller and buyer as part
of the trade transaction). This means that it is possible that the goods do not conform to the
specification agreed with the seller. However, this is not a responsibility of the presenting bank: in a
collection, the banks deal in documents, not the goods.

The presenting bank is responsible for the documents until the buyer pays (D/P) or accepts (D/A), but
may be willing to permit the buyer (as a trusted customer of the bank) to take away the documents
temporarily in order to inspect them before payment or acceptance. In these circumstances, the
presenting/collecting bank remains responsible for the documents until the buyer pays or accepts.

8.3 Matters for the bank to consider

A bank that is instructed to act in a collection must receive complete and precise instructions from the
principal in the collection order. Banks must act only in accordance with the specific instructions they
have been given and, subject to agreement between seller and buyer, in accordance with the Uniform
Rules for Collection.

9 Summary: advantages of documentary collection

Documentary collection has several advantages as a method of payment in international trade, when the
shipment of goods from seller to buyer takes a long time.

 No credit facility is required from a bank for a documentary collection. The seller or buyer may
wish to make finance arrangements with their bank, but this is separate to the collection.

 Documentary collection is a more secure method of trading internationally than open account
trading, although it is less secure than documentary credit.

 The buyer can make sure that the shipped goods have arrived in the buyer’s country before
paying for the goods.

 There is less risk for the seller, because the seller retains ownership of the goods until the
document of title is given to the buyer, on payment or acceptance.

 Collections are made in accordance with internationally-accepted rules.

However, banks deal in documents only, and do not get involved in trade disputes between buyers and
sellers.

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10 Summary of URC 522

The following table summarises the main rules in the Uniform Rules for Collections (URC 522).

Table 3.1: URC 522

Article 1 URC 522 applies to all collections where this is specified in the collection
instruction. A bank is under no obligation to handle a collection or collection
Application of
instruction, but if it chooses not to do so, it must inform the party from which
URC 522
it received the collection or collection instruction without delay.

Article 4 All documents sent for collection must be accompanied by a collection

order/instruction, which must state that the instruction is subject to URC 522.
Collection instruction
This Article states that the instructions must be complete and precise, and
lists the items of information that they should include.

Article 5 ‘Presentation’ is the procedure by which the documents listed in the collection
instruction are made available to the drawee. They should be presented to
Presentation
the drawee in the form in which they are received, although endorsements or
rubber stamps may be added.

The remitting bank should use a collecting bank nominated by the principal.
If the principal does not nominate a collecting bank, the remitting bank may
use a bank of its own choice (in the country of payment or acceptance).

Article 6 When documents are payable at sight, the presenting bank must present
them for payment ‘without delay’.
Sight/Acceptance
When the collection calls for acceptance, presentation for acceptance should
also be made without delay.

Where payment is called for at a future date, presentation for payment must
be made not later than the maturity date.

Article 7 When a collection includes a bill of exchange that is payable at a future date,
the collection instruction must state whether the document should be
Release of
released against payment (D/P) or against acceptance (D/A). If the collection
commercial
instruction does not specify which, the document should be released only
documents
against payment.

When a collection includes a bill of exchange that is payable at a future date,

and the collection instruction states that release of the commercial
documents should be against payment, the collecting bank should release the
documents only against payment and is not responsible for any consequences
that arise out of the delay in releasing the commercial documents.

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Article 10 Goods should not be delivered to the address of a bank, or shipped to the
order of a bank (as consignee for the goods) without the prior agreement of
Documents versus
the bank. If this happens, the bank is under no obligation to take delivery of
goods, services,
the goods, and the risks and responsibility for the goods remain with the
performances
person who sent the goods.

Banks are under no obligation to take any action with regard to the goods,
including action to arrange for their storage and insurance, even when they
receive specific instructions to do so. A bank will only take such action if it
agrees to do so.

If a bank does take action with regard to the goods, such as arrange storage
or insurance, it assumes no responsibility for the fate or condition of the
goods (including the actions of any third party entrusted with custody of the
goods). However, the bank must notify what it has done with the goods,
without delay, to the person from whom the collection instruction was
received.

Where the goods have been delivered to a bank or to the order of a bank,
the drawee has honoured the terms of the collection (by payment or
acceptance) and the collecting bank has then released the goods to the
drawee, it is ‘deemed’ that the remitting bank has authorised the collecting
bank to release the goods.

Article 11 A bank that uses the services of another bank in a collection does so for the
account of and at the risk of the principal. A bank assumes no liability or
Disclaimer for acts of
responsibility in the event that the instructions it gives to the other bank are
an instructed party
not carried out.

Article 12 Banks must check that the documents they receive in a collection appear to
be those listed in the collection instruction. They must notify the party from
Disclaimer on
which it received the collection instruction if any documents are missing or
documents received
found to be other than one of the documents listed. Banks have no other
obligation to check the documents and will present them as received without
any further examination.

Article 16 Amounts collected (less charges and expenses) must be made available
without delay to the party from which the collection instruction was received
Payment without
and payment should be made in favour of the remitting bank.
delay

Article 17 When payment is in the local currency of the country of payment, the
presenting bank should release the documents to the drawee only if the local
Payment in local
currency is available for disposal in the manner specified in the collection
currency
instruction.

Article 18 When payment is in a foreign currency, the presenting bank should release
the documents to the drawee only if the foreign currency can be remitted in
Payment in foreign
accordance with the requirement of the collection instruction.
currency

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Article 19 With clean collections, partial payments are acceptable, but the financial
document cannot be released to the drawee until full payment has been
Partial payments
made.

With documentary collections, partial payments are acceptable only if

specified in the collection instruction and the commercial documents will be
released only when full payment has been received.

Article 20 If a collection instruction states that interest must be collected, and the
drawee refuses to pay interest, the presenting bank may release the
Interest
documents against payment or acceptance unless the collection instruction
specifies that this is not permitted.

When payment of interest is refused, the presenting bank must notify,

without delay, the person from whom the collection instruction was received.

Articles 21 If a collection instruction states that charges and expenses are for the
account of the drawee, and the drawee refuses to pay them, the presenting
Charges and
bank may release the documents against payment or acceptance unless the
expenses
collection instruction specifies that this is not permitted.

If a collection instruction states that charges and expenses are for the
account of the principal, the collecting bank can recover charges and
expenses from the bank from which the collection instruction was received
and the remitting bank can recover all charges and expenses, including its
own, from the principal.

Banks reserve the right to demand payment of charges or expenses in

advance from the party from which the collection instruction was received.

Article 22 The presenting bank is responsible for checking that the form of acceptance
of a bill of exchange appears to be correct, but it has no responsibility for the
Acceptance
genuineness of the signature or the authority of the person to sign the
acceptance.

Article 24 The collection order should give specific instructions about protesting the
documents in the event of non-payment or non-acceptance. In the absence
Protest
of any such instruction, the presenting bank is under no obligation to protest
the non-payment/non-acceptance.

Article 25 The collection instruction may specify a case-of-need in the event of non-
payment or non-acceptance, but must indicate clearly and fully what the
Case-of-need
powers of the case-of-need should be.

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Chapter roundup

 A collection in international trade is the handling of documents by banks in accordance with instructions
received, for the purpose of obtaining a payment or a promise of future payment.

 A clean collection is a collection of a financial document, such as a cheque or bill of exchange, without
any accompanying commercial documents.

 A documentary collection is a collection of a financial document accompanied by commercial documents.

 In a collection, the principal gives a collection order to a remitting bank, who sends the instructions to a
collecting bank, (usually the presenting bank). The presenting bank presents the documents to the
drawee.

 In a collection involving payment for an international trading transaction, the principal is the exporter and
the drawee is the buyer/importer.

 On presentation of the documents, the drawee is required either to make an immediate payment or to
undertake to make a payment in the future, typically by accepting a bill of exchange.

 A bill of exchange is an unconditional order in writing, signed by the drawer, requiring the drawee to pay
on demand (sight bill) or at a future date (usance bill, time bill or term bill) a specified amount of money
to the order of a specified person.

 A trade bill in international trade is drawn on the importer/buyer. A bank bill is a bill of exchange drawn
on a bank.

 When a usance bill is first presented in a collection, the drawee undertakes to make the payment at a
future date by accepting the bill. The accepted bill is subsequently re-presented at maturity for payment.

 With documents against payment (D/P), commercial documents are presented to the drawee and
released to the drawee only against immediate payment of the financial document.

 With documents against acceptance (D/A) commercial documents are presented to the drawee and
released to the drawee only against acceptance of a usance bill of exchange.

 When the commercial documents for presentation include a negotiable bill of exchange, the drawee
(importer) cannot take possession of the imported goods until it has paid (D/P) or accepted the bill (D/A)
and received the commercial documents from the presenting bank.

 Collections are usually governed, by agreement between exporter and buyer, by the Uniform Rules for
Collections, ICC Publication Number 522.

 These rules cover practical aspects of collections, such as delays, partial payments, force majeure,
payments of interest and charges and expenses.

 If the drawee fails to pay a bill of exchange at maturity, the collection order from the principal may
specify that the dishonoured bill should be noted or protested for non-payment.

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chapter 4

DOCUMENTARY CREDITS

Contents
1 The nature of a documentary credit ............................................................................ 72
2 The process ............................................................................................................. 73
3 Authorising payment under a letter of credit ................................................................ 75
4 Content of a letter of credit........................................................................................ 77
5 Features of a letter of credit....................................................................................... 78
6 Confirmation of a letter of credit: added security for the seller ....................................... 80
7 Comparison of letter of credit arrangements: security for the exporter ............................ 81
8 Issuing, advising, confirming and negotiating banks ...................................................... 82
9 Application for a letter of credit .................................................................................. 83
10 Presentation of the documents ................................................................................... 86
11 Complying presentation and non-complying presentation: UCP 600 ................................. 88
12 Discrepancies in documentation .................................................................................. 90

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13 Role of the issuing bank in the presentation of documents ............................................. 92

14 ICC Uniform Customs and Practice for Documentary Credits: UCP 600 ............................. 92
15 Settlement ............................................................................................................... 93
16 Other common forms of letter of credit........................................................................ 94
17 Back-to-back credits .................................................................................................. 97
18 ‘Red clause’ letters of credit ....................................................................................... 99
19 Revolving credits .................................................................................................... 101
20 Anti-money laundering (AML) measures ..................................................................... 102
21 The Wolfsberg Trade Finance Principles ..................................................................... 103
22 AML procedures and letters of credit ......................................................................... 104
23 AML procedures and documentary collections ............................................................. 107
Chapter roundup.......................................................................................................... 108

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Learning outcomes
On completion of this chapter you should be able to:

 Analyse the purpose, contents, advantages and risks of documentary credits or letters of credit.
 Examine the role of the International Chamber of Commerce and the application and benefits of
the Uniform Customs and Practices for Documentary Credits.
 Analyse the legal and regulatory issues involved in documentary credits, particularly in the context
of money laundering.

Learning objectives
While working through this chapter you will learn how to:
 Examine the nature of a documentary credit (letter of credit).
 Identify the participants in a documentary credit and the process.
 Describe the documentary credit process.
 Distinguish between sight payment, deferred payment and acceptance letters of credit
and letters of credit available by negotiation.
 Distinguish between negotiation with and without recourse and how banks honour guarantees in
a letter of credit.
 Examine the contents and features of a letter of credit.
 Analyse the nature and purpose of confirmation of a letter of credit and silent confirmation.
 Appraise the different levels of security offered by various letter of credit arrangements.
 Describe the different roles banks play in a documentary credit arrangement.
 Describe the letter of credit application process.
 Demonstrate the role of the seller and third parties in the presentation of documents.
 Examine the role of the issuing bank in the presentation of documents.
 Examine the settlement process for a letter of credit.
 Describe the purpose and use of a transferable letter of credit, a back-to-back credit, a
red clause letter of credit, a green clause letter of credit and a revolving letter of
credit.
 Examine the role of the International Chamber of commerce.
 Appraise the rules in ICC Uniform Customs and Practice UCP 600.
 Explain the purpose of anti-money laundering procedures for international trade transactions.
 Explain the purpose of the Wolfsberg Trade Finance Principles.
 Examine trade-based money-laundering methods and AML risk-based control measures.
 Describe the nature of anti-money laundering procedures for documentary credit and
documentary collection transactions.

Introduction
A documentary credit, also called a letter of credit, is a method of payment in international trade that
involves the provision of a bank guarantee at the request of the buyer in favour of the seller/exporter. A
bank that participates in a documentary credit needs to make sure that the procedure is error-free.
Nearly all documentary credits are arranged in accordance with standard internationally-accepted rules,
the Uniform Customs and Practice for Documentary Credits (UCP 600).
The chapter describes the process of arranging payment by means of documentary credit, and explains
these international rules.

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1 The nature of a documentary credit

Key term
A letter of credit (L/C) is letter from a bank guaranteeing that a buyer's payment to a seller will be
received on time and for the correct amount. In the event that the buyer is unable to make payment on
the purchase, the bank will be required to cover the full or remaining amount of the purchase.

A documentary credit, also called a letter of credit (L/C) is:

 A form of guarantee issued by a bank, at the request of a buyer, in favour of a seller (exporter).

 It promises payment at sight, or at a later time, against presentation of documents (by the seller)
that conform to specified terms and conditions in the letter of credit.

A letter of credit is normally issued by an ‘issuing bank’ in the buyer’s country and notified to the seller
by an ‘advising bank’ in the seller’s country.

For nearly all issued documentary credits, the buyer and seller agree that the credit should be subject to
the Uniform Customs and Practice for Documentary Credits (UCP 600), which is issued by the
International Chamber of Commerce.

1.1 Irrevocable nature of a letter of credit

A documentary credit, or letter of credit, is irrevocable. This means that it constitutes a definite
undertaking by the issuing bank to ‘honour a complying presentation’.

 A ‘complying presentation’ means the presentation of documents to the bank that comply with the
requirements and specifications in the letter of credit.

 The issuing bank promises to ‘honour’ a complying presentation by one of three methods:
payment ‘at sight’ on presentation of the documents, payment by deferred payment, or
acceptance of a bill of exchange (‘draft’) drawn on the bank.

When the issuing bank has issued a letter of credit, it cannot revoke it and withdraw its undertaking to
pay or accept the bill of exchange.

1.2 The participants in a documentary credit

The participants in a documentary credit arrangement include the:

 Applicant for the letter of credit: this is the buyer/importer.

 Issuing bank: this is the bank, normally in the buyer’s country, that agrees to issue a letter of
credit at the request of the applicant/buyer.

 Advising bank: this is the bank, normally in the seller’s country, that is asked to present
(‘advise’) the letter of credit to the seller.

 Beneficiary: this is the seller/exporter who gets the guarantee of payment from the issuing
bank, on condition that the required documents are presented to the issuing bank in compliance
with the terms and conditions of the letter of credit.

The role of the advising bank is simply to advise the letter of credit to the seller, but it should also check
that the letter of credit is genuine. However, the advising bank may also add its guarantee to the
arrangement by ‘confirming’ the letter of credit. Confirmation of a letter of credit is explained later.

There may be other banks involved in a letter of credit arrangement. These are also explained later.

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1.3 Banks: dealing in documents, not goods

Like documentary collection, documentary credit involves dealing in documents. It is not dealing in the
goods themselves. The Uniform Customs and Practice UCP 600 states: ‘A credit by its nature is a
separate transaction from the sale or other contract on which it may be based.’

2 The process
A documentary credit goes through the following stages.

STEP 1 Agreement between buyer and seller

When they make their trade agreement for the sale of goods, the seller and buyer also
agree that payment should be arranged by means of documentary credit.

STEP 2 Application

The buyer makes an application to its bank for the bank to issue a letter of credit.

STEP 3 Issue of letter of credit

The buyer’s bank carries out a credit check on the buyer in a formal credit approval
process. The bank should also check that all the required permissions have been obtained
in the buyer’s country (including granting of import licences and, if required, currency
approval). If this checking and approval process is completed to the bank’s satisfaction, it
issues the letter of credit.

STEP 4 Advise the seller

The issuing bank selects an advising bank in the seller’s country to advise the letter of
credit to the seller. The letter of credit is usually sent to the advising bank by SWIFT
message.

The advising bank may also be asked to add its confirmation to the letter of credit. If so,
the advising bank will make a formal credit decision and decide whether it is willing to do
this.

The advising bank advises the seller of the letter of credit and its details, including whether
the letter of credit has been confirmed and details of where the L/C will be honoured for
payment, acceptance or deferred payment.

STEP 5 Seller checks the details

The seller must check the terms of the letter of credit to make sure that it is able to
comply with the instructions in the L/C about which documents must be delivered, and
where and when, in order to obtain payment or acceptance. If the terms of the L/C are not
practicable, the seller must contact the buyer, resolve the problem and agree to ask the
issuing bank to amend the L/C and advise the seller of the amendment through the
advising bank.

STEP 6 Shipment of goods and presenting the documents to the advising bank (or
another nominated bank)

The seller ships the goods and obtains the transport documents giving title to the goods.
The seller also obtains all the other documents specified in the letter of credit. The seller
must check that the documents conform to the specifications in the letter of credit and
that the information contained in all the documents is consistent.

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The seller presents the documents to the advising bank, which checks that they conform
to the specifications in the letter of credit. If there are any discrepancies the seller must be
notified and asked to obtain corrected documents if possible.

If it is not possible to correct the documents (for example, it will be too late to amend
errors in the shipping documents, since the goods have already been shipped), the
discrepancies must be approved by the buyer. If the advising bank makes a payment to
the seller, this payment will be with recourse and subject to the buyer’s approval.

STEP 7 Presentation of documents to the issuing bank

The advising bank sends the documents to the issuing bank. The issuing bank also checks
the documents. If the documents comply with the terms of the letter of credit, they are
approved by the issuing bank, and the buyer is obliged to make payment to the issuing
bank. (Payment to the seller will depend on the terms of payment in the letter of credit.)

If there are any discrepancies in the documents, the buyer should check them. If the
buyer approves them, the buyer is obliged to make payment to the issuing bank.

If the buyer does not approve discrepancies that are found in the documents, the issuing
bank holds the documents until the problem has been resolved between buyer and seller.
If the problem is not resolved, the documents are returned to the advising bank and from
the advising bank to the seller (against repayment of any payment made with recourse to
the seller).

STEP 8 Release of documents

The issuing bank releases the documents, including the transport documents giving title to
the goods, to the buyer, against payment at sight or payment at any later date specified in
the letter of credit.
This process is illustrated in the following diagram. The process shown in the diagram may be simplified,
because the seller (beneficiary) may present the documents to a different nominated bank.

The term ‘payment’ is used in the diagram, but this can mean payment at sight, deferred payment or
acceptance of a bill of exchange by a bank. A documentary credit may also provide for a nominated bank
to buy/discount the accepted bill of exchange and pay the proceeds to the seller. (This method of
settlement is by ‘negotiation’ and the bank that buys/discounts the bill is a negotiating bank.)

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Figure 4.1: The documentary credits process

4 Ship goods
Seller Buyer

3 1
Advise Apply
L/C for
L/C

5 Present 8 9 7
documents Payment Payment Documents
by
agreed
method
2 Issue L/C

Advising bank Issuing bank

(and possibly confirming bank)

6 Documents/payment
Key:
Paperwork, from seller to buyer
Paperwork, from buyer to seller
Payments

3 Authorising payment under a letter of credit

Payment under a letter of credit may be either at sight (payment on demand) or after a specified period
of time. The methods of authorising payment under a letter of credit are as follows:

3.1 Sight payment letter of credit

Key term
A sight payment letter of credit is a letter of credit that is payable once it is presented along with the
necessary documents. An organisation offering a sight letter of credit commits itself to paying the agreed
amount of funds, provided the provisions of the letter of credit are met.

With this type of letter of credit, payment is made upon presentation of specified documents that
constitute a ‘complying presentation’. A letter of credit that is payable at sight will usually specify a
nominated bank that will make payment upon presentation of the documents. This nominated bank
(the paying bank) is likely to be in the exporter’s country. It may be the advising bank, but need not
be. The nominated bank can agree to act as paying bank, but it is not obliged to do so.

By nominating a bank as the paying bank for a sight payment letter of credit, the issuing bank
authorises the paying bank to make the payment on a sight basis under the terms and conditions of the
letter of credit. The paying bank is reimbursed by the issuing bank.

A sight payment letter of credit may specify that the letter of credit is payable at any bank, without
nominating a specific bank.

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3.2 Deferred payment letter of credit

With a deferred payment letter of credit, a bank incurs a deferred payment undertaking, which means
that it undertakes to make a payment at a future date, provided that the terms and conditions of the
letter of credit are complied with.

This method of payment does not require a bank bill to determine the maturity date. The undertaking to
make the payment at a future date is given to the exporter (beneficiary) by the issuing bank, a
confirming bank or another nominated bank.

3.3 Acceptance letter of credit

An acceptance letter of credit specifies a bank that will accept a bill of exchange, thereby undertaking
to make payment at maturity, on presentation of documents that comply with the terms and conditions
of the letter of credit. The bank nominated as the accepting bank may be the issuing bank, the
confirming bank or another nominated bank.

3.4 Letter of credit available by negotiation

Negotiation means giving value to a bill of exchange (and/or other documents). A negotiating bank will
thus provide a payment to the beneficiary (exporter), in effect by purchasing the bill of exchange. A
usance/time bill is purchased at a discount to its face value, and the term ‘discounting’ a bill is also
used for negotiation of these bills.

A letter of credit that is available by negotiation must either:

 Specifically nominate a negotiating bank;

 Ensure that the credit is available for negotiation at any bank.

The issuing bank authorises the negotiating bank to negotiate documents that are presented to it under
the terms and conditions of the letter of credit. The issuing bank also undertakes to reimburse the
negotiating bank, provided that the terms and conditions of the letter of credit have been complied with.

The undertaking by the issuing bank to a negotiating bank in a letter of credit will consist of wording
such as: ‘Upon receipt of documents in strict compliance with the terms and conditions of the credit, we
shall remit proceeds according to your instructions.’

3.4.1 Negotiation with, and without, recourse

A negotiating bank usually negotiates a bill of exchange for the beneficiary of a letter of credit ‘with
recourse’. This means that if the issuing bank fails to reimburse the negotiating bank by paying the bill at
maturity, the negotiating bank is able to claim the money back from the beneficiary.

A bank may negotiate a bill without recourse. This means that if the issuing bank fails to reimburse the
negotiating bank by paying the bill at maturity, the negotiating bank will not claim the money back from
the beneficiary.

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3.4.2 Comparison of letter of credit payments

Letter of credit Timing of payment Type of payment

payment method

Sight payment Once terms and Specified amount

conditions satisfied

Deferred payment At specified future date Specified amount

once terms and
conditions satisfied

Acceptance Once terms and Negotiation of bill of

conditions satisfied exchange at discount

3.5 Honouring the guarantee in the letter of credit

UCP 600 uses the general term ‘honour’ to cover the various actions for the issuing or confirming bank
when documents are presented in compliance with the terms and conditions of the L/C. UCP 600 states
that ‘honouring’ a letter of credit and the bank’s guarantee in the L/C means:

 To pay at sight, if the credit is available by sight payment.

 To incur an undertaking to make a deferred payment, and then to pay at the due date, if the
credit is available by deferred payment.

 To accept a bill of exchange (‘draft’) drawn by the exporter/beneficiary on the bank and to pay
this bill at maturity, if the credit is available by acceptance.

The exporter is thus able to secure payment through one of the three methods of honouring the letter of
credit described above. Alternatively, if the exporter wishes payment prior to the maturity of a bill of
exchange, they may seek payment by negotiation as covered in Section 3.4 above.

4 Content of a letter of credit

As stated earlier, a letter of credit may be issued as a SWIFT message by the issuing bank to the
advising bank. A simplified example of a letter of credit in more ‘traditional’ document format is shown
below.

Figure 4.2: Letters of credit

Pacific Bank

Date: 18 October 201X Irrevocable Documentary Credit Number 12345

Beneficiary Applicant
ABC Canada Manila Engineering

Advising Bank Amount

DEF Bank Canada US$75,000

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Pacific Bank

Available by your draft in duplicate at sight drawn on the advising bank for the full invoice value,
accompanied by the following documents:

1 Full set of clean-on-board bills of lading made out to our order showing the applicant as notify
party and marked ‘Freight Paid’

2 Signed commercial invoices in triplicate

3 Insurance policy/certificate [plus some details, not shown here]

4 Certificate of origin, showing goods of Canadian origin

Evidence shipment of: Electronic parts CIF Manila

Partial shipments prohibited
Transhipment prohibited
Shipment from Port of Toronto to Manila no later than 2 December 201X
All documents must be presented within 10 days of shipment
This credit is valid until 13 December 201X

This credit is subject to the Uniform Customs and Practice for Documentary Credits, International
Chamber of Commerce Publication UCP 600

5 Features of a letter of credit

5.1 Draft drawn on a bank
An important feature of a letter of credit is that a bank guarantees the payment to the seller, provided
that the seller complies with the terms of the credit.

 The issuing bank undertakes to pay or accept a draft (bill of exchange) drawn on it by the seller.

 Alternatively, if the letter of credit is confirmed by the advising/confirming bank, the advising bank
pays or accepts a bill drawn on it by the seller.

The seller, is in possession of a guarantee of payment (unless the bank itself becomes insolvent)
provided that it complies with all the terms of the letter of credit.

A letter of credit costs more than other methods of payment, in international trade, because of the
greater amount of involvement by banks and because of the bank guarantee.

5.2 Period of validity

A letter of credit is irrevocable, which means that it is a binding undertaking by the issuing bank provided
that the seller complies with the terms and conditions of the letter of credit, and:

 Presents the specified documents to the issuing bank or a nominated bank (often the
advising/confirming bank).

 Does so before the date of expiry of the letter of credit (which is stated in the letter of credit).

The advising bank may be nominated as the bank where the seller must present the specified
documents. However, the advising bank has no obligation to make a payment to the seller, unless it has
confirmed the letter of credit.

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When a letter of credit is not confirmed by the advising bank, the issuing bank has the obligation to pay.
Payment may take longer than with a confirmed letter of credit, because the issuing bank is in the
buyer’s country.

5.3 Timing of the payment

The letter of credit must state when payment will be made. Payment may be:

 At sight, on presentation of the specified documents.

 At a later time, after presentation of the documents.

Payment after the date of presentation of the documents can be arranged in either of two ways:

 The seller draws a bill of exchange on the bank (the issuing bank or, if there is one, the
confirming bank), with a future payment date, which the bank accepts.

 The letter of credit may specify deferred payment terms, and the bank will make the payment at
the appropriate future time.

With both acceptance of a bill of exchange and with deferred payment, the bank guarantees payment on
the due date. This guarantee enables the seller to obtain finance or payment before the due payment
date, in the following ways:

 A term bill of exchange drawn on a bank can be sold (‘discounted’) in the money market at a
discount to its face value, and the sale proceeds are paid to the exporter.

 Alternatively, a bank may be willing to provide finance to the exporter in the form of an advance
payment.

In both cases, the seller must incur transaction costs and financing costs, but enjoys the benefit of
immediate payment. From the exporter’s point of view, deferred payment or acceptance by the issuing
or confirming bank is less desirable than payment in full at sight on presentation of the documents.

5.4 Place for presenting the documents

The letter of credit should indicate where the seller should present the documents specified in the letter
of credit. This is the place where the documents are to be payable:

 If the letter of credit is payable only at the issuing bank, the documents must be presented and
payment obtained at the issuing bank (in the buyer’s country).

 In all other cases, the issuing bank appoints or ‘nominates’ another bank, in the seller’s
country, to make the payment, incur a deferred payment obligation, or accept a draft drawn on it
by the seller (provided that the terms and conditions of the documentary credit are complied with
by the seller). The ‘nominated bank’ may be the advising bank, or may be another bank.

 From the seller’s point of view, it is normally best to present the documents at the advising bank
(in the seller’s own country). If the letter of credit has been confirmed, the seller should present
the documents at the confirming bank, and the confirming bank has an obligation to pay or
accept a bill of exchange, provided the terms and conditions of the L/C have been complied with.

 When the letter of credit is payable only at the issuing bank, the advising bank or another
nominated bank may agree to provide a payment to the exporter on presentation of the
document. When this happens, the advising or nominated bank negotiates the documents at
presentation and advances funds to the exporter; in other words, the letter of credit is issued as
‘available for negotiation’. This advance of funds by the negotiating bank is with recourse to the
exporter/seller, until the issuing bank has approved the documents and reimbursed the
advising/nominated bank.

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From the seller’s point of view, there are good reasons why the advising/confirming bank (in the
seller’s country) should be the place for presenting the documents.

 Payment or acceptance will occur sooner, when the documents are presented to and approved by
the advising bank.

 If there are discrepancies in the documentation, it may be easier to correct the errors directly with
the advising bank, before the documents are forwarded to the issuing bank.

From the buyer’s point of view, it may be preferable for the letter of credit to specify presentation of the
documents only at the issuing bank. This is because no payment is made to the seller until the buyer’s
own bank (the issuing bank) has examined the documents.

C A S E S T U D Y

A letter of credit expires on 10 March at the counter of the advising bank, which is also the nominated
paying bank.

The exporter/beneficiary delivers the documents to the advising bank on 10 March. After checking the
documents and finding them to be in order, the advising bank sends the documents to the issuing bank,
which receives them on 14 March.

In this example, the presentation of the documents to the advising bank is made within the validity of
the letter of credit, even though the issuing bank receives them after 10 March. The documents were
presented to the advising bank within the time allowed. The advising bank has taken less than five
banking days to check the documents and deliver them to the issuing bank, and this is acceptable.

If the exporter/beneficiary had chosen instead to present the documents directly to the issuing bank,
instead of the advising bank, the documents would have to be presented to the issuing bank by
10 March for the letter of credit to remain valid.

C A S E S T U D Y

A letter of credit expires on 10 April at the counter of the advising bank, which is also the nominated
paying bank.

The exporter/beneficiary delivers the documents to another bank which is not the nominated bank, on 10
April. After checking the documents and finding them to be in order, this bank sends the documents to
the advising bank, which receives them on 14 April.

In this example, the presentation of the documents is not made within the time allowed. The documents
are not delivered within the terms of the letter of credit until they reach the advising bank, after the
expiry date; the presentation is late. The expiry date of 10 April would apply to presentation of the
documents at the nominated bank, but not at the counter of a non-nominated bank.

6 Confirmation of a letter of credit: added security for the

seller
The issuing bank guarantees the letter of credit for the entire period of its validity, without exception.

There may be situations, however, when the seller has doubts about the ability or the willingness of the
issuing bank to make the payment. For example, the political conditions in the buyer’s country may be
unstable, or there may be restrictions on transfers of freely-convertible currency out of the buyer’s
country.

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When there are problems in the buyer’s country, the seller may ask for the letter of credit to be
confirmed by the advising bank. The seller must ask the buyer to apply for a confirmed letter of credit,
and the issuing bank must then ask the advising bank to confirm the L/C.

 Confirmation is voluntary. An advising bank has the right to refuse to confirm a letter of credit. A
bank that is nominated by an issuing bank to confirm the credit may refuse. In this situation, the
nominated bank must inform the issuing bank without delay, and may advise the credit to the
seller/beneficiary without confirmation.

 Confirmation means giving a definite undertaking to assume the liabilities and obligations of the
issuing bank. This means that even if the issuing bank is unable for some reason to honour its
undertaking in the letter of credit, the confirming bank will honour the undertaking. This adds to
the assurance that the beneficiary will be paid, provided that it complies with the terms and
conditions of the letter of credit.

 When the confirming bank makes a payment under the terms of the confirmed letter of credit, it
claims reimbursement from the issuing bank (provided that the terms and conditions of the letter
of credit have been complied with).

 The confirming bank makes a charge for the confirmation of the L/C.

The use of confirmation for letters of credit varies in practice with:

 The international standing and reputation of the issuing bank.

 The country of the issuing bank.
 Normal practice for letters of credit in the countries of the buyer and seller.

6.1 Silent confirmation of a letter of credit

Occasionally, a seller may ask the advising bank directly to confirm the L/C, without notifying the issuing
bank or the applicant for the letter of credit (the importer). The request for silent confirmation comes
from the beneficiary (the exporter).

Silent confirmation gives the exporter the same security of payment as normal confirmation (at the
request of the buyer and issuing bank).

The reason why a bank may agree to provide silent confirmation is to win the export business of a
business customer. The ‘silently-confirming’ bank will usually be selective in the letters of credit that it
agrees to confirm silently, based on its assessment of the letter of credit, and its expectation that the
exporter will present the documents for payment or acceptance in compliance with the terms of the
letter of credit.

7 Comparison of letter of credit arrangements: security for

the exporter
A letter of credit provides security for the seller, provided that the seller complies with its terms and
conditions. However, some letter of credit arrangements are more secure for the seller than others, as
indicated in the following table.

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Table 4.1: Features of a letter of credit

Feature of L/C Most secure arrangement for Least secure arrangement

the seller for the seller

Time of payment Payment at sight on presentation Acceptance of a bill of exchange

of documents or deferred payment undertaking
on presentation of documents

Place of presentation of Advising bank Issuing bank

documents

Security Confirmed L/C Not confirmed

Remember, however, that any letter of credit should be more secure for the seller than trading on open
account terms or documentary collection, because payment is guaranteed by a bank, not the buyer.

8 Issuing, advising, confirming and negotiating banks

The terms used for banks in a documentary credit arrangement may seem confusing, and the banks
which may be involved are explained below.

 Issuing bank. The issuing bank is the bank, usually the buyer’s own bank in the buyer’s country,
that issues the letter of credit on application from the buyer. The issuing bank guarantees to
‘honour’ the credit if the terms and conditions are complied with.

 Advising bank. This is the bank, usually in the seller’s country that is asked by the issuing bank
to notify the seller of the letter of credit and its terms. By advising a credit, the advising bank
indicates that:

– It is satisfied about the apparent authenticity of the letter of credit, and

– The advice accurately reflects the terms and conditions of the L/C it has received.

 Confirming bank. A bank (usually in the seller’s country) may be asked to confirm a letter of
credit. Confirmation is a definite undertaking by the bank to ‘honour’ a ‘complying presentation’
under the terms of the letter of credit. This is in addition to the undertaking from the issuing
bank. Confirmation of a credit enables the seller to draw a bill of exchange on the confirming
bank in its own country, instead of drawing the bill on the issuing bank in the buyer’s country.
Confirmation may also mean a definite undertaking by the confirming bank to negotiate a
complying presentation, rather than ‘honour’ it.

 Negotiating bank. Negotiation of a bill of exchange involves ‘buying’ a bill of exchange that has
been drawn on another bank. In a documentary credit arrangement, ‘honouring’ a complying
presentation may involve deferred payment or acceptance of a term bill of exchange, by the
issuing bank or possibly a confirming bank. With both deferred payment and an accepted bank
bill, payment is at a future date. A negotiating bank provides payment to the exporter (at a
discount to the amount payable) against this deferred payment undertaking or by purchasing an
accepted bank bill. The payment is made before the due payment date or the deferred payment
or accepted bill, which means that the exporter can obtain payment (less the charges and costs
for negotiation) in advance of the due payment date for the documentary credit.

A confirming bank may agree to act as a negotiating bank. Alternatively a negotiating bank may
be a different bank that is neither the confirming bank nor the advising bank.

 Paying bank. This is a bank that is nominated in the letter of credit to make payment to the
beneficiary against complying documentation. The paying bank may also be the advising bank or
confirming bank, or (in the case of negotiation of the bill) the negotiating bank.

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 Reimbursing bank. This is a bank that is authorised by the issuing bank to pay (reimburse) the
negotiating bank or paying bank. It is usually in the same country as the paying or negotiating
bank, and is a branch or a correspondent bank of the issuing bank.

A credit that is available for payment or negotiation at a confirming bank or negotiating bank is also
available at the issuing bank. The issuing bank remains under an obligation to honour a ‘complying
presentation’ under the terms of the L/C.

An issuing bank undertakes to reimburse the confirming bank or negotiating bank. Similarly, a confirming
bank undertakes to reimburse a negotiating bank.

8.1 T/T (Tested Teletransmission) reimbursement

Key term
Tested Teletransmission (T/T) is an electronic means of transferring funds overseas. By using this
method, the funds are generally available within 24 hours, and can be tracked in the meantime.

The paying bank (advising/confirming bank or negotiating bank) is reimbursed through a reimbursing
bank. The reimbursing bank is identified in a special instruction in the letter of credit. The letter of credit
will also indicate the method of reimbursement.

The paying bank may be required to send a draft (bill of exchange) to the reimbursing bank in order to
obtain reimbursement. Alternatively, it may be able to ask for T/T reimbursement.

T/T stands for Tested Teletransmission. T/T reimbursement is obtained by sending a SWIFT
message (or telex) to the reimbursing bank to ask for payment, without the need to submit a draft.
Payment is slightly faster when T/T reimbursement is used.

9 Application for a letter of credit

An importer applies to a bank for a line of credit under a letter of credit arrangement. Usually the
applicant for the line of credit must have some form of established banking relationship with the bank. A
bank will not agree to issue a letter of credit unless a line of credit has previously been agreed.

An application for an individual letter of credit is made using a standard application form, which specifies
the required terms and conditions for the letter of credit. These include the following specifications:

 The applicant for the credit

 The beneficiary (exporter)

 The expiry date for the letter of credit

 The place of expiry

 Whether confirmation is required or not required

 The amount of the credit

 The method of payment (sight, deferred payment, acceptance, negotiation)

 Whether partial shipment or transhipment is allowed

 Details of the shipment (including port or airport of departure and port of discharge/destination)

 The shipping terms (Incoterms) that apply

 Latest shipment date

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 Brief details of the goods to be shipped. Where the goods are specified in tonnes or kilograms,
rather than in units of product, the letter of credit may specify a tolerance amount, such as 5,000
kilograms plus or minus 5%. (However, there is no tolerance in the credit limit for the letter of
credit.)
 The documents that the exporter should be required to present
 Insurance details
 Latest date after issue of the shipping documents for the presentation of documents under the
letter of credit, with an additional specification that presentation must be made within the period
of validity of the credit
 Notification of whether the applicant for the credit or the beneficiary will pay confirmation charges
(where confirmation is required) and all other charges outside Malaysia
 Authorised signature(s) of a representative of the applicant for the credit.

Partial shipments of the goods and partial drawings (drawing bills for payment of a part of the
total amount of the credit) are permitted, but this must be specified in the letter of credit.

The letter of credit may also specify the number of shipments and the number of payments. For
example, a letter of credit may specify that shipment will be in three instalments, and that:

 The first instalment must be shipped before the end of July, the second before the end of August
and the third before the end of September.
 Payment will be made by means of three drawings, one for each instalment.
This type of arrangement is called ‘instalment drawings and shipments’. They differ from partial
drawings and shipments by specifying a final date for each part of the shipment, and if any instalment is
not shipped by its final permitted date, the letter of credit ceases to be valid.

An example of an application form for a documentary credit is shown on the following page.

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Figure 4.3: Documentary credit application form

Issuing Bank Advising Bank

Applicant Beneficiary

Date of application Expiry date ………………………………………. Place …………………………..

Issue by Swift Issue by airmail Transferable Revolving

Confirmation Credit available by

Required Not Required Sight payment Deferred payment

Acceptance Negotiation
Partial shipment Transhipment
With ………………………………………………………………………………….
Allowed Allowed Against the documents detailed herein and beneficiary drafts at
Not allowed Not allowed the Issuing Bank

Insurance covered by us (Policy/Cover Note enclosed)

Transportat Incoterms – subject FOB CFR CPT

on to ICC's INCOTERMS CIF FCA CIP
currently in force
1. Place of taking in Charge/Despatch from/Place of Receipt:
2. Port of Loading/Airport of Departure:
Latest shipment date:
3. Port of Discharge/Airport of Destination:
4. Place of final destination/for transportation to/Place of Delivery

Brief description of goods without excessive details

Documents Required:
Signed commercial invoice in …………………. Copies Insurance covered by shipper (Insurance Policy/Certificate) in the currency of
Full set clean on board Bills of Lading made to one of Issuing the credit for not less than CIF/CIP value plus 10% covering risk under the
Bank Institute Cargo Clause.
Combined Transport Document made to order of issuing Bank Clause A War risks Other causes
Air Waybills made to order of issuing Bank Clause B Strikes ………………………...
Non-negotiable Sea Waybill in ……………….. copies Clause C TPND …………………………
Delivery Order made out to issuing Bank for account of Applicant …………………………
Other transport documents …………………………….... Other documents:
Notify Party …………………………………………………….. ……………………………………………………………………………………..
Certificate of ……............ origin …..………….. copies ……………………………………………………………………………………..
……………………………………………………………………………………..
Weight List
……………………………………………………………………………………..
Packing List

Freight Prepaid Freight Payable Others

Documents to be presented within ……………… days after the date of issuance of transport document/delivery order but within validity of the credit.

Additional instructions

All charges outside Malaysia are for account of beneficiary applicant

Confirmation charges if any are for account of beneficiary applicant

We request you to issue your irrevocable documentary credit for our account Authorised Signature with Company Stamp
in accordance with the above instructions (marked X where appropriate).
The Credit will be subject to the current Uniform Customs and Practice for
Documentary Credit, published by the International Chamber of Commerce,
insofar as these are applicable. We agree to be bound by the general
conditions appearing on the reverse hereof.
Signature Verified

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9.1 Processing the application

When a bank receives an application for a letter of credit, it will carry out the following procedures.

 It will check that the applicant for the letter of credit has arranged a line of credit and that
sufficient credit is available.

 It will check that the signature(s) on the application for the credit are authorised signatories of
the applicant.

 It will also check whether an import licence will be required and whether exchange control
approval will be required. Where an import licence is required, the bank will usually ask for a
copy.

 The bank will normally carry out a status check on the beneficiary.

 Where the shipping terms indicate that the buyer is responsible for insurance of the goods, the
bank will ask for documentary evidence of the insurance cover, to make sure that the buyer has
obtained the required cover.

Subject to satisfactory checks, the bank will issue the letter of credit.

9.2 Transmission (method of issue)

It is common practice to send letters of credit electronically to the nominated advising bank by SWIFT
message, in a standard format. This process makes it easier for the issuing bank to issue the letter of
credit and for the advising bank to check that it is genuine and comes from an authentic source.

On receipt of a letter of credit by SWIFT message, the advising bank may advise the seller through an
internet-based advising service, which means that the seller can be advised of the letter of credit very
soon after it has been issued and the advising bank has received it.

An alternative to advising a letter of credit by SWIFT message is to advise by airmail. This is less
common in practice, and involves some delay while the notification/advice is in transmission.

9.3 Role of the advising bank

As explained earlier, letters of credit are advised or notified to the beneficiary by a correspondent bank of
the issuing bank, in the country of the exporter. Alternatively the advising bank is a branch of the issuing
bank located in the exporter’s country.

The role of the advising bank is to notify the exporter/beneficiary of the letter of credit and its terms and
conditions. The purpose of sending the notification to the exporter through an advising bank is to check
that:

 The letter of credit comes from an authentic source.

 The advice correctly reflects the terms and conditions of the letter of credit.

As explained earlier, the advising bank may be asked to confirm the letter of credit; if asked to do so, it
may agree.

10 Presentation of the documents

A letter of credit provides an undertaking by the issuing bank to make the payment, provided that the
seller complies with the terms and conditions of the L/C within the period of validity of the L/C. The
issuing bank and the buyer can refuse to make the payment under the terms of the letter of credit if the
seller fails to comply with these terms and conditions.

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The letter of credit will specify a latest date for presentation of the documents at the counter of a
nominated bank. An exporter will often present documents to its own bank, which may not be the
nominated bank. When this happens, the exporter’s bank is required to present the documents to the
nominated bank before the expiry date for the letter of credit; otherwise the letter of credit will cease to
be valid.

For the seller, failure to comply with the terms and conditions of the L/C would reduce what
should be a guarantee of payment from a bank to a documentary collection, without a
guarantee of payment.

It is therefore essential that the seller should:

 Check the details in the letter of credit, to make sure that these agree with the terms and
conditions of the trading contract with the buyer.

 Ensure that it will be able to comply with all the terms and conditions in the letter of credit: if the
seller is not be able to do this, it should re-negotiate either the terms of the trading contract or
the terms and conditions of the L/C.

 Ensure that the terms and conditions are fully complied with within the period of validity of the
L/C.

An important feature of a letter of credit is the list of documents that the seller must present. The most
common documents are the same as those in documentary collections, although a letter of credit usually
specifies in more detail how the document should be issued, and who should issue them. The documents
for presentation (possibly in multiple copies) should include:

 Transport documents: these may give title to the goods (bill of lading) but other transport
documents, such as an air waybill, may be specified in a L/C.

 Commercial invoice.

The specified documents may also include:

 Insurance documents for the shipped goods.

 Inspection certificates, verifying the quality or quantity of goods shipped.
 Certificate of origin (country of origin).
 Packing list of the items shipped.

UCP 600 states that at least one original of each document specified in the letter of credit must be
presented to the issuing, confirming or negotiating bank.

10.1 Documents issued or certified by a third party

The seller needs to check that all the documents specified in the letter of credit can be presented, and
that presentation can be made before the expiry date for the L/C.

This can be a particular problem when the documents will be:

 Produced by a third party, for example a certificate of inspection of the goods.

 Required to be approved or certified by a third party, such as a chamber of commerce or trade

officials in the embassy of the buyer’s country.

The seller needs to be confident that the documents can be obtained as specified in the L/C, and that
they will be available in time for either shipment of the goods or presentation of the documents under
the L/C.

The seller also needs to be aware that the terms of delivery of the goods in the L/C must be consistent
with the shipping and other documents. For example, if the L/C specifies that the seller must present a
clean on board bill of lading with an Incoterm CIF Manila, the seller must be able to present, within the
documents:

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 A bill of lading that indicates that the goods have been loaded ‘clean on board’ and are CIF
Manila.

 Appropriate insurance documents for the shipment.

10.2 Inspection of the goods by a third party

With both documentary credits and documentary collections, the buyer must honour the documents if
these are presented in accordance with the specifications, and normally the buyer has been unable to
inspect the goods before doing this.

This may not be a problem when the seller and buyer have a long-established business relationship, so
that any problems with the goods will be resolved between them.

There may be a problem, however, when the seller and buyer do not know each other well. To persuade
the buyer to agree to a letter of credit, the seller must be able to suggest a way of reassuring the buyer
that the goods shipped are in good condition and in the quantity and to the specification agreed with the
buyer. This can be done by appointing an independent third party firm of inspectors to check the goods
before shipment and issue a certificate of inspection. An arrangement for inspection of the goods should
be part of the contract between seller and buyer, and a third-party inspection certificate should be
included in the specified list of documents for presentation under the L/C.

11 Complying presentation and non-complying presentation:

UCP 600
UCP 600 states that when documents are presented in compliance with the terms and conditions of the
letter of credit, the bank must honour or negotiate.

 If the issuing bank decides that the presentation of documents complies with the terms and
conditions of the L/C ‘it must honour’ (UCP Article 15).

 If there is a confirming bank and this bank decides that the presentation of documents complies
with the terms and conditions of the L/C, it must honour or negotiate, and forward the documents
to the issuing bank.

 If there is a negotiating bank, and the negotiating bank decides that the presentation of
documents complies with the terms and conditions of the L/C and it honours or negotiates, it
must forward the documents to the confirming bank or issuing bank.

When a bank decides that a presentation of documents does not comply with the terms and conditions
of the letter of credit, it may refuse to honour or negotiate (UCP Article 16).

When an issuing bank decides that a presentation does not comply, it may use its judgement and
approach the applicant for the credit (the buyer) and ask whether the applicant is prepared to allow the
discrepancies.

When a confirming bank or negotiating bank refuses to honour or negotiate, it must give notice to the
presenter of the documents, and the notice should:

 State that the bank is refusing to honour or negotiate.

 List each discrepancy in the documents that explains its refusal to honour or negotiate.

 State that the bank is holding the documents pending further instructions from the presenter, or
that (as issuing bank) it is awaiting instructions from the applicant of the credit about whether the
discrepancies will be allowed, or that it is returning the documents to the presenter.

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11.1 Rules for the examination of paper documents

When a nominated bank, confirming bank and the issuing bank are presented with paper documents
under a letter of credit, they check the documents to decide whether they constitute a ‘complying
presentation’. In other words, each bank checks whether the presentation of the documents appears to
comply with the terms and conditions of the letter of credit.

A standard for the examination of documents is included in the Uniform Customs and Practice UCP 600
(Article 14). This includes the following specifications.

 A nominated bank (acting on its nomination), a confirming bank (if any) and the issuing bank
must examine a presentation to decide, on the basis of the documents alone, whether or not
the documents appear to constitute a complying presentation.

 Each bank has a maximum of five banking days following the day of presentation to
determine whether the presentation is ‘complying’.

 A presentation including transport documents must be made by the beneficiary not later than
21 calendar days after the date of the shipment, and not later than the expiry date for the letter
of credit.

 Data in a document must not conflict with other data in the document, data in any other
document or the letter of credit.

The International Chamber of Commerce has also issued an International Standard Banking Practice
(ISBP number 681) for the examination of documents presented, which is consistent with UCP 600.

E X A M P L E

A letter of credit expires at the counter of the nominated paying bank, which is also the advising bank,
on Monday 1 June. The letter of credit expires on Thursday 4 June.

Although the letter of credit expires on 4 June, the bank is still allowed five banking days after the
documents have been presented to carry out their checks. The bank therefore has until Monday 8 June
to make its checks. The time allowed for checking is not affected by the expiry of the letter of credit.

E X A M P L E

A letter of credit states that transport documents must be presented within 10 days of shipment. The
letter of credit expires at the counter of a nominated bank in the exporter’s country on 30 April.

In this example, the transport documents must be presented within 10 days of shipment and also before
the expiry date for the letter of credit. This means that:

 If the bill of lading is dated 16 April, the documents must be presented by 26 April for the
presentation to be valid. This is 10 days after shipment.

 If the bill of lading is dated 26 April, the documents must be presented by 30 April for the
presentation to be valid. This is the expiry date for the letter of credit.

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11.2 The examination of electronic documents

The use of electronic documents has increased in international trade. Electronic documentation is
transferred much quicker than paper documents, and is less expensive. In some cases, all the
documentation is in electronic format. In other cases, some of the documentation is in electronic form
and some in paper form.

Where electronic documentation is included in the documents for presentation with a letter of credit, the
seller and buyer can agree to apply supplementary articles eUCP 600 to the documentary credit.
These are supplementary articles to UCP 600, and documentary credits subject to eUCP 600 are also
subject to the main UCP 600 articles, and the documentary credit must specify that the provisions of
eUCP 600 should apply.

With electronic documentation, the bank needs to authenticate the document. This involves
checking:

 The apparent identity of the sender

 The apparent source of the document
 Whether it appears to be complete and unaltered.

Some of the rules in eUCP 600 for electronic documentation are, briefly, as follows.

 The letter of credit should specify an electronic address for the presentation of electronic
documents.

 The seller (beneficiary) does not have to present all the electronic documents at the same time.
Electronic documents (unlike paper documents) can be presented separately, but the beneficiary
must provide a ‘notice of completeness’ when all the electronic documents have been presented.

 The letter of credit must specify the required format for the electronic documents (for example,
html, pdf, gif, doc). If it does not specify a format, any format will be acceptable.

 Electronic records must identify the letter of credit to which they relate.

 Electronic records must be checked for compliance with the requirements of the letter of credit. If
the electronic records include a hyperlink reference, this reference is an electronic document that
must be checked. Failure to access a referenced hyperlink will be taken as a discrepancy in the
documentation.

 If a bank gives a notice of refusal, indicating that the electronic documents are not acceptable,
the beneficiary must supply disposition instructions to the bank within 30 days; otherwise the
bank may dispose of the electronic records without responsibility.

 When a letter of credit specifies a requirement for more than one original of a document or an
original plus copies, one electronic record is sufficient to satisfy this requirement.

 If an electronic document appears to have been corrupted, so that it cannot be opened or

checked, the bank should inform the presenter of the document and ask for the document to be
re-presented. The time allowed for examination of the documents is suspended until the re-
presented document is received.

 Although the bank must check an electronic record for apparent authenticity, the bank assumes
no liability for false identity of the sender, the source of the information or whether the record is
complete and unaltered, other than what is apparent from a commercially-acceptable process for
the receipt and authentication of electronic records.

12 Discrepancies in documentation
When there are discrepancies in the documentation, and differences between the documents specified in
the letter of credit and the actual documents presented, a bank must refuse to accept the documents
and notify the seller or bank from which the documents were received.

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Notification of a non-complying presentation (a notice of ‘refusal to honour’) must be given to the

presenter of the documents not later than the fifth banking day following the presentation. The
notice must list all the discrepancies that have been found in the documents, and state that the bank is
refusing to honour the presentation.

Several courses of action are now possible.

 The seller may be able to provide the appropriate documents before the expiry date for the credit.
If this is possible within the permitted time before expiry of the letter of credit, the bank may
permit documents with the corrections or amendments to be presented.

 However, this may not be possible. An alternative course of action may then be to send a SWIFT
message to the issuing bank asking for a waiver of the discrepancies. The issuing bank may
agree, but its decision must be reached within the five banking days allowed to the other bank for
checking the documents.

When a bank finds that the documents are non-compliant, cannot be corrected in time and the issuing
bank will not agree to allow the discrepancies, the bank guarantee of payment or acceptance disappe.
The documents must be either:

 Returned to the presenter with a notice of refusal to honour.

 Forwarded to the issuing bank for payment as a documentary collection. The letter of credit in
effect becomes a documentary collection, and the decision about whether to accept the goods
(and pay for them) is a matter for the buyer to decide.

12.1 Examples of discrepancies in documentation

Some possible discrepancies in the documentation are listed below.

 The bank does not receive all the documents listed in the letter of credit.

 The description of the goods in the invoice may be inconsistent with the specification of the goods
in the letter of credit. The description of the goods in the transport document may be inconsistent
with the description in the letter of credit and the invoice.

 Where an export licence is included in the required documents, the description of the goods for
which the export licence has been granted may differ from the description of the goods in the
letter of credit, invoice and transport document.

 The shipment terms specified in the invoice (for example, CIF) may not correspond with the
specification in the letter of credit.

 An on-board transport document may fail to identify the vessel and port of loading.

 The port of loading and port of discharge on the transport document may be different from those
specified in the letter of credit.

 The letter of credit may call for an on-board bill of lading, but there is no evidence on the bill of
lading to indicate that the goods have been loaded on board a vessel for shipment.

 The letter of credit may specify that an insurance policy document must be provided, but only an
insurance cover note is provided.

 The date of shipment of the goods on the transport documents may be later than the last date for
shipment specified in the letter of credit.

 The transport documents indicate part-shipments of the goods whereas the letter of credit states
that part-shipments are not allowed.

 The documents may be presented after the letter of credit has expired.

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Under Article 27 of the UCP 600, a bank should only accept a ‘clean’ transport document, such as a clean
on board bill of lading, which means that the goods have been accepted for shipment and are not
defective or damaged. However the bill of lading may be noted to indicate that there is evidence of
defective packing or damaged goods. When a transport document such as a bill of lading indicates
damaged goods, the bank must not accept it.

The above list of possible discrepancies is not comprehensive.

13 Role of the issuing bank in the presentation of documents

The issuing bank is subject to the same rules as other banks which check documents presented to them.

 If the documents are in order, the issuing bank must reimburse the nominated bank or confirming
bank, according to the terms of the letter of credit. In the case of deferred payment or
acceptance of a bank bill, payment must be made by the maturity date.

 The issuing bank must notify the applicant for the credit (the buyer) that the documents have
been received, and ask for payment under whatever arrangement has been agreed. The bank
should then release the documents to the buyer.

 If the presentation is non-complying and the failure to comply has been notified to the issuing
bank by the nominated or confirming bank, the buyer/applicant for the credit may be asked
whether it is prepared to accept the discrepancies. This decision must be obtained within the five
banking days allowed to the issuing bank for checking the presented documents.

 If the applicant agrees to accept the discrepancies, the presenting bank must be informed and
payment should be made by the issuing bank to the presenting bank in accordance with
instructions. The letter of credit is deemed to have been amended.

 If the applicant refuses to accept the discrepancies, or if the issuing bank discovers discrepancies
that the nominated or confirming bank had failed to identify, a notice of refusal to honour the
presentation must be given to the nominated or confirming bank within five banking days of the
presentation.

 Failure by the issuing bank to issue a notice of refusal to honour within five banking days means
that the issuing bank cannot claim that the documents do not comply. It must, therefore, honour
the sight payment or payment at maturity, in accordance with the payment terms in the letter of
credit.

 If the buyer/applicant refuses to accept valid documents and take delivery of the goods, the
issuing bank may have to clear the goods through customs and store and insure them. It may
then need to arrange for the goods to be sold to someone else or auctioned, in order to recover
money paid by the bank on the applicant’s behalf.

14 ICC Uniform Customs and Practice for Documentary

Credits: UCP 600
The purpose of UCP 600 is to provide an internationally-accepted set of practical rules for documentary
credits, and avoid confusion that would be caused by countries each having their own separate rules.
The International Chamber of Commerce (ICC) is a private international organisation, not a government
body, but its rules have gained almost universal acceptance.

Many of the rules in UCP 600 have been explained in the previous paragraphs.

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14.1 Force majeure

Just as in the Uniform Rules for Collection, the Uniform Customs and Practice state that banks will not be
liable for events ‘arising out of the interruption of its business by acts of god, riots, civil commotions,
insurrections, wars, acts of terrorism or by any strikes or lockouts or any other causes beyond its control’
(Article 36).

On resumption of its business, the bank will not honour or negotiate under a letter of credit that expired
during the interruption to its business.

15 Settlement
15.1 Settlement of sight bills with letters of credit
Sight bills are payable immediately on presentation of complying documents to the applicant. The issuing
bank will issue the documents to the applicant only when payment has been received. The applicant may
be financed by trust receipt (TR) or a banker’s acceptance to allow it time to process or sell the goods
and obtain income to make the payment. Trust receipts and bankers’ acceptances are explained in a
later chapter.

However, it does not matter whether the applicant for the credit pays or not – in the sense that, if the
presentation of the documents has been in compliance with the terms and conditions of the letter of
credit, the issuing bank must honour payment in accordance with the instructions of the presenter of the
documents. This is a key feature of a letter of credit. Recovering the money from the applicant is the
responsibility of the issuing bank. The arrangement between the issuing bank and the applicant for
payment is a separate contract, outside the letter of credit.

15.2 Settlement of usance bills

With usance letters of credit, where payment is due some time after presentation of the documents, the
issuing bank must honour the claims of the nominated bank at maturity of the bill, provided that the
documents have been presented in compliance with the terms and conditions of the letter of credit.

The issuing bank and the applicant for the credit make their separate arrangement for payment by the
applicant. The issuing bank may release the shipping documents to the applicant on acceptance of a bill
of exchange by the applicant, or in return for an undertaking to pay at maturity. The issuing bank may
arrange temporary finance for the applicant to enable the applicant to pay the bank. This arrangement is
described in more detail in a later chapter.

15.3 Letter of credit as a means of obtaining export finance

A letter of credit is a guaranteed payment, subject to known terms and conditions. With usance letters of
credit, an exporter may be able to use a letter of credit to obtain finance. Finance may be needed,
especially if the supplier is not a big company, to cover costs that it has incurred such as:

 Raw materials
 Payments to sub-contractors
 Operating costs for production and delivery
 Cost of insurance cover for the goods

Often the nominated bank will be prepared to purchase/discount the bill of exchange in order to provide
the exporter with finance until eventual payment, on the basis that payment to the supplier/exporter is
guaranteed, provided that the terms and conditions of the letter of credit are complied with.

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If the supplier needs this pre-shipment finance, it may be prepared to share the costs of the letter of
credit with the buyer, to persuade the buyer to agree to apply for the L/C.

15.4 Role of reimbursing bank

The reimbursing bank is the paying agent appointed by the issuing bank to honour claims submitted by
the paying or negotiating bank. It is usually in the same country as the paying or negotiating bank, and
is a branch or a correspondent bank of the issuing bank. As such the reimbursing bank in letter of credit
arrangements serves as the source of funds for payment to the beneficiary.

16 Other common forms of letter of credit

Letters of credit are issued in a number of different forms. In addition to ‘standard’ letters of credit, there
are:

 Transferable credits
 Back-to-back credits
 Red clause letters of credit and green clause credits
 Revolving credits.

16.1 Transferable credits

A transferable credit is a normal letter of credit, but is designated as transferable. This type of letter of
credit can be transferred at the request of the beneficiary to another person (a second beneficiary).
Where the letter of credit allows partial shipments, a transferable L/C may be transferred to more than
one second beneficiary.

A transferable L/C may be used when the seller is a middleman who cannot, alone, supply the goods (or
all the goods) to the buyer, and therefore relies on another supplier to provide some or all of the goods.

A transferable credit allows the middleman to transfer some or all of its rights under the credit to one or
more second beneficiaries.

If a transferable letter of credit has been confirmed, the benefit of the confirmation is transferred to the
second beneficiary.

16.2 Arranging a transferable letter of credit

The procedure for issuing a transferable letter of credit is as follows.

 The buyer/importer instructs its bank to issue a transferable letter of credit in favour of the seller
(first beneficiary).

 The issuing bank asks a bank in the seller’s country to advise the letter of credit. It will usually
ask this advising bank to act as the transferring bank.

 The advising bank notifies the first beneficiary of the transferable letter of credit.

 The first beneficiary instructs the transferring bank to transfer a part or the whole of the amount
of the letter of credit to the second beneficiary. Some details in this letter of credit to the second
beneficiary will differ from the details in the letter of credit to the first beneficiary, and the first
beneficiary must specify what these amendments should be.

 After making the changes instructed by the first beneficiary, the transferring bank informs the
second beneficiary that a transferable L/C has been transferred in its favour.

This procedure is shown in the following diagram, where there is one second beneficiary.

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Figure 4.4: Transferable letter of credit process

Applicant (importer) First beneficiary (middleman)

1. Sales contract

2. Applies for 4. Advises 5. Request to

transferable transferable transfer L/C to
credit credit second beneficiary

Issuing bank Advising/nominated transferring bank

3. Issues transferable credit

6. Notification of
transferred credit

Second beneficiary

16.3 Changes in the transferred letter of credit

A credit can be transferred only when it relates to identical goods. However, when a credit is
transferred, the middleman can alter some specific details which may be reduced or shortened, such as
the:

 Latest date for shipment

 Expiry date for the credit

 Amount payable in the invoice and unit price for the goods

 Quantity of goods, where only a part of the full shipment will be supplied by the second
beneficiary.

The middleman may also substitute some of the documentation. In addition, the middleman can
substitute its own invoices for presentation, to replace the invoices of its own suppliers.

Usually the buyer is made aware of the middleman’s situation, and authorises the transferability of the
credit.

E X A M P L E

Transferable credit
The following example shows comparable details of an original letter of credit and a transferred letter of
credit. The buyer/importer is ABC Ltd USA, the first beneficiary is DEF Exports and the second beneficiary
is GH Manufacturing.

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Transferable L/C Transferred L/C

Applicant ABC Ltd USA DEF Exports

Beneficiary DEF Exports GH Manufacturing

Quantity of goods 1,000 units 1,000 units

Amount of credit US$250,000 US$200,000

Unit price US$250 US$200

Expiry date 30 June [Year] 18 June [Year]

Presentation 21 days from shipment 14 days from shipment

Last shipment date 8 June [Year] 8 June [Year]

Insurance 110% CIF value 137.5% CIF value

The insurance cover in the transferred L/C will indicate to the second beneficiary the size of the profit
margin on its trading transaction as middleman. If standard practice is for insurance cover to be 110% of
CIF value, the second beneficiary can work out that the price charged per unit by EFG Export to ABC Ltd
USA is US$200 × 137.5/110 = US$250, so EFG Exports is making a profit margin of US$50 per unit or
25%.

To hide this information from the second beneficiary, the first beneficiary may try to negotiate the letter
of credit so that the buyer pays for the insurance of the goods.

The process of substitution of documents by the first beneficiary, and the settlement of the L/C, is shown
in the following diagram.

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Figure 4.5: L/C settlement process

First beneficiary
Applicant (importer)

7. Releases
documents 4. Provides
documents for
substitution

3. Request for
documents to be
substituted

5. Presents
documents Transferring bank
Issuing bank

6. Honours L/C

2. Presents
documents

Second beneficiary
1. Ships goods

17 Back-to-back credits
A transferable credit may be used only when the transferred credit relates to identical goods and with
(mostly) the same terms and conditions as in the original letter of credit.

If the goods provided by a supplier to the beneficiary in a letter of credit need to be amended or altered
in any way, a transferable credit cannot be used. In this situation the original letter of credit may be used
as security by the beneficiary to arrange for its bank to issue one or more new letters of credit in favour
of the suppliers.

In other words, a middleman can arrange for an initial letter of credit to be obtained from the buyer’s
issuing bank, and then use this letter of credit as security for one or more new letters of credit issued in
favour of its own suppliers.

A back-to-back letter of credit, like a transferable credit, is commonly used when there is a middleman
acting between the buyer and an original supplier. A back-to-back credit may be arranged where the
original supplier insists on payment by means of a letter of credit.

17.1 Arranging a back-to-back credit

There are two separate letters of credit.

 There is a letter of credit between the middleman and the buyer/importer. This may be called the
master L/C.

 There is another letter of credit between the original supplier and the middleman. This may be
called the slave L/C, or simply the back-to-back credit.

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The middleman arranges for the buyer/importer to arrange for a letter of credit to be issued in its favour.
This is the master L/C. The middleman also instructs its bank to issue a letter of credit in favour of the
original supplier. This is the slave L/C (back-to-back credit).

The master L/C and slave L/C are two separate agreements, but their terms and conditions will have
many similarities, as well as some differences. Some of the documents for presentation with the slave
L/C are different from the documents for presentation with the master L/C. However, the shipping
documents and the insurance documents must be the same.

The master L/C and slave L/C may differ in the following ways.

 The credit value of the slave L/C will be less than the value of the master L/C (to provide the
middleman with a profit on the transaction).

 The latest shipment date and expiry for the slave L/C will be earlier than the latest shipment date
and expiry date for the master L/C.

 The period allowed for presentation of the documents after shipment is usually shorter for the
slave L/C than for the master L/C.

 The slave L/C will usually expire at the counter of the issuing bank (the issuer of the slave L/C).
This is necessary to ensure that the documents will be received from the original supplier and
substituted by the middleman before the expiry of the master L/C.

 Since the insurance documents must be the same, and if the beneficiary is responsible for
arranging insurance for the goods, the slave L/C should specify a higher insurance value (as a
percentage of goods value) than the master L/C/. (This is illustrated in the previous example of a
transferable L/C.)

17.2 Difference between a transferable credit and a back-to-back credit

Transferable credits and back-to-back credits are both used by middlemen when the agreed method of
payment is a documentary credit. The differences between the two types of letter of credit are as
follows.

 With a transferable credit, there is one letter of credit and this is designated as transferable by
the issuing bank. With a back-to-back credit, there are two separate letters of credit: the master
L/C, issued by the buyer’s bank, and the slave L/C, issued by the middleman’s bank.

 A back-to-back credit is issued on the responsibility of the issuer of the slave L/C. With a
transferable credit, the transferring bank issues the transferred credit without any responsibility.

 The issuer of the slave L/C may be obliged to honour the slave L/C when the documents are
presented in compliance with the terms and conditions of the slave L/C, even if the master L/C is
not honoured because of a failure by the middleman to comply with the terms and conditions of
the master L/C.

 Both types of letter of credit are subject to the rules in UCP 600, but UCP 600 includes an article
(Article 39) that applies specifically to transferable credits.

17.3 Procedural checks on a back-to-back credit

Since the back-to-back credit is a separate contractual arrangement from the original master letter of
credit, the bank that issues the back-to-back credit should check the details of the two letters of credit,
to ensure that they are consistent with each other.

One way of doing this would be to prepare a back-to-back credit checklist, which sets out the terms and
conditions of each letter of credit side-by-side, to enable easier comparison, and any apparent
discrepancies can be referred to the beneficiary of the master credit/applicant for the back-to-back
credit.

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A checklist may contain details as follows, copied from each letter of credit:

Term/condition Master L/C Back-to-back L/C Remarks/Approval

Amount

Unit price

Expiry date

Latest shipment date

Presentation period

Description of goods

Bill of lading

Draft

Invoice

Inspection certificate

Insurance
policy/certificate/value

Packing list

Other documents

Special instructions

Method of sending
documents to issuing bank

Bank charges payable by

Presentation: terms of
payment (eg at sight)

If negotiation, negotiation
within ___ days of shipment

Confirmation of L/C?

Reimbursement instruction

18 ‘Red clause’ letters of credit

A red clause letter of credit is a letter of credit that includes a special clause. (This used to be written in
red ink, which is the origin of the term for this type of credit.) This special clause allows the beneficiary
to receive all, or part of, the payment for the value of the L/C before shipping the goods. A red clause
letter of credit is therefore a documentary credit that provides for an advance payment to the exporter.
The amount of the advance payment is usually 30%-70% of the value of the exports.

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The advance is normally paid against a commitment in writing from the beneficiary to subsequently
deliver the transportation documents by an agreed date. It is given at the risk and responsibility of the
issuing bank and is unsecured. (The advance payment is made by a nominated bank in the beneficiary’s
country.)

The exporter can request, on presentation of one or more specified interim documents, that the
nominated bank should pay an agreed amount in advance, defined in the terms and conditions of the
documentary credit. The advance is basically intended to help the exporter to pay for the production of
the goods to be delivered under the documentary credit, for example pay for purchase of raw
material/processing/packing of the goods to be exported.

The interim document or documents to be presented in order to receive the advance payment is
specified in the L/C. As indicated above, these should include a written confirmation or undertaking from
the exporter that the goods will be shipped at a later date.

The balance of the payment for the exported goods is paid after shipment, in accordance with the terms
and conditions of the L/C.

This type of letter of credit creates an additional risk for the buyer. This is the risk that the seller may fail
to ship the goods, having received partial payment for them. Although the issuing bank provides the
payment without security, the applicant for the credit will be required to reimburse the bank in the event
that the exporter fails to ship the goods.

A red clause in a letter of credit will usually be agreed only when the exporter and buyer have a close
working relationship, and the buyer trusts the exporter to ship the goods in accordance with the terms of
their trading agreement.

18.1 ‘Green clause’ letters of credit

A green clause credit is an extended version of the red clause credit, and supplements a red clause
credit. Like a red clause credit, it is a documentary credit arrangement that provides for an advance
payment to the exporter.

 A red clause credit provides for an advance payment to the beneficiary, up to the time that the
goods are delivered at the port of shipment.

 A green clause credit covers the period during which the goods are held in a warehouse, awaiting
shipment, up to the time of actual shipment.
It provides for a further advance payment to the beneficiary to cover charges for warehousing of goods
at the port of shipment, when waiting for ship or space and the cost of insurance of the goods during
this time.

Unlike the red clause letter of credit, the advance is paid only against receipt of:

 A document (a warehouse receipt) providing proof that the goods to be shipped have been
warehoused, as well as

 A written commitment from the beneficiary to subsequently deliver the transportation documents
by an agreed date

 Proof of adequate insurance cover, with the bank as beneficiary, may also be required.

The exporter can draw an agreed percentage of the value of the goods to be shipped against
presentation of warehouse receipts as collateral (security). The warehouse receipt will be issued by an
authorised party, such as a bonded warehouse, and issued or endorsed in favour of the bank.

The warehouse receipt gives the bank control over the goods. In some countries, a warehouse receipt
provides its holder with legal title to the goods.

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The credit is revolving, in the sense that (like a red clause credit) it must be self-liquidating with the
eventual proceeds from the export sale used as the source of repayment for the relevant advance
payments.

The advantage of a green clause letter of credit over a red clause credit is that the lender (bank or
buyer) has some control over the goods after they have been delivered into a warehouse at the port of
shipment.

Depending on an assessment of the reliability and trustworthiness of the exporter, the bank may decide
to appoint someone to supervise the goods on their behalf. This supervision is usually called collateral
management.

19 Revolving credits
When a L/C is used for repeat shipments in a long-term contract between seller and buyer, or for similar
shipments by the seller to the buyer over a long period of time, a practicable arrangement may be for
the buyer to apply for a revolving letter of credit.

The amount of the credit is automatically restored to its original value after each presentation of
documents by the seller, or when the remaining balance falls to a specified lower level.

However, a revolving credit must have:

 A final due date/expiry date, and/or

 A limit to the number of times the credit can be revolved.

E X A M P L E

A revolving letter of credit may be available to the beneficiary for up to US$100,000 per shipment during
a fixed period of time, say six months, subject to a maximum of six shipments. This means that the letter
of credit is available to the beneficiary for up to US$100,000 after making each shipment. Provided that
documents are presented for each shipment within the terms and conditions of the letter of credit, the
same L/C is used for all the shipments within the period, up to a maximum of six shipments.

This type of revolving credit is said to revolve in relation to time.

Another type of revolving credit is a credit that revolves in relation to value. The letter of credit has
an expiry date but, within the time limit for the L/C, the beneficiary is able to provide any quantity of
goods up to the value limit of the letter of credit. When a shipment is made that complies with the terms
and conditions of the credit, the amount of credit available to the beneficiary is restored to its full
amount. There is no limit to the number of shipments within the period of validity of the L/C.

(Note: A letter of credit may be available for a fixed total value and specify that a quantity of goods
should be delivered in a stated number of shipments within a specified period. This is an L/C available
by instalments rather than a revolving L/C.)

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Table – Summary of types of credit

Transferable Back-to-back Red clause Green clause Revolving

credit

Key feature Can be Original L/C Allows Extended red Balance

transferred to used as beneficiary to clause allows available on
second security for receive all or for payment L/C restored
beneficiary if issue of one or part payment while goods to original
goods identical more L/Cs before goods are balance after
shipped warehoused seller
before presents
shipment documents

Use Middleman can Middleman can Assists the Assists the Used for
use if another use if another exporter in exporter in repeat
supplier used to supplier used covering the covering shipments
provide identical to provide production warehousing
Between
goods non-identical costs of the costs and
buyer and
goods goods to be insurance costs
seller
shipped

20 Anti-money laundering (AML) measures

The Anti-Money Laundering and Anti-Terrorism Financing Act 2001 (AMLA) was introduced as part of
a global initiative to prevent or identify money laundering by criminals and the financing of terrorist
organisations.
Money laundering is a process whereby money which has been obtained from criminal activity is
‘cleaned’ so that it appears to come from a legitimate source. An important element in the process of
money laundering is the transfer of funds between banks, often banks in different countries.
This text does not describe the anti-money laundering regulations in detail, but two key elements in the
regulations deal with:
 ‘Know your customer’.

 Reporting suspicious transactions (in Malaysia, banks must report suspicious transactions to the
Financial Intelligence Unit of BNM).

The same rules apply to transactions that may involve funding of terrorist organisations.

20.1 Know your customer

Reporting institutions, such as banks, must verify the identity of every new customer before agreeing to
transact business with them, and must apply ‘know your customer’ procedures. The AML guidelines
state: ‘Every reporting institution must conduct customer due diligence and obtain satisfactory
evidence and properly establish in its records, the identity and legal existence of any person applying to
do business with it. Such evidence must be substantiated by reliable and independent source
documents.’
These procedures must be applied when the reporting institution:
 Establishes a business relationship with a new customer.
 Carries out an occasional transaction with a customer in excess of a specified amount.

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If a customer fails to provide the evidence of identity required, the bank should not enter into a business
relationship or should not perform the transaction. It should also consider making a suspicious
transaction report to the relevant department.

21 The Wolfsberg Trade Finance Principles

Banks should report transactions that they suspect may be for the purpose of money laundering. Anti-
money laundering regulations for banks apply to domestic and foreign banking transactions, but do not
focus in any detail on trade finance transactions.

In 2008, a group of international banks, known as the Wolfsberg Group, published a set of principles that
banks can use to implement anti-money laundering procedures for international trade transactions.

 The Wolfsberg Group consists of Banco Santander, Bank of Tokyo-Mitsubishi-UFJ, Barclays,

Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, JP Morgan Chase, Société
Générale and UBS.

 Its principles are known as the Wolfsberg Trade Finance Principles.

 Although the principles apply to dealing with risks of both money laundering and terrorist
financing, it is recognised that banks can do little about terrorist financing, and the principles
focus mainly on anti-money laundering measures.

21.1 AML and trading on open account terms

Most world trade is conducted on open account terms. Banks are involved only to the extent that they
are instructed to make clean payments, and know nothing about the underlying trade transaction and
the reason for the payment. For these payments, banks can do nothing more than conduct the standard
AML procedures that have been established within the bank, for domestic and foreign payments.

The Wolfsberg Principles therefore concentrate on documentary credits and documentary collections,
where banks handle commercial documents, having had the opportunity to see more details of the
underlying trading transaction (or, in the case of money laundering, the alleged underlying trading
transaction).

21.2 Trade-based money laundering

Money launderers can use several methods for transferring ‘dirty’ money illegally by means of
international trading transactions and the shipment of goods. Usually, the methods rely on collusion
between the seller and the buyer, possibly where the seller and buyer are both under the control of the
same person. Money or value can be transferred in the following ways.

 Over-invoicing. The seller may overstate the price of the goods in the invoice, so that when the
buyer pays, value is transferred from buyer to seller.
 Under-invoicing. The seller may understate the price of the goods in the invoice, so that when
the buyer pays, the buyer gains excess value from seller.
 Multiple invoicing. The same documents for the same transaction and the same goods may be
used more than once, in order to make two or more payments. The money launderers will use
different banks for each of the payments.
 Short shipping. The seller may ship fewer goods or goods of a lesser quality than indicated in
the commercial documents. This has the same effect as over-invoicing.
 Over-shipping. The seller may ship more goods than indicated in the commercial documents.
This has the same effect as under-invoicing.
 Phantom shipping. No goods at all may be shipped, and all the documentation for the
collection or documentary credit may be false.

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 Deliberately disguising the type of goods. The documentation may be deliberately disguised
or falsified to disguise the type of goods that are shipped, where the buyer and seller do not want
the authorities to know the true details of the transaction.

21.3 Risk-based approach to AML measures

The Wolfsberg Principles recommend a risk-based approach to anti-money laundering measures for
documentary credits and documentary collections. The success of this approach depends on:

 The availability of lists of known terrorists (or suspected major criminals), provided to banks by
the government authorities in their country.

 The skills of the individuals checking the documents for a letter of credit or a documentary
collection.

The Principles state, with reference to letters of credit and documentary collections: ‘The complex paper-
based nature of these transactions provides a large amount of information about the parties, goods and
services being transferred and involves scrutiny of the relevant documents. Whilst certain elements in
this process may be automated … the overall process of reviewing trade documents by its nature cannot
be successfully automated … The most effective means by which to identify terrorist involvement in trade
finance transactions is for competent authorities to identify those individuals and organisations connected
to terrorist activities and provide that information to [banks] in a timely manner.’

AML controls can be grouped into four categories:

 Due diligence. This is the process of identifying and ‘knowing’ the customer, and possibly also
checks on a party who may not be a customer, such as a bank in another country or a beneficiary
in another country.

 Reviewing. This is a process of reviewing relevant information about a transaction, such as the
parties involved, the documents presented and the instructions received. A review should be
carried out before the transaction is allowed to proceed.

 Screening. This is a process, often automated, to check information in the documents against a
reference file of ‘sanctioned’ individuals or entities, such as a list of terrorists. Screening is
normally carried out at the same time as reviewing.

 Monitoring. This involves measures to review transactions that have completed or that are in
progress, for the presence of unusual or suspicious features.

22 AML procedures and letters of credit

In a simple documentary credit transaction, there is an applicant for the credit (the buyer), the issuing
bank, the advising/paying bank and the beneficiary (the seller).

22.1 Due diligence

Due diligence will be conducted as follows.

 The issuing bank will conduct due diligence on the applicant for the credit.
 The advising bank will conduct due diligence on the beneficiary.
 The issuing bank may conduct due diligence on the advising/paying bank.
 The advising/nominated/paying bank may conduct due diligence on the issuing bank.

Due diligence by the issuing bank on the applicant for the credit should include ‘know your
customer’ and screening procedures, and the information the bank should consider includes:

 The countries with which the applicant for the credit trades;
 The goods traded;

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 The type of parties with which the applicant does business (suppliers, customers).

‘Enhanced’ due diligence will be appropriate when the applicant for the credit falls into a ‘high risk’
category, or where the nature of the trade suggests that enhanced due diligence (checking more
carefully) would seem appropriate.

Due diligence by the advising bank on the beneficiary should not be necessary where the bank
already has an established banking relationship with the beneficiary. Where a bank in the documentary
credit process does not have an established banking relationship with the beneficiary:

 The advising bank, confirming bank, paying bank or negotiating bank should carry out ‘name
screening’ on the beneficiary. This is a check on the beneficiary’s name against the list of
‘sanctioned’ organisations or individuals.

 The confirming bank, paying bank or negotiating bank should make payment only to a bank
(which has been name screened) through an established payment channel.

 A confirming bank or negotiating bank should carry out additional ‘risk-based’ checks on the
beneficiary.

Due diligence by one bank on another will be necessary where the banks do not have an
established correspondent relationship. As a minimum requirement, an advising/nominated bank must
ensure that there is a means of authenticating any letter of credit received from the issuing bank.

22.2 Reviewing
Reviewing activities will normally be as follows.

 Before agreeing to issue a letter of credit, the issuing bank will review the application for the
credit.

 The advising bank will review the letter of credit that it receives from the issuing bank, before
agreeing to advise it to the beneficiary.

 Depending on its exact role in the documentary credit procedure, the nominated bank may review
the documents presented by the beneficiary.

 The issuing bank will review the documents received from the nominated bank (before paying the
nominated bank, which in turn will pay the beneficiary).

 Both banks will review the payment (or other) instructions that they receive.

For the issuing bank, the main reviewing checks are carried out when the application for the
letter of credit is received. Matters that should be considered at this stage in relation to the possibility
of money laundering, are:

 The country in which the beneficiary is located.

 The goods involved.

 The country where the goods will be shipped from, the country of destination, and any
transhipment points in-between.

 The type, value and quantity of goods involved, and whether these are consistent with what the
bank knows of the applicant’s business.

 Whether the beneficiary is consistent with what is known of the applicant’s business.

The bank should also look for unusual aspects of the transaction, such as aspects which:

 Involve unrelated parties.

 Involve highly unorthodox documentation.

 Create an unusual trigger point for a payment to be made under the letter of credit, for example
before the shipment of the goods without the need to present relevant documentation.

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Depending on the information that comes from the review, the bank may need to:

 Make further internal enquiries about the appropriate course of action, such as reporting it to the
relevant authorities as a suspicious transaction.

 Ask for more information from the applicant for the credit before agreeing to issue the L/C.

 Agree to issue the L/C but make a record of the circumstances.

 Refuse to issue a L/C if the further enquiries do not produce satisfactory answers.

When making payment, the issuing bank should first screen the names in the payment instruction,
including the names of any banks involved.

22.3 Monitoring
The Wolfsberg Principles state that the monitoring process is fragmented, and it is unusual for one bank
to get the opportunity to review an overall trading transaction for suspicions of money laundering. For
example, banks are generally not equipped to assess whether a transaction is unusual due to under-
invoicing or over-invoicing (or other situations where the value of the trading transaction is
misrepresented). ‘For banks involved in processing L/Cs, the knowledge and experience of their trade
staff must therefore serve as the first and best line of defence against criminal abuse of these products
and services.’

The Principles provide a list of risk indicators that may be used at the monitoring or reviewing stage,
before the trading transaction has occurred (pre-transaction) or after the transaction has occurred (post-
transaction). Here are some examples of risk indicators or ‘red flags’:

Risk indicator: examples Pre- or post-transaction

Deal structure beyond the capacity of the customer; improbable goods, Either
quantities, origin, destination

Obvious anomalies between value and quantity, suggesting over- or Either

under-invoicing

Transaction totally different from the customer’s known business

Country in the bank’s ‘high risk’ list. Any attempt to disguise the countries Either
actually involved in the trade

The goods are transhipped through a high-risk country for no apparent Either
reason

Illogical payment instructions Either

Inability of customer to produce trade documentation to back up a Pre-transaction

request for a L/C

Significant discrepancies between the description of the goods in the bill Post-transaction
of lading and the invoice, or between the description of the goods in the
L/C and in the bill of lading

A transaction structure that seems unnecessarily complex Either

A third party, with no obvious connection to the buyer, paying for the Post-transaction
goods (as shown by the commercial invoice)

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23 AML procedures and documentary collections

In a documentary collection, the opportunities for special anti-money laundering checks are less than for
letters of credit, because banks are not as heavily involved in the procedure.

Due diligence checks should be similar to those for a documentary credit.

 The remitting bank should conduct due diligence on the principal.

 The collecting bank should conduct due diligence on the drawee.
 The remitting bank may conduct due diligence on the collecting bank.
 The collecting bank may conduct due diligence on the remitting bank.

Review checks are likely to be limited to standard checks on the country where the other party is
located and the goods involved. Enhanced review checks by either the remitting bank or collecting bank
may be considered appropriate when:

 The country where the other party is located is considered ‘high risk’.

 The goods involved in the transaction do not seem consistent with what is known of the
principal’s or drawee’s business.

Monitoring checks for money laundering will also be limited.

The remitting bank has no responsibility for making the payment or checking documents.

The collecting bank acts on instructions received from the remitting bank, but has limited time to do this.
The Wolfsberg Principles comment: 'A bank’s position with regard to checking documents is …
fundamentally different to the position with L/Cs. A detailed examination of documents attached to a
[documentary collection] is consequently unlikely to be productive due to the absence of any specified
terms and conditions against which to check them…. In determining whether transactions are suspicious
due to over- or under-invoicing … it needs to be understood that banks are not required to check the
underlying documents presented.'

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Chapter roundup

 A documentary credit is where a bank issues a letter of credit that promises payment to a beneficiary
provided that the beneficiary complies with terms and conditions.

 In international trade, an issuing bank issues a letter of credit at the request of an importer for the
benefit of the exporter.

 Compliance with the terms and conditions of a letter of credit requires the presentation of specified
documents at the counter of a nominated bank before the expiry date for the letter of credit.

 A documentary credit involves the bank dealing with documents.

 A letter of credit is advised to the beneficiary through an advising bank in the beneficiary’s country.

 Confirmation involves the addition of a guarantee of payment by the confirming bank.

A confirmed letter of credit has the guarantees of both the issuing bank and the confirming bank.

 After shipment of the goods, the exporter/beneficiary must present specified documents to a nominated
bank.

 A letter of credit is irrevocable after it has been issued, but it must have an expiry date and place of
expiry.

 The nominated bank checks the presented documents for compliance with the terms and conditions of
the letter of credit.

The issuing bank then presents the documents to the importer/applicant for the credit.

 Every bank that receives a presentation of documents for a letter of credit has up to five banking days
after receipt of the documents to check whether they comply with the terms and conditions of the L/C.

 On presentation of the documents to the importer, the importer must either pay at sight or agree to pay
at a future date.

 If the documents include a negotiable bill of lading, the importer has legal title to the goods and can take
possession of them.

 The exporter/beneficiary may receive immediate payment (payment at sight), or may wait until maturity
of the accepted bill for payment.

 If presented documents are presented after the expiry date for the letter of credit, the L/C is no longer
valid.

If the problem is not resolved the bank should refuse to honour the letter of credit.

 When a bank refuses to honour a letter of credit, the documents may be returned to the beneficiary.

 UCP 600 (Uniform Customs and Practice for Documentary Credits, ICC Publication Number 600) contains
internationally-recognised rules and guidelines for documentary credits.

 A back-to-back credit may also be used when a middleman is selling goods to a foreign buyer that come
from an original supplier.

 A red clause letter of credit allows the beneficiary to receive some or all of the payment before the goods
are shipped.

 A revolving letter of credit is used when an exporter makes a number of shipments to an importer.

 A revolving L/C must have an expiry date. It will also often specify a limit to the number of times the
credit can be ‘revolved’ in this time.

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 Banks are required to have anti-money laundering procedures in place.

 The Wolfsberg Principles, are principles that banks may use in their anti-money laundering procedures
for international transactions.

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chapter 5

GUARANTEES AND STANDBY

LETTERS OF CREDIT

Contents
1 The nature of bank guarantees ................................................................................. 113
2 Applying for a bank guarantee .................................................................................. 114
3 Direct and indirect guarantees .................................................................................. 115
4 Conditional guarantee and demand guarantee ............................................................ 116
5 Types of guarantees................................................................................................ 119
6 ICC rules for guarantees .......................................................................................... 123
7 Standby letters of credit .......................................................................................... 127
8 International Standby Practices, ICC publication number 590 (ISP98) ............................ 128
9 Guarantee or standby L/C?....................................................................................... 131
10 Shipping guarantees................................................................................................ 132
Chapter roundup.......................................................................................................... 134

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Learning outcomes
On completion of this chapter you should be able to:

 Analyse the purpose, form, uses and limitations of guarantees and standby letters of credit.
 Examine the role of the International Chamber of Commerce and the application and benefits of
their Uniform Rules in relation to guarantees.

Learning objectives
While working through this chapter you will learn how to:

 Describe the nature of bank guarantees and the main parties to a guarantee.
 Differentiate between direct and indirect guarantees.
 Analyse the nature of a conditional guarantee and a demand guarantee.
 Explain the risks for the principal with a demand guarantee.
 Analyse the purpose of guarantees or bonds issued by a commercial bank.
 Describe the different types of guarantees or bonds that may be issued by a bank.
 Examine the rules that apply to the examination of a demand for payment under the terms of a
bank guarantee.
 Examine the nature and use of a standby letter of credit.
 Explain the difference between a guarantee and standby letter of credit.
 Analyse the nature and purpose of a shipping guarantee issued by a bank.
 Examine the uses and limitations of URCG 325.
 Apply the rules in URDG 758 for demand guarantees.
 Apply the rules in ISP98 for international standby letters of credit.

Introduction
It is common practice in international trade for either the seller or the buyer (or both) to demand an
undertaking from the other, separate from their trade contract with each other, which may be necessary
to reduce risks and may take the form of a guarantee, standby letter of credit or a bond.
For example:
 A buyer may demand an undertaking from the seller, separate from their trade contract, to deliver
the goods in the contract.
 A seller may demand an undertaking from the buyer, separate from their trade contract, to pay for
the goods.
 An undertaking may relate to something other than delivery and payment obligations. For example,
a buyer may want an undertaking from the seller with regard to the installation of equipment
delivered by the seller, or a guarantee relating to the future performance of the equipment or a
warranty period.
The most common forms of undertaking for ordinary international commercial trading transactions are
demand guarantees and standby letters of credit.

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1 The nature of bank guarantees

1.1 The reason for bank guarantees
Risks in international trade are usually much greater than the risks with domestic trade. The risks are
especially high when an ‘export’ transaction involves a major construction contract and a large contract
to supply capital goods over a period of time.

For example an American construction company is in competition with a European construction company
to win a contract to construct a new airport terminal in a foreign country. The client, offering the major
contract has to choose one of the bids or tenders from competing construction companies. The risks for
the client include the possibility that a certain construction company will be awarded the contract, but
will then be unable or unwilling to do the work. If the client thinks that this risk is high, it will be
reluctant to award the contract – especially to construction companies that do not have an established
international reputation.

In order to win major contracts, a company may be required to obtain the support of a bank, in the form
of a bank guarantee. Without the guarantee, the company may not succeed in winning the foreign
business. The guarantee may be required for the duration of the contract.

In the same way, customers may demand a bank guarantee from an exporter of capital goods, as
protection against the risk that the exporter will be unable to manufacture and deliver the goods
specified in the contract.

An exporter faces the risk that it will deliver goods to a foreign customer, and the customer will be
unable or unwilling to pay. The problems – costs, time and resources needed to pursue a defaulting
buyer for payment through the courts of the buyer’s country – may seem excessive. This is especially
true when the export contract involves delivery of a large quantity of goods over a long period of time, or
a foreign construction contract. Without a guarantee of payment from a bank, in the event of default by
the buyer, the exporter may be unwilling to agree to provide the goods or accept the contract work.

An exporter and a buyer may therefore agree, as a condition of their trade contract, that one of them
should apply for a bank guarantee. This may be a guarantee of performance by the exporter or a
guarantee of payment by the customer.

Guarantees therefore help to promote international trade.

1.2 Guarantees: definition

Key term
A bank guarantee is a guarantee from a lending institution (bank) ensuring that the liabilities of a
debtor will be met. In other words, if the debtor fails to settle a debt, the bank will cover it.

A bank guarantee is a written undertaking issued by a bank:

 On behalf of a client (who may be called the applicant or the principal)

 In favour of a named beneficiary (who may be the buyer or the seller)

A guarantee is a supplementary agreement relating to performance of a specific transaction. However, it

is separate from the underlying commercial transaction.

In its undertaking, the bank promises to make certain payments on behalf of its client to the beneficiary,
in the event that the bank’s client fails to carry out a specified condition or requirement of the
commercial contract. The bank’s commitment is legally independent of the underlying commercial
contract.

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A buyer’s bank may issue a guarantee in favour of the seller, undertaking to make a payment for the
goods in the event that the buyer fails to do so. A seller’s bank may issue a guarantee promising to make
certain payments to the buyer, in the event that the seller fails to undertake certain commitments in the
commercial contract.

A bank guarantee does not involve any financing for the applicant for the guarantee (the principal).

The bank will charge a commission for providing a guarantee. With a conventional guarantee (not
an Islamic bank guarantee), the amount of the guarantee is based on both:

 The amount of the maximum guarantee payment.

 The length of time to the expiry of the guarantee.

The commission should also allow for the bank’s assessment of the risk that a demand for payment will
be made by the beneficiary under the terms of the guarantee.

A bank guarantee may also be called a bond (but this term must not be confused with bonds that
are debt securities issued by a company to raise debt capital).

1.3 A commitment to make a payment

A bank guarantee, or a standby letter of credit (explained later) is a commitment to pay, in full or in part,
an amount of money specified in the guarantee. It does not guarantee fulfilment of the actual delivery of
the goods or any other specific obligation covered by the guarantee.

For example, if a bank issues a guarantee for the delivery of goods by the seller to the buyer, up to a
specified amount, and the seller fails to deliver the goods, the bank will make the specified payment. It
will not undertake to ensure that the seller delivers the goods.

(An exception to this general rule for guarantees is a ‘surety bond’ issued by an insurance company. With
a surety bond, the insurance company gives an obligation to ensure that the underlying transaction is
fulfilled or completed. For example, the insurance company may undertake to find an alternative supplier
to fulfil the contract if the original supplier fails to do so. Surety bonds are designed mainly for building
and construction contracts, or contracts for the supply of major capital equipment.)

1.4 Deciding whether to use a guarantee

A guarantee (or standby letter of credit) may be used in several different circumstances. For example:

 When the seller and buyer trade on open account terms, the buyer may want a guarantee as
protection against failure by the seller to fulfil his obligations under the terms of the contract. (An
alternative to a guarantee with open account trading might be a commercial letter of credit.
However, as stated in a previous chapter, trading on open account makes up the majority of
international trade.)

 When a buyer invites foreign contractors to tender for a major contract, a bid bond, a
performance guarantee, an advance payment guarantee and warranty guarantee may
all be required from a contractor.

2 Applying for a bank guarantee

When an exporter and a buyer agree that there should be a bank guarantee to support their trading
agreement:

 The exporter should ask a bank to issue a guarantee, where the guarantee is required to support
the performance of the contract or other obligation of the exporter.

 The buyer should ask a bank to issue a guarantee, where the guarantee is required to ensure
payment to the exporter, or any other obligation of the buyer.

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A bank issues a guarantee at the request of a customer, in favour of the other party in the trading
contract.

2.1 Main parties to a guarantee

Unless a second bank is involved, there are three parties to a bank guarantee.

 The applicant or principal – This is the seller or buyer, which applies to its bank for the issue
of a guarantee from the bank to cover a particular performance requirement in a commercial
transaction, the ‘primary contractual obligation’.

 The guarantor or issuing bank – This is the bank that issues the guarantee on behalf of the
applicant. The guarantor is usually the applicant’s bank and is located in the same country as the
applicant. Before agreeing to issue a guarantee, the bank conducts a credit assessment of the
applicant/principal and checks compliance with any relevant exchange control regulations.

 The beneficiary – This is the person in whose favour the guarantee has been issued, and is
either the seller or buyer in the commercial contract. The beneficiary requires security (in the
form of a bank guarantee) against the risk of the principal’s non-performance or default under the
primary contractual obligation.

Figure 5.1: Main parties to a bank guarantee

Beneficiary Primary contractual obligation Applicant/Principal

(Buyer or seller) (Seller or buyer)

Application for
guarantee

Guarantor/Issuing bank
Guarantee

3 Direct and indirect guarantees

3.1 Direct guarantees
A guarantee issued by the bank and given to the beneficiary is known as a direct guarantee. The
issuing bank provides the guarantee direct to the beneficiary, and does not give the guarantee to the
principal for the principal to give to the beneficiary.

With a direct guarantee, the guarantee is provided to the beneficiary by the issuing bank in the
applicant’s country. Direct guarantees are normally subject to the laws that apply in the issuing bank’s
country.

A direct guarantee may be issued to the beneficiary though an advising bank in the beneficiary’s own
country, without any further obligation on the part of the advising bank. The role of the advising bank is
then simply to forward the guarantee to the beneficiary and verify the authenticity of the issuing bank.

Although the guarantee has been advised by a nominated bank, the guarantee is a direct guarantee.

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3.2 Indirect guarantees

In some cases, the beneficiary may require the local bank to provide its guarantee. For example, it may
be a local law that a bank guarantee must be issued by a local bank, and not a foreign bank in another
country.

In other situations, the intended beneficiary may not want to receive the guarantee from a bank in
another country, preferring instead to receive a guarantee from a bank in its own country.

An applicant for a guarantee may therefore ask its bank to arrange for a guarantee to be issued to the
beneficiary by a bank in the beneficiary’s country.

A guarantee issued by a bank in the beneficiary’s country at the request of the applicant’s bank is an
indirect guarantee.

An indirect guarantee may also be required when the beneficiary wants the guarantee to be governed by
the laws of his country (because a guarantee is usually subject to the laws of the country of the issuing
bank). The applicant for the guarantee should check the legal position prior to issuing an indirect
guarantee.

3.3 Indirect guarantees and counter-guarantees

With an indirect guarantee:

 The ‘local’ bank issues the guarantee to the beneficiary in its own country.
 The applicant’s bank (the ‘instructing bank’) issues a counter-guarantee to the local bank,
which is a guarantee to repay the issuing bank in the event that the issuing bank is required to
make a payment under the guarantee it has issued. The instructing bank is also known as the
counter-guarantor.
With an indirect guarantee and counter-guarantee, four parties are involved.

Figure 5.2: Parties in indirect and counter-guarantees

Beneficiary Primary contractual obligation Applicant/Principal

(Buyer or seller) (Seller or buyer)

Application for
Guarantee guarantee

Issuing bank Counter-guarantee Instructing bank

(in beneficiary’s country)

The instructions between banks are normally sent electronically by SWIFT message.

4 Conditional guarantee and demand guarantee

4.1 Conditional guarantee
A conditional bank guarantee is a ‘traditional’ type of bank guarantee, in which the bank guarantees to
make a payment in the event of a failure by the principal/applicant for the guarantee to fulfil specified
terms or conditions in the commercial contract for which the guarantee is issued. However, before
making a payment, the bank and the principal must be satisfied that the demand for payment is valid
and that the principal is in breach of the obligations for which the guarantee was issued.

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A conditional guarantee must therefore include the following information.

 The issuing bank (including authorised signature on the guarantee and date of issue of the
guarantee).

 Beneficiary.

 Guarantee identity number.

 The other party to the commercial contract (the applicant/principal).

 The commercial contract to which the guarantee relates, and (where appropriate) specific terms
or conditions in this contract.

 A statement that the bank is issuing a guarantee at the request of the applicant/principal.

 The maximum payment that the bank will make under the guarantee.

 The national law and jurisdiction that applies to the guarantee.

 Expiry date for the guarantee.

 A statement that claims under the guarantee should be made in writing to the bank.

The bank undertakes to make a payment under its guarantee if there is a breach of the terms of the
commercial contract, or breach of a specific aspect of the terms and conditions of the contract.

This is a conditional guarantee. Payment to the beneficiary will be made on condition that the terms of
the commercial contract are broken by the applicant/principal for the guarantee.

The guarantee therefore becomes payable when:

 The issuing bank has verified that the applicant/principal is in breach of its contractual obligations
under the terms of the commercial contract.

 The beneficiary has suffered loss or damage, as specified in a claim document to the bank, and
has submitted a demand for payment.

In many cases, it may be fairly clear that the applicant/principal has been in breach of the terms of the
commercial contract, and the bank should make a payment under the terms of its guarantee. However, a
problem may arise when the two parties to the commercial contract are in dispute. One party may claim
a breach of contract and the other party may deny it. Until the dispute is resolved, it is not possible to
decide if a payment should be made under the guarantee for breach of the contract terms. The
applicant/principal will instruct the bank not to make a payment under the guarantee. This may result in
a dispute and long delay, involving lawyers, court proceedings or formal arbitration before payment
under the guarantee can be made. For this reason, conditional guarantees have not been popular in
international trade, and beneficiaries are generally unwilling to accept a conditional guarantee. A long
delay in making a payment under a guarantee would remove an important purpose of a guarantee – to
receive payment or compensation when problems arise with the underlying commercial contract.

4.2 Demand guarantee

The lack of equality between the applicant for a guarantee and the beneficiary led to the development of
the demand guarantee, and it is now usual practice for guarantees to be issued as demand
guarantees.

Key term
A demand guarantee is a type of protection that one party in a transaction can impose on another
party in the event that the second party does not perform according to predefined specifications. In the
event that the second party does not perform as promised, the first party will receive a predefined
amount of compensation by the guarantor, which the second party will be required to repay.

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This gives the beneficiary an unrestricted right to make a claim under the guarantee, regardless of any
objections from the principal or the issuing bank. A demand guarantee therefore puts the beneficiary in a
much stronger position than with a conditional guarantee.

With a demand guarantee, the issuing bank is required to make a payment under the guarantee:

 On demand from the beneficiary.

 Without the need for approval from the applicant/principal.

 Without the need to prove to the issuing bank that a breach of the contract terms has occurred,
for which payment under the guarantee should be made.

The beneficiary writes to the issuing bank stating that a relevant breach of the terms of the commercial
contract has occurred and a specified amount of payment is therefore required under the terms of the
bank’s guarantee. The bank must then make the payment (provided that it does not exceed the
maximum amount guaranteed, and the guarantee has not expired).

A demand guarantee must therefore include the following information.

 The issuing bank (including authorised signature on the guarantee and date of issue of the
guarantee).

 Beneficiary.

 Guarantee identity number.

 The other party to the commercial contract (the applicant/principal for the guarantee).

 The commercial contract to which the guarantee relates, and (where appropriate) specific terms
or conditions in this contract.

 A statement that the bank guarantees a payment on demand, at the request of the beneficiary, in
the event of an alleged breach of the commercial contract by the principal, or an alleged breach
of a specific aspect the commercial contract.

 The maximum payment that the bank will make under the guarantee.

 The national law and jurisdiction that applies to the guarantee.

 Expiry date for the guarantee.

 A statement that claims under the guarantee should be made in writing to the bank.

4.3 The risk for the principal with a demand guarantee

There is a risk with a demand guarantee that the beneficiary will make a false or unfair claim, and that
the beneficiary is still in dispute with the principal.

For example, suppose that a seller applies to its bank for the issue of a demand guarantee in favour of
the buyer. If there is any dispute between the seller and buyer about the commercial contract, the seller
is in a vulnerable position.

 The buyer has the option of applying to the issuing bank for payment under the guarantee.

 The seller knows this, and in the event of a dispute the seller may therefore ‘back down’ to avoid
a claim under the guarantee.

 If a payment is made under the demand guarantee, it will be difficult for the seller to recover the
money, regardless of the outcome of the commercial dispute, if the buyer is reluctant to give the
money back.

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5 Types of guarantees
The more common types of guarantees in international trade are explained below. The terms ‘guarantee’
and ‘bond’ are both commonly used.

5.1 Bid bond

Key term
A bid bond is a debt secured by a bidder for a construction job, or a similar selection process for the
purpose of providing a guarantee to the project owner that the bidder will take on the job if selected.
The existence of a bid bond provides the owner with assurance that the bidder has the financial means
to accept the job for the price quoted in the bid

A bid bond or tender guarantee may be required when a company submits a bid or tender to win a
contract from a ‘buyer’. The bond or guarantee protects the beneficiary (the buyer) against the risk that
the company bidding for the contract will submit a tender but then:

 Withdraw its tender

 Attempt to amend the tender
 Refuse to sign the contract when it is awarded to it
 Refuse to apply for a performance guarantee if the contract is awarded to it.

The validity of a bid bond extends from date of issue to the signing of the contract or issuance of the
performance guarantee. Once the contract has been awarded to the successful bidder, the bonds of the
unsuccessful bidders are returned for cancellation.

A bid bond may typically be required when companies are invited to submit tenders for a major
construction project in the buyer’s country.

5.2 Performance bond

Key term
A performance bond is a bond issued to one party of a contract as a guarantee against the failure of
the other party to meet obligations specified in the contract.

When a contract has been awarded, a performance bond may be required. This guarantees the
performance of the seller/contractor under the contract, from commencement of the contract to
completion. The bank issuing the performance bond guarantees to pay a specified sum of money to the
beneficiary if the applicant does not fulfil specified contractual obligations.

The validity period for the bond extends to the completion of the contract. However, depending on the
nature of the contract, it may be to the applicant’s advantage to have separate performance bonds for
each stage of the contract.

5.3 Advance payment guarantee or repayment guarantee

An advance payment guarantee protects a beneficiary who makes an advance payment to the applicant
(or a progress payment during a major contract). A refund of a progress payment is guaranteed if the
applicant does not fulfil the terms of the contract.

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5.4 Retention money guarantee

Under a primary contractual obligation, it is often a condition of the contract that the buyer can retain a
proportion of the purchase price for a period of time, as protection in the event that the final part of the
contract is not completed fully or properly. For example, a buyer may negotiate a retention of 15% of
the purchase price for items of equipment, for a specified period of time, as protection in the event that
the equipment is not properly installed by the seller or does not operate properly after installation.

The buyer may agree to forgo retention money, so that the seller receives full payment sooner, but only
against a guarantee of payment in the event of a claim for which the retention money would have been
used.

5.5 Warranty guarantee/maintenance bond

This type of guarantee is designed to protect the beneficiary by covering the cost of any defect or
malfunction which may be discovered after the completion of the project. The guarantee remains in force
for the duration of the ‘maintenance and warranty period’ as specified in the contract between the
beneficiary and the applicant.

5.6 Summary of the different types of guarantees

The following diagram summarises the different guarantees and when they may be used.

Figure 5.3: Types of guarantee

Guarantee Contract event Return of

issued guarantee
Bid bond Bid /tender

Advance Advance
payment payment
guarantee Bid bond guarantee and/or
Contract awarded returned performance
guarantee issued
Performance
guarantee Advance
Goods shipped payment
guarantee
returned

Warranty Installation/acceptance of Performance

guarantee goods by buyer guarantee
(time limit) returned

Guarantee period ends Warranty

with completion of guarantee
commercial contract returned

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C A S E S T U D Y

Guarantees and contract work

A government department in a foreign country has decided to rebuild a bridge over a river, because it is
concerned that the bridge is no longer safe for traffic. It believes that there are no construction firms
within its own country that have the capability, and it therefore decides to put out an offer to foreign
construction companies to do the work.
The government department advertises in the international trade press, inviting firms to bid for the work,
which it thinks could be a three-year project. A condition of submitting a bid for the work is that each
bidding company must provide a bid guarantee or tender guarantee from a bank that is acceptable
to the government department. The guarantee should be for 5% of the amount of the tender, and
should be valid from the date of its issue, up to the time that the government department awards the
contract to the successful bidder. The tender process may last for some time, possibly about six months.
The reason for demanding a bid guarantee is that the government department incurs time, effort and
money in dealing with bids from contractors. Without a guarantee from a bank, it would have no way of
recovering any of its costs if a bidder decides to:

 Withdraw from the tender process before the contract is awarded, or

 Refuse to accept the contract work if it is successful in the tender process and is awarded the work.
Once the selected contractor is awarded the contract and signs the contract agreement, the bid
guarantee expires. However, the government department will ask for the bid guarantee from the
successful contractor to be replaced by a performance bond (or performance guarantee). This is a
guarantee from the contractor’s bank that the contractor will perform the contact in accordance with the
terms of the contract agreement. The guarantee may be for about 5% – 10% of the value of the
contract work. If the contractor fails to perform the work, the government department has a right to
claim a payment under the guarantee. The performance bond is valid from the date it is issued and
should expire when the contract work is completed.
In some cases, the amount of the guarantee may be reduced, in accordance with the terms of the
guarantee, as the contract work progresses and as each stage of the work is successfully completed.
At the time that the contract is signed, the successful contractor may have insufficient finance to
undertake the work or pay for getting the required equipment and materials to the construction site.
The contract may therefore provide for the government department to make an advance payment to
enable the contractor to get the work started. Where an advance payment is provided in this way, the
government department may demand an advance payment guarantee from the contractor’s bank.
This is a guarantee from the bank to repay the advance payment in the event that the contractor fails to
perform specified obligations.
At the end of the contract, when the bridge has been built, the contractor will expect to receive the final
payment from the government department. Its bank will be released from its performance bond and
advance payment guarantee. However, the government department will want to be sure that if there is
any problem with the bridge in the months after it becomes operational, the contractor will undertake to
carry out repairs and improvements. This is usually arranged by retaining a proportion of the contract
value (say 5%) for a period of time after the contract work is completed and including a clause in the
contract (a warranty clause) that the contractor will carry out any repair work that is necessary during
this time.
The contractor may be able to obtain full payment, without the government department holding back
any retention money, provided that the contractor’s bank provides a retention money guarantee or
warranty guarantee. This is a guarantee that the contractor will carry out any work that is required
under the terms of the warranty agreement. If the contractor fails to carry out any such work when
required to do so, the bank will be required to make a payment under the guarantee. This guarantee will
expire at the end of the warranty period, which may last for six months or even longer after contract
work has been completed.

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5.7 Duty-exempt guarantee

This type of guarantee may be used when items are shipped to a foreign country for display at a
business fair or exhibition, such as a motor show or technology exhibition. Importation of these goods is
usually subject to payment of customs duties (import duty), but not if they will only remain in the
country temporarily and be shipped out again when the fair or exhibition has ended.

A duty-exempt guarantee is issued in favour of the local customs authorities. Payment of customs
duties is guaranteed in the event that the imported goods are not shipped out of the country within a
specified period of time.

5.8 Payment guarantee

A payment guarantee is issued on the application of a buyer in favour of a seller. It is a guarantee of
payment under the terms of a commercial contract.

A payment guarantee may be used to cover individual payments within a long-term contract, with a
guarantee of payment for the individual delivery, but within a total payment guarantee for the contract
as a whole.

Payment guarantees and standby letters of credit that provide a payment guarantee are used quite
extensively in international trade.

5.9 Guaranteed acceptance (aval)

Key term
An aval is a guarantee added to a debt obligation by a third party who is not the payee or the holder,
but who ensures payment should the issuing party default. The debt obligation could be a note, bond,
promissory note, bill of exchange or draft. The third party providing the aval is usually a bank or other
lending institution.

A buyer may wish to arrange payment to a seller by accepting one or more bills of exchange drawn on
the buyer by the seller. However, the seller may want some security for the payment of the accepted
bills.

The buyer may arrange for its bank to guarantee payment of the buyer’s promissory notes or accepted
trade bills. The bank’s payment guarantee can be provided by ‘avalising’ the bills or notes.

‘Aval’ is a French word for guarantee and an ‘aval’ is given by means of an endorsement to the bill or
note. This endorsement is provided by adding words such as ‘per aval for the account of the drawee’ on
the reverse side of the bill or note, together with an authorised signature of the bank.

With guaranteed acceptance, a bank adds its own guarantee directly to the bill of exchange of the
buyer. If the buyer fails to pay its accepted bills on the due date, the bank will make the payment under
its guarantee.

The potential benefits of avalising for seller and buyer in an international trading transaction are as
follows.

 It provides reassurance to the seller/exporter that the bill or note will be paid at maturity.

 If the buyer’s bills or notes are avalised, the exporter may be willing to give a longer period of
credit to the buyer.

 It is fairly simple to administer, because the bank guarantee is provided by endorsement of the
original trade bill or promissory note. There is no requirement for an additional guarantee
document (unlike other bank guarantees and unlike a letter of credit).

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When a bank provides any guarantee, it is in effect providing credit to its customer, and the bank will
carry out a credit analysis on the buyer before agreeing to avalise the buyer’s bills or notes.

In addition to the bank’s guarantee, the exporter may also ask for a currency transfer guarantee issued
by the central bank of the buyer’s country, promising that there will not be any restriction on the
payment of the bill in foreign currency to the exporter.

When a bank avalises the trade bills or promissory notes of a customer, it may also be willing to buy
them immediately at a discount, and so purchase the right to the payment at maturity.

 This will provide the seller with immediate payment.

 The buyer has time to sell the goods and generate the cash needed at maturity to pay the bill or
note.

Avalising bills or notes is an arrangement used in forfaiting. This is a method of financing trade, which
is described in a later chapter.

(Note: A promissory note is a financial instrument/document that is a promise to pay at a future date.
It is an ‘I Owe You’ and it is a promise to pay by its issuer. A promissory note may be used instead of a
usance bill. A usance bill is an instrument that is a ‘You Owe Me’ when it is first drawn on the drawee,
and on acceptance becomes an ‘I Owe You’ and a promise by the drawee to pay at maturity.)

6 ICC rules for guarantees

The International Chamber of Commerce has issued various rules for the use of guarantees. These are:

 Uniform Rules for Contract Guarantees, ICC publication number 325 (URCG 325).

 Uniform Rules for Demand Guarantees, (2010 revision) ICC publication number 758 (URDG 758).

 International Standby Credits, ICC publication number 98 (ISP98). Standby credits are explained
later.

6.1 Uniform Rules for Contract Guarantees: URCG 325

The International Chamber of Commerce has issued Uniform Rules for Contract Guarantees (URCG 325).
These rules could be applied to conditional guarantees such as bid bonds, performance bonds and
advance payment guarantees. However, these rules do not include a definition of a guarantee
agreement, and they cannot be applied to demand guarantees or payment guarantees.

URCG have not gained general acceptance in international trade and contracts. Guarantees from banks
are generally issued either as demand guarantees subject to the Uniform Rules for Demand Guarantees
or as standby letters of credit (‘standbys’) subject to International Standby Practices.

6.2 Uniform Rules for Demand Guarantees: URDG 758

Although there is a risk that the beneficiary may make unfair claims under a demand guarantee, the use
of demand guarantees appears to have increased substantially in international trade following the issue
of revised voluntary international rules, the Uniform Rules for Demand Guarantees. These revised rules
were issued by the ICC in 2010 as ICC publication number 758, and the rules are commonly referred to
as URDG 758.

URDG apply to counter-guarantees issued by an instructing bank in an indirect guarantee

arrangement, as well as to direct guarantees.

The main rules in URDG 758 are set out below.

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6.3 Definitions in URDG 758

A demand guarantee is defined as:

 Any bond, guarantee or other payment undertaking.

 Issued by a guarantor, such as a bank, in writing.

 For the payment of money on presentation (in accordance with the terms of the guarantee) of:

– A written demand for payment, and

– Any other document(s) as may be specified in the guarantee conditions, such as a

certificate from an architect or an engineer, a court judgement or an award by an
arbitrator.

A counter-guarantee is defined as a written guarantee issued by an ‘instructing party’ to a guarantor:

 For the payment of money to the guarantor.

 On presentation of a written demand for payment and documents specified in the counter-
guarantee which ‘appear on their face to be in accordance with the terms of the counter-
guarantee’.

Documents ‘in writing’ include authenticated digital messages.

Guarantees are separate transactions from the underlying contract or undertaking to which they relate,
and counter-guarantees are separate transactions from the underlying guarantee to which they relate.

6.4 URDG 758: issuing a demand guarantee

All guarantees should specify:

 The principal

 The beneficiary

 The guarantor

 The underlying transaction requiring the issue of the guarantee

 The maximum amount payable under the guarantee and the currency of payment

 The expiry date and/or expiry event for the guarantee

 The terms for demanding payment

 Any provision for reduction in the amount of the guarantee, by a specified or determinable
amount, on a specified date (or dates) or on presentation of a specified document (or documents)
to the guarantor

Guarantees and counter-guarantees are irrevocable (unless otherwise indicated).

6.5 Commencement date for a guarantee

A guarantee should identify the time from which it begins and becomes valid. Unless the guarantee
states otherwise, it will come into force on the date of its issue.

A performance guarantee should not commence until the buyer/beneficiary has fulfilled all the necessary
commercial obligations on his side of the contract. For example, the buyer may be required to make an
advance payment, or to meet particular legal requirements or obtain particular local approvals.

Similarly, a warranty guarantee should not commence until any performance bond issued previously has
been returned to the issuing bank.

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6.6 URDG 758: Presentation of a demand for payment

When a bank is presented with a demand for payment under a guarantee or counter-guarantee, all the
documents (including the demand itself) should be examined by the guarantor to check whether or not
they appear ‘on their face’ to confirm with the terms of the guarantee. If they do not, the demand for
payment should be refused.

The demand for payment should be in writing and (in addition to any other document or documents
specified for presentation with the demand under the terms of the guarantee) the demand must be
accompanied by a statement – in the demand itself or in a separate statement – that the principal is in
breach of the obligations or undertaking for which the guarantee was issued.

The bank should be allowed up to five business days following the day when the demand for payment is
due, in which to examine a demand for payment and decide whether or not to make the payment. If the
bank refuses to make the payment, it must inform the beneficiary by sending a notice no later than the
close of the business day on the fifth day following the receipt of the demand for payment.

A bank should check whether the documents appear to conform to the terms of the guarantee. However,
banks and instructing parties bear no responsibility or liability for:

 The sufficiency, accuracy, genuineness or falsification of any document.

 The statements made in them.
 The good faith or acts or omissions of any other person.

Guarantors and instructing banks must act in good faith and with reasonable care, but otherwise they
have no liability or responsibility for:

 Delays or loss in transit of any message or document.

 Events that can be described as force majeure.

 Failure by another party to carry out instructions given to them by the guarantor or instructing
bank, for the purpose of carrying out the instructions of the principal.

The demand for payment must be presented to the bank ‘before its expiry at its place of issue’.
Otherwise the bank should refuse the demand for payment.

 A guarantor is liable to the beneficiary only up to an amount specified in the guarantee. When a
bank has paid up to this maximum amount, the guarantee terminates.

 Otherwise the guarantee expires on its stated expiry date or on the occurrence of a stated event
in the terms of the guarantee.

The guarantor must transmit ‘without delay’ the beneficiary’s demand for payment and a copy of the
documents from the beneficiary accompanying the complying demand to:

 The ‘instructing party’, usually the applicant for the guarantee.

 The counter-guarantor bank, in the case of an indirect guarantee.

6.7 Expiry of a guarantee and amount covered by the guarantee

A standby letter of credit should specify an expiry date. A guarantee should also ideally specify a
calendar date as its expiry date, but this may not always be possible due to local laws and rules that
apply to guarantees.

When a guarantee cannot specify a calendar date as the expiry date, it may be possible to link expiry to
the production or delivery of a particular document, such as delivery of shipping documents to the buyer.
If this is the case the guarantee should specify this event as its expiry date. If the guarantee states
neither an expiry date nor an expiry event, it terminates (under the rules of URDG 758) three years after
the date of its issue.

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When the applicant for a guarantee is the seller, the risk from an uncertain or distant expiry date may be
lessened by providing in the guarantee for a gradual reduction in the amount of the guarantee
over time, during the period of validity of the guarantee. For example, the amount of the guarantee
may be reduced in line with specified events in the commercial contract, such as the presentation of
shipping documents by the seller.

For example, when a commercial contract provides for several shipments from seller to buyer, a
guarantee may specify the maximum amount of the guarantee, and also include an added statement
that the guarantee will be reduced by a specified amount with each successive shipment of goods,
evidenced by presentation of the relevant shipping documents to the issuing bank.

6.8 Demand guarantees and force majeure

URDG 758 specifies rules for the extension of expiry for a demand guarantee in the event of force
majeure. Force majeure is defined as ‘acts of God, riots, civil commotions, insurrections, wars, acts of
terrorism or any causes beyond the control of the guarantor or counter-guarantor that interrupts its
business...’

Under the rules (Article 26):

 Each guarantee and counter-guarantee should be extended by 30 calendar days from the date
when it would otherwise have expired.

 Where a presentation for payment has been made and the bank is in the process of checking
whether it is a complying demand, the period for checking should be suspended until the
resumption of the guarantor’s business.

 A complying demand for payment under a guarantee that has not been paid because of the force
majeure should be paid when the force majeure ceases, even though the expiry date for the
guarantee has passed. In addition, the guarantor is allowed 30 days after the ending of the force
majeure to present a demand to the applicant’s bank under a counter-guarantee.

6.9 URDG 758: Extension of a guarantee

Article 23 of the URDG 758 allows the guarantor bank to extend the guarantee and suspend payment for
up to 30 calendar days following the receipt of a demand from the beneficiary.

Extension may be suggested by the beneficiary, to allow time for the dispute with the applicant to be
resolved.

If the demand for payment is a non-complying demand, this means the demand does not meet the
requirements of a complying presentation, so the guarantor bank is not obliged either to pay or extend.

If the demand for payment is a complying demand, the demand meets the requirements of a
complying presentation and the following action can be taken:

 The guarantor should inform the principal of this request.

 Payment by the bank should be suspended, to allow the principal and beneficiary to reach
agreement on the extension of the guarantee.

 Unless agreement is reached within a reasonable time (up to 30 calendar days), the bank should
make the payment of the beneficiary’s demand, without incurring any liability for interest (or
otherwise).

 Even if the principal agrees to an extension of the guarantee, extension will not be granted unless
the guarantor bank (and where appropriate the instructing bank) also agrees.

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7 Standby letters of credit

Standby letters of credit are a type of documentary credit, but they serve a different purpose from a
commercial letter of credit.

 A commercial letter of credit is a payment method for a transaction, as explained in the previous
chapter on documentary credits.

 A standby letter of credit is a secondary payment mechanism, when the trading is on open
account. In this respect it is similar to a guarantee. A bank issues a standby letter of credit on
behalf of an applicant to provide a guarantee in the event of failure by the applicant to comply
with the terms of a contract with the beneficiary.

The standby letter of credit provides a guarantee to the beneficiary in support of the performance by the
applicant of its obligations under the terms of the commercial contract.

Standby letters of credit originated in the USA, where banks are not allowed by law to issue guarantees
to third parties. They are used in other countries, as an alternative to bank guarantees and are usually
subject to the general rules on standby letters of credit in the ICC’s International Standby Practices 1998
(ISP98). These are rules issued by the ICC that are designed to facilitate the use of standby letters of
credit. ISP98 provides separate rules for standby letters of credit that are more specialised than those in
UCP600.

7.1 Using a standby L/C as a bank guarantee

The standby letter of credit is often used to guarantee performance or to strengthen the credit-
worthiness of a customer. Standby letters of credit therefore serve a similar purpose as bank demand
guarantees. They can provide guarantees for:

 Payment by the buyer, either a guarantee that payment will be made on schedule or a guarantee
against non-payment.

 Repayment of money that has been advanced or provided as a loan by another party.

 Contract tenders, contract performance: standby L/Cs may be referred to as a ‘performance

standby’, a ‘bid bond standby’, or an ‘advance payment standby’, to indicate their similarity with
bank guarantees issued for the same purposes.

Every standby letter of credit, like every bank guarantee, has an expiry date. A standby letter of credit
may be in force for about one year, which allows enough time for payment to be made through the
standard contractual guidelines. They may be used in international trade transactions, as a guarantee for
the purchase of goods from another country. At the request of an exporter, the buyer applies to its bank
for a standby letter of credit to be issued. The beneficiary (exporter) can claim payment under the terms
of the standby letter of credit if the buyer fails to make payment by a specified date.

The applicant must pay for the letter of credit, whose cost for a payment guarantee may be 1-8% per
year of the value of the credit. However, a standby letter of credit can be cancelled as soon as the terms
of the contract have been met by the purchaser or borrower.

7.2 Presentation of documents under a standby letter of credit

A feature of a letter of credit is that payment (or acceptance) is made against presentation of valid
documents to the bank by the beneficiary. The same applies to standby letters of credit. A beneficiary
wishing to apply for payment under a standby letter of credit, because of a failure by the applicant to
comply with terms and conditions of the commercial contract, must present specified documents to the
bank.

 These documents will include a written demand for payment.

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 They may also include one or more documents providing evidence to support the demand for
payment, such as an engineer’s certificate or a court judgement.

However, the only documents for presentation under a standby letter of credit are those specified in the
letter of credit itself. The required documents may simply be a written demand for payment, signed by
the beneficiary.

The standby letter of credit is often used to guarantee performance or to strengthen the credit-
worthiness of a customer.

8 International Standby Practices, ICC publication number

590 (ISP98)
Standby letters of credit are a type of letter of credit, and so could be issued subject to UCP600.
However, the rules in UCP600 were made primarily for letters of credit issued in support of an underlying
trading transaction or other commercial transaction. They are not entirely appropriate for standby letters
of credit issued as guarantees.

For this reason, the ICC published a separate set of rules, the International Standby Practices, as ICC
publication number 590. Strangely perhaps, the rules are known by their year of issue, and are
commonly referred to as ISP98. The rules apply to any standby credit that is issued with specific
reference to them. Although UCP600 may also apply to standby credits, ISP98 states that the rules in
ISP98 supersede any conflicting rules in any other rules of practice to which a standby letter of credit is
also subject.

The main ISP98 rules are summarised below.

8.1 ISP98: General principles

A standby letter of credit, referred to in ISP98 as a ‘standby’, is an undertaking that is separate from the
underlying transaction to which it relates. As a separate agreement, it does not depend on:

 The right or ability of the issuing bank to obtain reimbursement from the applicant for the credit.

 The beneficiary’s right to obtain payment from the applicant.

 The issuing bank’s knowledge of any performance or breach of obligation relating to the
underlying transaction for which the standby has been issued.

The issuing bank is not responsible for performance or breach of the underlying transaction or obligation
between the applicant and the beneficiary.

8.2 ISP98: Obligations

An issuer of a standby undertakes to honour a presentation of documents that appears to comply with
the terms and conditions of the standby. An issuing bank honours a presentation:

 If the standby provides for payment of a demand at sight, by payment.

 If the standby provides for acceptance of a bill drawn by the beneficiary on the issuer, by
accepting the bill and subsequently paying the bill at maturity.

 If the standby provides for deferred payment, by giving an undertaking to pay at maturity and
then making the payment at maturity.

 If the standby provides for negotiation, by paying at sight the amount demanded from the
negotiating bank, without recourse.

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Similar obligations apply to any bank that confirms a standby. A confirming bank undertakes to honour a
complying presentation by paying the amount demanded at sight, by acceptance, by deferred payment
or by negotiation.

When an advising bank advises the standby to the beneficiary, this signifies that:

 The advising bank has checked the apparent authenticity of the advised message from the issuing
bank.

 The advice to the beneficiary reflects the message received from the issuing bank.

Standbys, as guarantees, may be amended after they have been issued.

A standby may state that it is subject to ‘automatic amendment’ by an increase or reduction in the
payment available, or an extension of the expiry date. Automatic amendments are effective
automatically, without further advice to the beneficiary. If an amendment is not automatic, the
beneficiary must consent to it before it becomes binding, and the same bank should be used to advise
the beneficiary of the standby and any subsequent amendments.

8.3 ISP98: Presentation

A standby gives instructions as to the time and place where a presentation should be made.

 If the standby is not confirmed, presentation should be made at the premises of the issuer from
which the standby was issued.

 If the standby is confirmed, presentation should be made at the premises of the confirming bank
from which the confirmation was issued.

To comply with the terms and conditions of the standby, the document(s) must be presented in the
medium indicated in the standby.

 Where the standby does not indicate the medium, the presented document must be in paper
form.

 An exception to the above rule is that if the only document to be presented is the demand itself, a
SWIFT message or similar authenticated message is acceptable.

 A presentation is not presented in paper form if it is received electronically and the bank prints
out the document on to paper.

If the beneficiary makes a non-complying presentation, this does not take away its right to make a
subsequent complying presentation before the expiry of the standby. This means that if a beneficiary
makes a claim for payment under the terms of the standby and the bank refuses to honour the
presentation because it is non-complying, the beneficiary may still make another presentation before the
expiry of the standby. Refusal to honour the first presentation will not compromise the beneficiary’s
rights under a subsequent presentation.

The standby specifies a maximum amount payable by the issuing bank.

 If the written demand for payment exceeds this amount, the demand document is ‘discrepant’
and the presentation should not be honoured.

 However, if the written demand is for an amount within the standby limit, but another presented
document indicates an amount in excess of the standby limit, the presentation is not discrepant
and should be honoured.

A beneficiary may present a demand for payment but with a request for an extension to the expiry
date for the standby. This would be a request to the bank to extend the expiry date, on condition that if
the bank refuses to the extension, the bank should honour the presentation by payment or acceptance
(etcetera). If the standby is amended and the expiry date is extended, the beneficiary withdraws the
demand for payment.

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The issuing bank is not required to notify the applicant for the credit of any presentation it has
received from the beneficiary.

8.4 ISP98: Examination of documents

A demand for honour of a presentation must be examined for compliance with the terms and conditions
of the standby.

 Documents that are presented, but which are not required by the standby, need not be examined.

 The issuing bank or nominated bank is required to examine the documents for inconsistency with
each other only to the extent specified in the standby.

 The language in the document must be the language of the standby.

 Any document required for presentation must be issued by the beneficiary unless the standby
indicates that it should be issued by a third person, or the document is of a type that standard
practice requires to be issued by a third person (for example, a court judgement).

 If the standby does not specify any document for presentation, it should be deemed that
presentation requires the presentation of a written demand from the beneficiary.

ISP98 contains a number of rules about the required contents of presented documents, such as the
demand for payment, a statement of default (by the applicant) and legal or judicial documents.
Presented documents must be originals (except that electronic presentation, where permitted or
required, is deemed to be ‘original’).

8.5 ISP98: Notice

Notice of dishonour of a presentation must be given within a time after presentation that is ‘not
unreasonable’.

 Notice given within three days is ‘not unreasonable’.

 Notice given later than seven days after presentation is ‘unreasonable’.

Notice of dishonour should be sent to the beneficiary by telecommunication (if available); otherwise or
‘promptly’ by another available means. Notice of dishonour should be sent to the person from whom the
documents were received (whether the beneficiary or a nominated bank).

The notice of dishonour should state all the reasons why the presentation was dishonoured.

When a presentation is dishonoured, the beneficiary can ask for the presented documents to be
forwarded to the issuing bank to request a waiver from the applicant of the discrepancies in the
documents. (The beneficiary may ask the issuing bank directly to request a waiver of the discrepancies
from the applicant.) There is no obligation on a bank to forward the documents and request a waiver
from the applicant for the standby.

The applicant for the standby may submit a notice of objection to the honouring of a non-compliant
presentation by the issuing bank. Any such notice of objection must be given promptly, and must specify
the discrepancies that should have been a reason for the issuing bank to dishonour the presentation.

8.6 ISP98: Other provisions

A standby may be issued as a transferable standby (somewhat similar to a transferable conventional
letter of credit). A beneficiary may submit a request to the issuing bank or nominated bank that the
drawing rights under the terms of the standby should be transferred to another person.

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The standby must state that it is a transferable standby. A standby that is transferable without further
provision may be transferred in its entirety, but may not be partially transferred and may not be
transferred unless the issuing bank (and confirming bank, if there is one) agrees to and effects the
transfer.
When a standby is transferred in its entirety, a draft (bill of exchange) and demand must be signed by
the beneficiary to whom the drawing rights have been transferred.
A standby cannot be cancelled without the consent of the beneficiary. Consent may be given in
a written document or by an action such as the return of the standby to the issuing bank. The consent of
a beneficiary to cancellation is irrevocable after it has been communicated to the applicant for the
standby.
Reimbursement. Where payment is made against a complying presentation under the terms and
conditions of a standby:

 The applicant must reimburse the issuing bank.

 The issuing bank must reimburse the bank nominated to honour the presentation.
The applicant must pay the charges and expenses of the issuing bank and reimburse the issuing bank for
the charges and expenses it has paid to the nominated/confirming banks.
Expiry. A standby must contain an expiry date or ‘permit the user to terminate the standby upon
reasonable prior notice or payment.’

9 Guarantee or standby L/C?

Since a standby letter of credit is a form of guarantee, you may be asked to explain the difference
between a standby letter of credit and a guarantee.
 A standby letter of credit is usually subject to the ICC rules ISP98, which were issued specially for
standby L/Cs. Direct guarantees usually are governed by the ICC rules URDG 758.
 The standby letter of credit originated in the United States, where the law prevented banks from
issuing direct guarantees. (Most countries outside the USA allow bank guarantees.) To circumvent
this banking rule, US banks created the standby letter of credit.
Some banks make no distinction between standby letters of credit and guarantees, which are essentially
the same and fulfil the same purpose.
 The choice between using a bank guarantee or a standby letter of credit may depend to a large
extent on normal practice in the countries of the buyer and seller.
 URDG 758 has brought greater certainty and improved regulation to the use of demand
guarantees, so both demand guarantees and standby letters of credit are covered by ICC rules
 In some countries, local laws may affect the terms that can be applied to a bank guarantee, such
as laws relating to the expiry of bank guarantees. Where there is uncertainty about local laws, or
where local laws seem to be biased against the applicant/principal, it may be more appropriate to
use a standby letter of credit.

The choice between standby and demand guarantee may therefore be a matter of preference or usual
practice.

9.1 Agreeing the terms and conditions of a guarantee or standby letter of

credit
The wording and content of a guarantee or standby letter of credit will depend on the nature of the
underlying commercial contract, including the terms of payment, and also local laws and practices.
However, all guarantees and standby letters of credit should include the following items of information:

 The parties to the underlying commercial contract and the nature/identity of the contract.

 The purpose of the guarantee (what the guarantee covers).

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 The currency and the maximum amount payable under the guarantee.

 The term of validity of the guarantee and (if possible) its expiry date.

 The last date when claims under the guarantee can be made by the beneficiary.

 What documentation (if any) must be provided when a claim is made under the guarantee or
standby L/C.

 Reference to the relevant ICC rules, if these are to apply.

 The applicable law governing the guarantee.

9.2 Jurisdiction/applicable law

Any jurisdiction or national laws can be agreed for a guarantee.

In practice, the jurisdiction and laws applied to a guarantee are the local laws of the issuing bank,
provided that these laws are internationally recognised and so acceptable to both seller and buyer.

10 Shipping guarantees
With fast methods of transport, such as air transport, goods often reach their destination before the
documents for presentation with a letter of credit or documentary collection.

When they reach their destination the goods are cleared through customs and stored, awaiting collection
by the buyer or the buyer’s agent. They are stored in a warehouse belonging to the carrier or the
carrier’s agent.

Normal practice is for the carrier to allow the customer a period of time to take delivery of the goods,
and to store the goods without charge during this period. After this ‘grace period’ has ended, the carrier
will make a charge for storage. These charges are called ‘demurrage charges’. The importer has to
pay demurrage charges from the time that the grace period ends until the goods are taken away from
storage. The existence of these charges provides an incentive for the importer to take delivery of the
goods as soon as possible.

A bank will often assist an importer to avoid demurrage charges by issuing a shipping guarantee. A
shipping guarantee is a letter of indemnity to the carrier, for allowing the importer to take possession of
the goods without the document of title (bill of lading). The shipping guarantee is signed by the
consignee (importer) and countersigned by the bank (and is issued by the bank). The
countersignature of the bank is to guarantee performance by the importer.

With a shipping guarantee, the importer (consignee):

 Claims to be the rightful owner of the goods.

 Indemnifies the carrier against any consequences that may arise from allowing the consignee to
take delivery of the goods without the required documents.

 Undertakes to pay any freight charges or other charges payable for the goods.

 Undertakes to deliver the bill of lading, duly endorsed, when it is eventually received.

The advantages of issuing a shipping guarantee are that:

 Demurrage charges are avoided.

 The importer can take possession of the goods without having to wait for presentation of the
required documents.

A disadvantage of using a shipping guarantee is that when the method of payment is a letter of credit,
the bank (as issuing bank for the L/C) loses the protection of the letter of credit in the event that
discrepancies are subsequently found on checking the presented documents.

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10.1 Practical aspects of a shipping guarantee

Before it agrees to issue a shipping guarantee, the bank will require documentary evidence of the value
of the goods.

When goods are delivered by air the bank will endorse the air waybill in favour of the importer, thereby
enabling the importer to take possession of the goods from the carrier. The bank incurs the same
potential liability as with goods shipped under a bill of lading.

By issuing a shipping guarantee, when the method of payment is a letter of credit, the bank loses control
over the goods. It also becomes liable for any claims by the true owner of the goods, in the event of a
legal dispute involving claims to ownership. The bank, as issuing bank for the letter of credit, will
therefore require the importer (applicant for the credit) to forgo its protection under the letter of credit in
the event that discrepancies are subsequently discovered in the presented documents.

When the documents are eventually presented under the letter of credit, if these include a bill of lading
as the shipping document, the bank delivers the documents to the importer/applicant, with the exception
of the bill of lading, which it sends to the carrier in exchange for the shipping guarantee that it has
issued.

Banks charge a commission, as a percentage of the invoice value (subject to a minimum commission
charge) for issuing a shipping guarantee.

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Chapter roundup

 A bank guarantee is a written undertaking issued by a bank on the application of a customer in favour of
a named beneficiary, issued in support of an underlying commercial transaction.

 The bank undertakes to make a specified payment in the event that the principal fails to fulfil specified
requirements relating to an underlying commercial transaction.

 The guarantee is an entirely separate legal agreement from the underlying commercial transaction.

 A bank guarantee may be issued directly by the bank to the beneficiary.

 A beneficiary may require a bank guarantee from a bank in its own country. In this situation, the
principal’s bank may instruct a bank in the beneficiary’s country to issue its own guarantee to the
beneficiary.

 This is an indirect guarantee. With an indirect guarantee, the instructing bank provides a counter-
guarantee to the bank that issues the guarantee to the beneficiary.

 A conditional guarantee is a traditional bank guarantee, in which the bank undertakes to make a
payment in the event that the principal fails to carry out required terms and conditions in the underlying
commercial contract.

 A claim for payment by the beneficiary may be disputed, leading to long delays before any payment.

 A demand guarantee gives the beneficiary the right to make a claim under the guarantee and receive
payment.

 Banks issue guarantees for a variety of different purposes.

 Guarantees issued for the purpose of international trade are usually demand guarantees subject to
internationally agreed rules.

 A standby letter of credit is a type of documentary credit.

 The issuing bank provides a guarantee of payment to the beneficiary in the event that the applicant for
the credit fails to comply with the terms and conditions of the credit.

 A standby letter of credit may be issued to guarantee a payment, or to guarantee performance of a

requirement by the applicant for the credit under the terms of an underlying commercial contract.

 A bank may issue a shipping guarantee to the carrier of goods, after the goods have been delivered to
the buyer’s country and are held in storage due to delays.

 The shipping guarantee provides an indemnity to the carrier.

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chapter 6

FOREIGN EXCHANGE AND

EXCHANGE CONTROLS

Contents
1 Arranging payments and receipts in foreign currency .................................................. 138
2 Nostro accounts and vostro accounts......................................................................... 139
3 Dealing in foreign currencies .................................................................................... 139
4 Spot FX transactions ............................................................................................... 140
5 Changes in spot rates: exchange rate volatility and currency risk .................................. 143
6 Forward exchange contracts ..................................................................................... 145
7 Close out and extension of forward exchange contracts ............................................... 150
8 Other ways of managing currency risk ....................................................................... 151
9 Foreign currency options.......................................................................................... 152
10 Range forward option .............................................................................................. 153
11 Participation forward contract................................................................................... 154
12 Borrowing in a foreign currency to manage exposure to currency risk............................ 155

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13 Hedging decisions for currency risk ........................................................................... 155

14 Exchange controls ................................................................................................... 158
15 Malaysian exchange control legislation ...................................................................... 159
Chapter roundup.......................................................................................................... 161

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Learning outcomes
On completion of this chapter you should be able to:
 Analyse the role of the systems and arrangements for making foreign currency settlements.
 Analyse the functioning of foreign exchange markets, exchange rate risk and methods available
for hedging or limiting that risk.
 Examine the uses of exchange controls.

Learning objectives
While working through this chapter you will learn how to:
 Demonstrate how foreign currency (FX) payments are made.
 Contrast the nature of nostro and vostro accounts.
 Describe the main participants in the foreign currency markets.
 Examine the nature of spot FX transactions, spot rates, margins and the spread between
bid and ask rates.
 Apply a spot rate to calculate an amount payable or receivable in a spot transaction.
 Calculate a cross rate.
 Analyse the reasons for exchange rate volatility.
 Describe the nature of currency risk.
 Appraise the nature of forward FX contracts and the use of these contracts to hedge
exposures to currency risk.
 Apply a forward rate to calculate an amount payable or receivable at settlement of a forward FX
contract.
 Demonstrate how forward FX rates are derived.
 Compare a fixed forward FX contract and an option forward FX contract.
 Describe how forward FX contracts may be closed out or extended.
 Calculate the settlement amount on close-out of a forward contract.
 Appraise methods of hedging exposures to currency risk, other than forward FX contracts.
 Describe the features of currency options and how these options may be used to hedge
exposures to currency risk.
 Compare over the counter and exchange traded currency options.
 Analyse the nature and features of a range forward option and a participating forward
contract.
 Explain how to decide whether to hedge FX exposure and what hedging method to use.
 Compare economic FX exposure and translational FX exposure.
 Analyse the purpose and effectiveness of exchange controls.
 Examine the impact of exchange controls on international trade.

Introduction
International trade involves the payment or receipt of amounts in a foreign currency, for the buyer, the
seller or both. Banks are involved in foreign currency transactions by:

 Maintaining foreign currency bank accounts for some customers

 Buying and selling foreign currency

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When a customer has a bank account in a foreign currency, receipts in that currency can be paid directly
into the account and payments can be made from the account. The bank is required to process the
money transfers.

In the event of the customer wishing to buy/sell foreign currency, the bank is required to buy/sell the
currency and process the payment through the customers domestic bank account.
The market for buying and selling currency is known as the foreign currency market or FX market. This
is an enormous international market, involving banks in all countries where international trade occurs.
Note: Sections 15 to 21 focus on the Exchange Control Act and Exchange Control of Malaysia Notices
(ECMs) – examples relevant to all markets. Due to the nature of these sections, we have not individually
identified Malaysia specific content as this applies throughout.

1 Arranging payments and receipts in foreign currency

Ultimately, all the currency of any country is held by the banks of that country. For example, all US
dollars are held, ultimately, by US banks.

International banks keep their foreign currencies with a branch or a correspondent bank in the relevant
country. For example, Australian banks holding Singapore dollars will keep this money in accounts with a
branch or correspondent bank in Singapore. When a bank makes a payment for a customer in a foreign
currency, or receives an amount in foreign currency, the money goes through this bank account.

C A S E S T U D Y

An Australian customer receives a payment in Hong Kong dollars from a customer in Hong Kong and
arranges to sell these dollars to its bank in Australia. The bank will buy the Hong Kong dollars and credit
the customer’s account in Australian dollars (AU$). The payment in Hong Kong dollars will be credited to
the Australian bank’s account in Hong Kong dollars with its branch or correspondent bank in Hong Kong.
The Australian bank has therefore received a payment in Hong Kong dollars and credited the AU$
account of its customer with the AU$ value of the Hong Kong dollars.

C A S E S T U D Y

An Australian customer wishes to make a payment in Thai baht for goods purchased from a supplier in
Thailand and arranges with its bank to buy baht in exchange for Australian dollars (AU$), and to make
the payment to the Thai supplier. The bank will debit the AU$ account of the customer with the cost of
the baht and will make the payment in baht through its account with a branch or correspondent bank in
Thailand. The Australian bank has therefore made a payment in Thai baht from its account with the Thai
branch or correspondent bank, and taken the AU$ value of the baht from the customer’s AU$ account.

C A S E S T U D Y

When customers have a foreign currency account with their bank, receipts and payments by customers
are made through the bank’s currency account with its foreign branch or correspondent bank. A
European company may have a US dollar account with its bank in France. A receipt of US dollars will be
credited to the company’s US dollar account with the bank. The money will be paid into the bank’s US
dollar account with a branch or correspondent bank in the USA.

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2 Nostro accounts and vostro accounts

Key term
A nostro account is a bank account held in a foreign country by a domestic bank, denominated in the
currency of that country. Nostro accounts are used to facilitate settlement of foreign exchange and trade
transactions. The term is derived from the Latin word for 'ours'. Conversely, accounts that are held by
the domestic bank in its home country for foreign banks are called vostro accounts, derived from the
Latin word for 'yours'.

For example, a US bank may hold Australian dollars with a correspondent bank in Australia. For the US
bank, the Australian dollar account is a nostro account, an asset of the bank. An Australian bank may
hold a US$ account with the US bank, and for the US bank, this customer account is a vostro account.
Like all customer deposits, money in a vostro account is a liability for the bank.

C A S E S T U D Y

A corporate customer of a British bank receives a payment of 10,000 Australian dollars (AU$10,000) and
arranges with the bank to sell these dollars in exchange for GBP £5,000.

British bank:

 The British bank will credit the sterling account of its customer with GBP £5,000.

 The bank will receive the payment of AU$10,000 into its nostro account with a correspondent
bank in Australia.

Australian bank:

 The Australian bank will debit the account of its customer with AU$10,000.
 The bank will also credit the vostro account of the British bank with AU$10,000.

The nostro account and the vostro account are the same bank account, with the difference that:

 The nostro account is an account in the financial records of the British bank, and
 The vostro account is the equivalent financial record in the accounts of the Australian bank.

3 Dealing in foreign currencies

Huge amounts of foreign currency transactions are made each day for international trade. As a result,
banks may need to acquire more of one currency in order to process currency payments for customers,
or they may acquire excess funds in a currency that it does not expect to need in the foreseeable future.
Banks therefore buy and sell currencies between themselves, usually in very large transactions. Inter-
bank FX trading provides liquidity in currencies for customers of the banks, because customers are able
to buy and sell currencies with their banks because banks are able to deal with other banks regionally or
globally.

Key term
Forex Trading (often abbreviated to FX) is trading currencies from different countries against each
other. Forex is acronym of Foreign Exchange

The FX markets globally consist of many small transactions between banks and their customers, and also
many large transactions between banks or between banks and major international corporate customers
(or governments).

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The buying and selling of foreign currencies between banks is done by dealers working in the
international department of their bank. They make buying and selling transactions, or lending and
borrowing transactions, with dealers in other banks. Inter-bank transactions may be made by telephone
or through electronic trading platforms.

This text is concerned with FX transactions for international trade, and will therefore focus on smaller
transactions between banks and their customers, rather than the global FX markets for large-scale
dealing between banks. In principle, however, basic FX transactions are similar, regardless of size.

Although there are about 150 different currencies in the world, most international payments are made in
one of the major trading currencies, which include:

 US dollars
 Euros
 Japanese yen

Dealings in some currencies are mainly at a regional level. For example, in South East Asia and Australia,
a large proportion of FX transactions involve ringgit, Hong Kong dollars, Singapore dollars, and Australian
dollars, as well as US dollars. The Chinese renminbi is also emerging as a major international currency.

FX dealing in some currencies, such as ringgit and renminbi, is subject to exchange control regulations.
Exchange controls are described later.

3.1 Customers for FX transactions

In foreign trade transactions, businesses receive and make payments in foreign currencies, for goods,
services and investments.

Individuals have similar requirements, except usually these are on a much smaller scale than commercial
transactions.

Corporate customers vary in size. Smaller companies with infrequent currency transactions are likely to
contact their branch of the bank whenever they want to buy or sell currency. Larger companies may
employ specialists in their treasury department, whose tasks include dealing with their bank to buy or sell
currency. The treasury departments of very large companies may have direct access to the main FX
dealing rooms of their banks, and may be able to negotiate very favourable rates for their currency
transactions.

4 Spot FX transactions
A spot FX transaction is a transaction for the ‘immediate’ purchase or sale of one currency in exchange
for another. However to allow for administrative processing of spot transactions, the value date is
usually two business days after the date that the spot transaction is agreed.

This means, for example, that if a spot transaction is made on Monday, settlement will take place on
Wednesday, two business days later.

Banks are able to arrange different value dates for spot transactions with customers, but the two-day
gap between transaction date and value date is standard for inter-bank transactions in most currencies.

4.1 Spot rates

Exchange rates are quoted as a quantity of one currency in exchange for one unit of another currency.
For example, when the exchange rate for the US dollar (US$) against the Australian dollar (AU$) is
quoted as 1.1102 this means that the exchange rate is 1.1102 AU$ in exchange for one US$. In this
example, the AU$ is the variable currency and the US$ is the ‘base currency’.

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Spot rates can be quoted the other way round. For example if the US$/AU$ rate is 0.9089 AU$ per US$
the rate could also be quoted as 0.91AU$ per one US$.

It is important to recognise which way round a currency exchange rate is quoted.

 In the international FX markets, it is usual to quote exchange rates against the dollar in terms of
units of the other currency per US dollar.
 In domestic banking, it is usual to quote exchange rates in terms of units of the foreign currency
per unit of domestic currency.
The smallest price change that a given exchange rate can make is referred to as a ‘point’ or ‘pip’. Since
most major currency pairs are priced to four decimal places, the smallest change is that of the last
decimal point – this is the equivalent of 1/100 of one percent, or one basis point.

4.2 Bid and offer rates

Banks quote two prices for currency transactions.

 The bid rate is the rate at which the bank will purchase one unit of the base currency in
exchange for the variable currency.
 The offer rate, also called the ask rate, is the rate at which the bank will sell one unit of the
base currency in exchange for the variable currency.
For example, a US bank may quote the exchange rate between the Singapore dollar and US$ (base
currency) as 1.250 – 1.255. This means that the bank will:

 Buy US dollars (US$) in exchange for Singapore dollars (SGD) at the rate of 1.250 dollars per US
dollar
 Sell US dollars (US$0 in exchange for Singapore dollars (SGD) at the rate of 1.255 dollars per US
dollar.
The difference between the two rates is called the ‘bid-offer spread’ or the ‘bid-ask spread’. In the
inter-bank FX market, the size of the spread is referred to as ‘pips’. When the spot rate is 1.250 – 1.255,
the bid-offer spread is 5 pips.

The spread represents a ‘profit’ for the bank on its FX dealings.

The size of the bid-offer spread depends on several factors, but for transactions between a bank and
a corporate customer the size of the spread will depend to a large extent on the size of the transaction,
and a bank will make more favourable exchange rates available to customers for larger transactions.

When a single exchange rate is quoted in the press, this is usually the average or mid-point rate
between the bid and the offer rate in the global FX markets. For example, if the bid-offer rates for
Australian dollar against the US dollar in the FX markets is 0.9112 – 0.9116, the rate quoted in the
financial press would be 0.9114.

It is often difficult for non-bank customers to understand which rate is available for buying or selling
currencies. The confusion may arise because the buying and selling rates for a bank are the selling and
buying rates for the bank’s customer, and it may also be difficult to remember whether a buying rate
applies to the variable currency or the base currency.

The basic rule to remember, when identifying which rate to apply to a FX transaction, is that the bank
applies the rate to every transaction that is the more favourable to itself.

For example, if the USD/MYR spot rate is 3.0525 – 3.0535 and a customer wants to sell 20,000 US
dollars to the bank, the bank will apply a spot rate of 3.0525 and pay the customer RM61,050 for the
dollars. (If it applied the offer rate of 3.0535, the bank would have to pay RM61,070 for the dollars,
which would be less favourable to itself.) The bank is buying the base currency (USD) and so applies the
lower (bid) rate to the transaction.

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4.3 Cross rates

Banks quote exchange rates to their customers for a number of different foreign currencies against their
domestic currency but, in the global FX markets, it is usual for most currencies to be quoted against the
US dollar. This avoids the need for the markets to quote exchange rates for every convertible currency
against every other convertible currency.

The exchange rates for any pair of currencies, excluding the US dollar, can then be calculated from their
rates against the US dollar. This derived exchange rate is known as a cross rate and, in the global FX
markets, an exchange cross rate is an exchange rate for any pair of currencies where neither currency is
the US dollar.

C A S E S T U D Y

The following spot rates apply in the FX markets:

USD/EUR: 0.9975 – 0.9976

USD/CAD: 1.0550 – 1.0650

From these rates against the dollar, the following spot rates for Euros (EUR) against Canadian dollars
(CAD) can be calculated, with Euros as the base currency.

Bid rate

The bid rate is:

Spot bid rate for CAD against USD 1.0550

= = 1.0575
Spot offer rate for EUR against USD 0.9976

Offer rate

The offer rate or ask rate is:

Spot offer rate for CAD against USD 1.0650

= = 1.0677
Spot bid rate for EUR against USD 0.9975

The spot rate for Euros against Canadian dollars is therefore 1.0575 – 1.0677.

4.4 Exchange rates and margins (spreads)

The market rates quoted by foreign exchange dealers in banks apply to large transactions with dealers in
other banks, and these rates can change very frequently. Most of the bank’s customers want to buy or
sell much smaller amounts of foreign currency. It would not be practical for dealers to quote a rate for
every single small transaction between a bank and its customers. Instead, banks issue daily quotations to
their branches.

These quotations have a wider spread between the bid and offer rates than is the case for large
FX market deals, to make sure that dealings by branches remain profitable even if spot rates change in
the FX market.

In the banking halls of commercial banks in Malaysia, foreign exchange rates are normally quoted at the
start of each day (Monday to Friday).

Foreign exchange rates are normally quoted at:

 Selling rates – the rate at which the bank will sell the foreign currency to the customer
 Buying rates – the rate at which the bank will buy the foreign currency from the customer.

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Two different buying rates are quoted:

 A buying OD rate. This is the rate for a transaction where the foreign currency will be delivered
to the bank at a later date. For example, when a bank buys foreign currency travellers’ cheques, it
will only receive the currency when the travellers’ cheques have been cleared. The same applies
to the purchase of foreign currency cheques by the bank.

 A buying TT rate. This is the rate that the bank applies when the currency has already been
delivered to the bank. For example, a European company may receive payment in Hong Kong
dollars from a customer and arrange with the bank to sell the dollars spot in exchange for euros.
The bank already has the Hong Kong dollar payment, and will therefore apply the buying TT rate.
The buying TT rate is more favourable to the customer than the buying OD rate.

For small transactions, banks can usually quote the same rates throughout the day, because the wider
spread between the bid and offer rates allows them some variation in spot rates without risk to their
profitability. Although banks quote spot rates on a daily basis, they reserve the right to change these
rates at any time, in the event that there are big movements during the day in the spot market rate, and
the bank wants to pass the change in rate on to its customers.

Companies may ask for a rate to be quoted for a specific transaction, where the transaction is quite
large. As mentioned previously, banks will usually be willing to offer a more favourable rate to a
customer for a larger-sized currency transaction.

It should also be remembered that customers can choose which bank to use for currency transactions,
and although banks quote their own exchange rates, they need to be aware of the rates that other banks
are quoting. If a bank quotes rates that are less favourable to customers than the rates quoted by rival
banks, it will lose business. For this reason is it usual to find that banks quote similar rates for currency
transactions.

5 Changes in spot rates: exchange rate volatility and

currency risk
Spot rates in the inter-bank FX markets change continually. Sometimes, the changes can be by a large
amount in a fairly short time.

Exchange rate volatility can be described as the existence of unpredictable changes in an exchange
rate. When spot rates change unpredictably and by fairly large amounts, they are said to be ‘volatile’.

5.1 Reasons for exchange rate volatility

Exchange rate volatility is caused by changes in supply and demand for currencies in the foreign
exchange markets. Several factors affect the strength of supply and demand for any currency.

 International trade in goods and services. International trade involves receipts or payments
in a foreign currency, and this creates transactions for buying and selling currencies between
businesses and their banks.
 Movements of capital between countries also create demand and supply for currencies. For
example, if the Malaysian government issues bonds and some of these are purchased by foreign
investors, the foreign investors must obtain ringgit to purchase the bonds. This will lead to a
demand from these investors to buy ringgit.
 In some countries (including Malaysia) the government may want to take measures to
protect its currency against speculation. A large fall (or rise) in value of a domestic currency can
have a profound effect on the national economy. The government, assisted by the central bank,
may therefore take measures that affect demand and supply in the FX market. Measures may
include using the government’s foreign exchange reserves to buy domestic currency in the FX
market, to prevent a large fall in the value of the currency. Alternatively, the central bank may
enforce exchange controls that limit foreign currency transactions involving the currency.

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5.2 Currency risk

Volatility in an exchange rate can create risk for businesses that conduct foreign trade that involves the
two currencies. This risk is called exchange rate risk or currency risk. It does not affect spot
transactions that are made ‘today’, but it affects currency transactions that will be made (or may be
made) in the future.

Currency risk exists in both the long term and the short term.

In the long term, the ability of an exporter to compete in foreign markets depends on the value of its
domestic currency.

 If the US$ were to rise in value over time relative to other currencies, it would become
increasingly difficult for US exporters to compete in foreign markets with foreign competitors,
because the cost of their exports to buyers would increase with the rising value of the dollar.
(Alternatively, US exporters would have to reduce their prices in US$ in order to remain
competitive.)
 If the US$ were to fall in value over time relative to other currencies, it would become
increasingly easier for US companies to compete with foreign competitors, because the cost of
imports would rise relative to the cost of US-produced products.
Long-term currency risk is unavoidable, although it can be reduced for global companies by establishing
business operations in different countries with different domestic currencies.

Short-term currency risk occurs when a business expects to make a currency payment or obtain a
currency receipt in the near future, perhaps in a few months, but it is too early to make a spot
transaction to buy or sell the currency. The risk is that between ‘now’ and the time that the payment is
made or the income is received, the spot rate may move adversely, with the result that:

 The amount of the payment (in domestic currency) increases.

 The amount of the receipt (in domestic currency) falls.
For example, volatility in the exchange rate between the US$ and the Indonesian rupiah (IDR) creates
currency risk for US companies dealing with Indonesian customers or suppliers.

 If a US company purchases goods from an Indonesian supplier and is required to pay for the
goods in rupiah in three months’ time, there is a risk that the rupiah will increase in value against
the US$ during the next three months. If this happens, the amount of the future payment in US$
to make the payment in rupiah will become more expensive, because of the adverse movement in
the spot rate.
 Similarly, if a US company sells goods to an Indonesian customer and agrees to accept payments
in rupiah in six months’ time, there is a risk that the rupiah will fall in value against the US$ in the
next six months, so that future income in US$ from payments received in rupiah will fall in value
because of the adverse movement in the spot rate.
In the short term, credit risk arises largely from the fact that credit is given in international trade, and
exporters agree to payment at some time in the future. During this time, the spot exchange rate could
move adversely, for either the exporter or the foreign buyer.

5.3 Currency risk as a two-way risk

Currency risk is a form of risk that arises from the change in price of one currency against another.
Whenever investors or companies have assets or business operations across national borders, they face
currency risk.

Currency risk is a two-way risk, in the sense that a spot exchange rate may move adversely, but may
move favourably instead. When the exchange rate moves favourably for an exporter, it moves adversely
for the buyer. If an exchange rate moves favourably for an importer, it moves adversely for the seller.

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It may therefore be asked why currency risk is important. If a company regularly exports goods to
different countries, it may incur ‘losses’ from adverse movements in the exchange rate with some
transactions, but it may also make a ‘profit’ from favourable movement in the exchange rate for other
transactions.

When the volatility in an exchange rate is small, the currency risk should be low, and companies may
therefore be willing to accept the currency risk.

However, when an exchange rate is volatile, adverse movements in a spot exchange rate could reduce
significantly the expected profit on a trading transaction. In some cases, it might eliminate the expected
profit entirely and turn an expected profit into an actual loss.

For this reason, many companies give serious consideration to the management of currency risk, and
take measures to control and limit the scale of the risk.

Forward foreign exchange contracts (forward contracts) are a commonly-used method for
managing exposures to short-term currency risk.

6 Forward exchange contracts

A forward foreign exchange contract is a contract agreed ‘now’ for the purchase and sale of an agreed
quantity of one currency in exchange for another, for settlement at a future date. It is a contract that
fixes the exchange rate, the quantities of each currency that will be exchanged, and the future
settlement date.

In the inter-bank FX market, the value date for a forward exchange contract is measured from the value
date for a spot transaction. The value date for a spot transaction is usually two working days after the
date that the transaction is made. For example:

 A spot transaction on Monday 1 April is normally settled on the spot value date Wednesday 3
April. A three-month forward transaction made on 1 April should therefore have a settlement date
three months after 3 April, which is Wednesday 3 July.
 A spot transaction on Monday 3 January is normally settled on the spot value date Wednesday 5
January. A one-month forward transaction made on 3 January should therefore have a settlement
date one month after 5 January, which is 5 February. However, as this date is a Saturday (not a
working day), value date for the forward contract is the next working day, Monday 7 February.

6.1 Forward rates

Forward rates are often quoted in the same way as spot rates, with a bid rate and an offer or ask rate.

For example, exchange rates for US dollars may be quoted as follows:

Spot: 1.6455 – 1.6465

One month (forward): 1.6470 – 1.6484

In this example, the forward rate is higher than the spot rate. This means that the exchange value of US
dollar against UK sterling is lower forward than spot. When the forward rate is higher than the spot rate,
the variable currency is quoted forward at a discount to the spot rate.

In this example, the size of the discount, in ‘points or pips’ is calculated simply as follows:

Spot 1.6455 – 1.6465

Forward rate 1.6470 – 1.6484
Forward discount 0.0015 – 0.0019
The discount (in points) is 15 – 19.

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Forward rates may be lower than the spot rate. For example, the spot and two-month forward rates for
Canadian dollars against euros may be:

Spot: 1.4585 – 1.4593

Two months forward: 1.4570 – 1.4580

When the forward rate is lower than the spot rate, the variable currency is quoted forward at a
premium to the spot rate.

In this example, the size of the premium, in ‘points or pips’ is calculated simply as follows:

Spot 1.4585 – 1.4593

Forward rate 1.4570 – 1.4580
Forward premium 0.0015 – 0.0013
The premium (in points) is 15 – 13.

For reasons that need not be explained in this text (because they are not required for the examination
syllabus):

 When a forward rate is at a discount to the spot rate, the size of the discount is lower for the bid
rate than for the offer rate.
 When a forward rate is at a premium to the spot rate, the size of the premium is higher for the
bid rate than for the offer rate.
Forward rates may be quoted for one month, two months, three months and so on. However, banks will
quote forward rates on request to a customer for any forward date (up to a maximum time limit for
forward rates between the currencies). Forward contracts do not need to be for an exact number of
calendar months.

6.2 How are forward rates determined?

Forward rates in the interbank FX markets are determined by differences in short-term
(money market) interest rates between the two currencies. Forward rates are not a
prediction or forecast of what the spot rate will be at settlement date for the forward
contract.

 When the interest rate on the variable currency is higher than the interest rate on the base
currency, the forward rate for the variable currency will be at a discount to the spot rate (higher
than the spot rate).
 When the interest rate on the variable currency is lower than the interest rate on the base
currency, the forward rate for the variable currency will be at a premium to the spot rate (lower
than the spot rate).
The simplified example below illustrates this.

E X A M P L E

Suppose that the three-month interest rate for US dollars is quoted as 3% and the three-month interest
rate for euros is quoted as 2%. The current spot exchange rate is 0.8000 (euros to one US dollar).

It is assumed that the three-month rate is therefore 0.75% for US dollars and 0.5% for euros. At the
spot rate, US$10,000 is equal in value to €8,000.

 A bank could invest US$10,000 for three months, and at the end of that time, the investment
would have grown in value to US$10,075.

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 Alternatively, the bank could sell US$10,000 spot at 0.7500 in exchange for euros, and invest
€8,000 for three months to earn interest of 0.5% and at the end of three months the investment
would be worth €8,040 (= 8,000 × 1.005).

 To the bank, US$10,075 in three months’ time is equivalent in value to €8,040.

 The bank can therefore quote a three-month forward exchange rate of 8,040/10,075 = 0.7980.

The euro would be quoted forward at a premium to the spot rate, because the interest rate on the euro
is lower than the interest rate on US dollar.

6.3 Using forward exchange contracts to manage exposures to currency

risk
Forward exchange contracts can be used by exporters or importers to manage currency risk on foreign
trade transactions where payment or receipt of the foreign currency will occur at a future date. This will
be explained with two case studies.

C A S E S T U D Y

An Australian exporter sells goods to a customer in the Middle East, and the agreed price is US$20,000.
Payment will be made in three months’ time. The bank’s rates for USD/AUD are as follows:

Spot: 1.1010 – 1.1020 (AUD per USD)

Three months forward: 1.1017 – 1.1030

The exporter wants to exchange its US dollar receipts into Australian dollars. What are its choices?

 The exporter can wait for three months, and when it receives the payment in US dollars, it can
ask its bank to exchange the dollars for Australian dollars at the spot rate that is available in three
months’ time. This spot rate may be higher or lower than the current spot rate (1.1010) but is
unlikely to be the same as today’s spot rate. The exporter will therefore be exposed to the risk of
change in the spot rate in the next three months. This change could be either favourable or
adverse.

 Alternatively, the exporter could arrange a forward contract now to sell US$20,000, for settlement
in three months’ time, at the forward rate of 1.1017. At the settlement date in three months’
time, it will receive AU$22,034 (20,000 × 1.1017) in exchange for its dollars. The forward rate
therefore fixes the amount of the future receipt in Australian dollars. This removes the risk of an
unfavourable movement in the spot exchange rate in the next three months. At the same time, it
means that the exporter cannot benefit from any favourable movement in the spot rate. A
forward contract is a binding contract, and the exporter would have to sell its dollars at the fixed
forward contract rate of 1.1017.

The exporter’s choice may depend on its view of the likely future movements in the spot rate. If the
exchange rate is volatile, it may prefer to ‘hedge’ the exposure to currency risk and fix the exchange
rate with a forward contract.

C A S E S T U D Y

A European company buys goods from a supplier in Japan and the agreed purchase price is 150,000 yen.
Payment will be made in one month’s time. The bank’s rates for EUR/JPY are as follows:

Spot: 140.00 – 140.40 (JPY per EUR)

One month forward: 139.95 – 140.37

The exporter wants to buy yen in order to make the payment. What are its choices?

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 The company can wait for one month, and then buy 150,000 yen at the spot rate from its bank.
This spot rate may be higher or lower than the current spot rate (140.00) but is unlikely to be the
same as today’s spot rate. The company will therefore be exposed to the risk of change in the
spot rate in the next month. This change could be either favourable or adverse.

 Alternatively, the company could arrange a forward contract now to buy JPY150,000 for
settlement in one month’s time, at the forward rate of 139.95. At the settlement date in one
month’s time, it will pay €1,0721.81 (150,000/139.95) to obtain the yen in order to make the
payment. The forward rate therefore fixes the amount in euros for the future payment. This
removes the risk of an increase in the value of yen against euros over the next month. At the
same time, it means that the company cannot benefit from any favourable movement in the spot
rate. A forward contract is a binding contract, and the exporter would have to buy the yen at the
fixed forward rate of 139.95.

The company’s choice may depend on its view of the likely future movements in the spot rate. If the
exchange rate is volatile, it may prefer to ‘hedge’ the exposure to currency risk and fix the exchange rate
with a forward contract. For example, if there is a possibility that the yen will increase in value by about
5% over the next month, to 133.00, the cost of the yen spot would increase to €1,128.

As a general rule, companies may decide to use a forward exchange contract to manage its exposures to
foreign exchange risk in the following circumstances.

 When the exchange rate is volatile, so that the spot exchange rate may change by a large amount
in a short time.

 When the forward settlement date is a long time in the future, because the spot rate is more
likely to change substantially over a longer period of time than over a short time.

 When the amount of the transaction is large, because even a small change in the spot rate can
have a large effect on the cost of an import transaction or the income from an export transaction.

6.4 Quotation of currency forwards

Below is an example forward quote for EUR/USD.

EUR/USD Bid Ask

SPOT 1.3523 1.3524

1 MONTH FWD 1.47 1.53

3 MONTH FWD 3.72 3.90

6 MONTH FWD 6.86 7.66

The forwards are quoted as premiums (if negative values), or discounts (if positive values), to the spot
rate and are quoted in pips (points). For example, a European customer wishing to buy dollars three
months forward will be dealing at the bid rate and the forward discount will be 3.72 pips (or 0.000332
dollars). Thus the rate for the transaction will be 1.352672 (1.3523 + 0.000372).

The fact that the dollar is at a forward discount is that US interest rates exceed euro interest rates.

6.5 Fixed forward contract and option forward contracts

The forward contracts described so far are fixed forward contracts. This means that the future
settlement date for the contract is on a fixed date.

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 A company may know that it must make a currency payment at some time in the future, and
wants to hedge its exposure to currency risk with a forward contract, but it does not know the
exact date that the payment will be made.
 Similarly a company may know that it will receive income in a foreign currency at some time in
the future, and wants to hedge its exposure to currency risk with a forward contract, but it does
not know the exact date that the money will be received.
When there is some doubt about the required future date for settlement of a forward contract, a
customer can arrange an option forward contract with the bank. An option forward contract is also called
a value date option contract.

Key term
A value date is a future date used in determining the value of a product that fluctuates in price.
Typically, you will see the use of value dates in determining the payment of products and accounts
where there is a possibility for discrepancies due to differences in the timing of valuation. Such products
include forward currency contracts, option contracts, and the interest payable or receivable on personal
accounts. Also referred to as 'valuta'.

An option forward contract gives the customer a choice of settlement dates for the forward contract, at
any time between a specified earliest date and a specified latest date. The customer can arrange to
settle the forward contract at the agreed forward rate on any working date of its choosing between the
earliest and latest date.

When arranging an option forward contract, the bank will apply the forward rate (for the earliest or latest
settlement dates) that is most beneficial to itself.

C A S E S T U D Y

An Australian company has sold goods to a customer in Hong Kong at an agreed price of HK$25,000.
There is some uncertainty about the date that the money will be received. If the customer pays on time,
the money will be received two months from now. However, the customer is often late with payments,
so that the money may not be received for three months.

The company wants to hedge its exposure to currency risk by arranging to sell the Hong Kong dollars
forward, and its bank is quoting the following rates.

Spot: 7.0750 – 7.0760 (HKD per AUD)

Two months forward: 7.0745 – 7.0757

Three months forward: 7.0738 – 7.0752

If the company arranges an option forward contract, for settlement at any time between two months and
three months in the future, it will be selling HK dollars and the bank will be buying HK dollars/selling
Australian dollars.

 As it is selling Australian dollars (the base currency) it will quote an offer rate.

 The offer rate is 7.0757 for a two-month forward contract and 7.0752 for a three-month forward
contract. The more favourable of these rates for the bank is 7.0757.

 The rate for the option forward contract is therefore 7.0757 and at the settlement date (no earlier
than two months in the future and no later than three months) the bank will buy HK$25,000 from
the customer in exchange for AU$3,533 (= 25,0007.0757).

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7 Close out and extension of forward exchange contracts

7.1 Close out of forward contract
Occasionally, a customer of a bank may find that it does not need a forward exchange contract that it
has already made with a bank, because the expected currency payment or receipt is no longer expected
to happen. When this happens, the bank will arrange to ‘close out’ the contract.
A contract is closed out by arranging a spot contract or a new forward contract to offset the original
forward contract.
For example, suppose that a European company is expecting a payment of US$30,000 from a customer
and has arranged a forward exchange contract to sell the dollars to its bank, for settlement on 9 May, at
an exchange rate of 1.37666. The company then discovers that the customer will not pay the money
because it is insolvent and has gone out of business. The forward contract is a binding contract, and the
company must ask the bank to close out the contract.
 It can do this by selling US$30,000 to the company at the spot rate on 9 May, and using these
dollars for settlement of the forward contract at a rate of 1.37666. Close out involves either a net
payment from the customer to the bank or a net a payment by the bank to the customer,
depending on what the spot rate happens to be on 9 May.
 Alternatively, if the company is aware before 9 May that the dollars will not be received, it can ask
the bank to close out the forward contract before 9 May, by arranging a forward contract to sell
US$30,000 to the customer at the current forward rate, for settlement on 9 May. This will result in
either a net payment from the customer to the bank or from the bank to the customer, depending
on the forward rate for the new forward contract.

C A S E S T U D Y

Close out
ABC Boston sells goods to a Hong Kong customer at an agreed price of HK$900,000. It decides to cover
the currency risk by arranging with its bank to sell the Hong Kong dollars in exchange for US$112,500 at
a forward rate of HKD8.00/USD1, for settlement in two months’ time on 25 June.

The Hong Kong customer subsequently cancels the order and refuses to pay any money. ABC Boston
asks the bank to close out its forward contract on 25 June.

At close out the settlement between ABC Boston and the bank depends on the spot exchange rate at the
time of the close-out. We shall consider two possible situations:

Situation 1: The spot exchange rate at close-out is 7.9000 – 7.9010

Situation 2: The spot exchange rate at close-out is 8.2000 – 8.2010.

The net settlement for each scenario is calculated as follows:

Situation 1 Situation 2
USD USD
Spot transaction to close out:
Bank sells HK$900,000 at 7.9000/8.2000 113,924 109,756
Forward contract:
Bank buys HK$900,000 at forward rate 8.00 (112,500) (112,500)
Net settlement: ABC Boston pays bank 1,424
Net settlement: bank pays ABC Boston 2,744

An alternative measure would be to close out the original forward contract before settlement date by
arranging an offsetting forward contract for the same settlement date. In this example, ABC Boston may
ask the bank to close out the original forward contract on 15 May. To do this, the bank would arrange a
forward contract on 15 May to sell HK$90,000 to ABC Boston for settlement on 25 June, at the forward
rate that applies on 15 May.

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7.2 Extension of forward contract

Another situation that may occur is for a customer of a bank to arrange a fixed forward contract, only to
discover later that it wants settlement to occur at a later date. For example, a European company may
arrange a forward contract to buy US dollars in exchange for the euro, for settlement on 12 September.
It may then discover that it will not make the payment until 12 October.

The company can arrange for the bank to extend the forward contract for settlement on 12 October.
This is achieved by means of:

 Closing out the original forward contract, and

 Arranging a new forward contract for settlement at the new date. The forward rate for this new
contract will be more favourable to the customer than the rate that would be applied to other
forward contracts for the same settlement date.

8 Other ways of managing currency risk

Businesses use forward exchange contracts as a method of managing exposure to currency risk. There
are other ways of managing currency risk, some of them involving a transaction with a bank, but some
not involving a bank transaction.

Methods of managing exposures to currency risk that do not involve a transaction with a bank include
the following.

Invoice in domestic currency. An exporter may insist that goods should be priced in the exporter’s
domestic currency. When this happens, the buyer has the exposure to currency risk. Similarly, it may be
possible for a buyer to insist that its purchases from a foreign supplier should be priced in the buyer’s
domestic currency. When this happens, the seller has the exposure to currency risk. The currency for
pricing and invoicing is a matter for negotiation between the buyer and the seller.
Include a currency clause in the trading transaction. The buyer and seller may agree to share the
risk of changes in the exchange rate by including a currency clause in their trading agreement. For
example, an Australian company may arrange to sell goods to an American customer at a price of
AU$40,000. The seller and buyer may agree that this price is based on an assumed spot exchange rate
of 1.1 Australian dollar (AUD) per US dollar (USD). Their agreement may also include a currency clause
to share the gain or loss from changes in the spot exchange rate up to the due date of payment for the
goods. For example, their contract may include an agreement that:
 If the Australian dollar falls in value and the spot exchange rate rises above AUD1.13 = USD1, the
American company will pay the Australian dollar equivalent value (at the spot exchange rate) of
US$35,398 (= 40,000/1.13).
 If the Australian dollar rises in value and the spot exchange rate falls below AUD1.07 = USD1, the
American company will pay the Australian dollar equivalent value (at the spot exchange rate) of
US$37,383 (= 40,000/1.07).
This currency clause means that the buyer and seller share the risk of future movements in the spot rate
up to the date of payment for the transaction.
This is just one example of a currency clause. There are other ways in which the currency risk can be
shared between buyer and seller by means of a currency clause in the trading contract.
Business organisations can also use other methods involving a bank to manage currency risk
exposures. These include:
 Foreign currency options
 Second generation forward contracts such as a:
– Range forward contract
– Participation forward contract

 Short-term borrowing in a foreign currency.

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9 Foreign currency options

A currency option is a type of financial derivative contract. It is different from, and should not be
confused with, an option forward contract.

9.1 The features of an option contract

An option is purchased by a customer from a bank (although some options can be purchased on a
derivatives exchange).

Key term
A call option gives its holder the right to buy, but not the obligation, a specified quantity of an
underlying item on or before a specified future date (the expiry date for the option) at a fixed price; this
is known as the exercise price or strike price for the option.

A put option gives its holder the right, but not the obligation, to sell a specified quantity of an
underlying item on or before a specified future date (the expiry date for the option) at a fixed price; this
is known as the exercise price or strike price.

The option holder has the choice whether to exercise the option and buy (call option) or sell (put option)
the underlying item at the exercise price.

 If the option holder exercises the option, the option seller (bank) is contractually obliged to sell
(call option) or buy (put option) the underlying item at the exercise price.
 If the option holder does not exercise the option before its expiry date, the option lapses (ceases
to exist).
An option therefore allows its buyer to obtain a ‘worst possible’ price for the underlying item. This is the
exercise price. The option holder can also buy or sell the underlying item at the spot rate in the market,
if this is more favourable than the exercise price for the option. If the option holder buys or sells at the
spot rate, it can let the option lapse.

9.2 The features of a currency option contract

A currency option contract is one type of option contract. Currency option markets developed to offer
greater flexibility for both hedgers and speculators. Currency options are arranged with and purchased
‘over the counter’ or traded on an exchange. When hedging FX exposure using options it is important to
decide whether to trade over the counter, or through an exchange:
 Over the counter options are custom options contracts negotiated directly with a bank. They offer
flexibility, as the underlying currency, size, strike price and expiry date can all be tailored exactly
to the needs of the hedger. However, they also carry credit risk – if the bank defaults before the
option contract expires, the contract will not settle, which could result in significant losses for the
hedger. If the hedger holds an OTC option but then realises they no longer need the option, it
may be difficult to sell the option due to its customised terms.
 Exchange traded currency options are traded on recognised exchanges such as the Chicago
Mercantile Exchange. These options carry very low credit risk, as the hedger is trading with the
exchange. The currency options offered on the exchange are traded in standard sizes and
specifications, which offers good liquidity, making it easy for hedgers to trade in and out of
positions. However, the standard contracts offered may not meet the exact requirements of the
hedger.
A currency option gives its holder the right to buy a quantity of one currency in exchange for another
currency (call option) or sell a quantity of one currency in exchange for another currency (put option), on
or possibly before a specified future expiry date, at a fixed rate of exchange (the exercise rate).
An example should help to explain how currency options may be used.

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E X A M P L E
A company needs to buy US$25,000 in two months’ time in order to make a payment to a foreign
supplier, and intends to buy the dollars from its bank in order to make the payment. It is aware of the
exposure to currency risk, and the possibility that the US dollar will rise significantly in value against the
ringgit during the next two months. Although this is a possibility, the company thinks it is more likely that
the dollar will remain stable in value against the ringgit or may even fall in value during this time.
The company may consider three possible courses of action.
 Do nothing and buy the US$25,000 in two months’ time at the available spot rate. If
the exchange rate remains stable over the next two months, the company will probably be
satisfied with its decision to do nothing. However, if the US dollar rises in value, the company will
have to pay more than expected to buy the US$25,000, and it will suffer a ‘loss’ from the adverse
movement in the spot exchange rate.
 Arrange a forward contract to buy US$25,000 in two months’ time. This will fix the cost
of the dollars for the company. However, if the US dollar falls in value so that the spot rate is
more favourable than the forward rate, the company will have lost the opportunity to benefit from
the favourable movement in the spot rate. This is because it must settle the forward exchange
contract at the fixed forward rate. Therefore hedging using forward contracts results in a
symmetrical return – any gain on the spot rate will be offset by an equal loss on the forward
rate and vice versa.
 Buy a currency option from its bank, giving it the right but not the obligation to buy
US$25,000 at the exercise rate in the option in two months’ time. If the dollar increases in value
during the next two months the company can buy the dollars at the exercise rate in the option, if
this is more favourable than the spot rate. However, if the spot rate in two months’ time is more
favourable than the exercise rate for the option, the company can let the option lapse and buy
the dollars at the available spot rate. The option therefore allows the company to benefit from a
favourable exchange rate, whilst fixing a worst-possible exchange rate by means of the option.
The disadvantage of a currency option, however, is the cost of the option premium. The potential
benefits from buying an option should be sufficient to justify the purchase cost of the option.
Therefore hedging using options results in an asymmetrical return. They allow hedgers to
mitigate against downside risk but also allows them to make profits from hedging activities.

10 Range forward option

A range forward option is a type of currency option that may be arranged with a bank. The cost of this
option depends on the exchange rates in the option agreement.

This type of option:

 Fixes a maximum exchange rate for the purchase or sale of a currency.

 Fixes a minimum exchange rate.
If the spot rate at expiry of the option is between the maximum and the minimum exchange rates, the
option holder can let the option lapse and buy or sell the currency at the available spot rate.

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C A S E S T U D Y

A company is required to make a payment in US dollars in three months’ time, and will have to buy the
dollars with euros in order to make the payment. The company’s treasurer expects the US dollar to
remain fairly stable in value against the euros during the next three months, or perhaps fall in value.
There is also a possibility, however, that the dollar will rise in value.
The treasurer discusses the possibility of arranging a range forward option and the bank quotes the
following rates.
For the range option:

Maximum rate: 0.7800

Minimum rate: 0.7100
Current spot rate: 0.7500
Rate for a two-month forward contract: 0.7650
If the company agrees to the range option, the following outcomes may occur in two months’ time, when
the range option reaches its exercise date:
 If the USD increases in value above the maximum rate of 0.7800, the company will exercise the
option to buy the dollars at this rate.
 If the USD falls in value below the minimum rate 0.7100, the company will be required by the
bank to buy the dollars at this rate, and not at the more favourable spot rate.
 If the spot rate is anywhere between the minimum and the maximum rate in the range option,
the company will buy the US dollars at the spot rate.
The advantages of this range option for the company are as follows.
 It fixes a maximum rate of 0.7800. This is not as good as the available rate for a forward
exchange contract, but the company treasurer does not really expect the USD to rise significantly
in value in the next two months.
 The company will be able to buy the dollars at the available spot rate in two months, if this is
between the minimum and maximum rates for the range option. If the value of the dollar remains
stable over the next two months (at around 0.7500), buying dollars at the spot rate will be more
favourable than a forward exchange contract (0.7650).
 If the dollar falls in value, the company can at least obtain a rate of 0.7100 (the minimum rate for
the range option) and so will enjoy some benefit from the weaker dollar.

11 Participation forward contract

With a participation forward contract (between a company and a bank) the company is able to hedge its
exposure to currency risk and also share in any favourable movement in the spot rate with the bank on a
50:50 basis.
The following example will explain the features of a participation forward.

E X A M P L E

A company is required to make a payment in US dollars in six months’ time, and will have to buy the
dollars with euros in order to make the payment. The company’s treasurer thinks that the US dollar is
overvalued and will fall significantly in value during the next six months. The treasurer wants the
company to benefit from any fall in the value of the dollar, but also wants protection against the
possibility that the dollar may rise in value and become more expensive to buy.

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The company is able to arrange a six-month participation forward (PF) with its bank. This sets a forward
rate for buying the dollars in six months’ time at a rate of 0.7800. This is the maximum rate that the
company will pay for the dollars.

In addition, the company will participate on a 50:50 basis with the bank, and share the benefit of any
amount by which the spot rate is below 0.7800 at settlement date for the contract.

For example, if the spot rate at settlement date is 0.7200, the PF rate for the company to buy the US
dollars will be:

PF rate minus [50% × (PF rate – Spot rate at maturity)]

= 0.7800 – [50% × (0.7800 – 0.7200)]

= 0.7800 – 0.0300
= 0.7500

On the other hand, if the dollar has strengthened in value and the spot rate at maturity is, say 0.8100,
the company will pay the PF rate of 0.7800 to buy the dollars.

12 Borrowing in a foreign currency to manage exposure to

currency risk
Foreign currency borrowing is a source of finance for foreign trade. It may also be used as a measure to
manage an exposure to foreign currency risk, in a situation where a company expects to make a
payment in foreign currency at a future date.

For example, suppose that an Australian company expects to make a payment in US dollars in six
months’ time, and it wants to fix the cost in Australian dollars of this US dollar payment. One method of
managing the risk would be to arrange a forward contract to buy the dollars in six months’ time.

Another method is to borrow US dollars now and put the money on deposit for six months. The amount
borrowed should be a sufficient amount so that the original borrowed amount plus the interest income
receivable in six months’ time add up to the amount required to make the dollar payment.

13 Hedging decisions for currency risk

Companies engaged in exporting or importing need to make decisions about whether or not to hedge
exposures to currency risk, and what they should do if they wish to hedge an exposure to risk.

Large companies may have a formal policy for their treasury department about hedging exposures to
risk, but the following explanation relates to decisions about hedging exposures to currency risk:

 For an individual import or export contract.

 For a company that does not have an established hedging policy.

Key term
Hedging is the process of making an investment to reduce the risk of adverse price movements in an
asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures
contract.

13.1 Deciding whether to hedge an exposure to currency risk

In order to decide whether to hedge exposures to currency risk for a foreign trade transaction, there are
three questions to consider.

1 Is there an exposure to currency risk in the transaction?

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2 If so, what is the nature of the risk?

3 Is the risk significant?

Is there an exposure to currency risk in the transaction?

There is a risk in a foreign trade transaction:

 For an importer, if the purchased goods or services must be paid for in a foreign currency and not
domestic currency.
 For an exporter, if the goods are sold at a price that is payable in a foreign currency and not
domestic currency.
There is no currency risk for an importer who pays the supplier in their own domestic currency for the
imported goods (into an ‘external account’ of the supplier). There is no currency risk for a an exporter
who prices the exported goods in their own domestic currency.

What is the nature of the risk?

The currency risk will be the risk that one of the two currencies will weaken or strengthen in value
against the other, between the time of making the trading transaction and the time that payment will be
made.

Currency risk is a two-way risk, and an exchange rate can move favourably as well as adversely. The
exporter or importer needs to recognise which direction of exchange rate movement would be an
adverse movement, and which would be a favourable movement.

For example, suppose that a European exporter intends to sell goods to a foreign buyer and ask for
payment in US dollars, with settlement three months after shipment of the goods. The exporter does not
have a foreign currency account in US dollars with any bank. The risk for the exporter is that
between shipment and payment, the US dollar will fall in value against the home currency. (The exporter
would benefit from a stronger US dollar.)

Similarly, suppose that a European company is importing goods that must be paid for in US dollars after
120 days from sight of the documents in a documentary credit arrangement. The importer does not have
a foreign currency account in US dollars with any bank. The risk for the importer is that the US dollar will
strengthen in value against the home currency during the credit period, and that it will cost more to buy
the dollars in order to pay the supplier.

Is the risk significant?

The size or significance of an exposure to currency risk depends on several factors:

 The volatility in the exchange rate

 The expected future direction of change in the rate
 The size of the exposure in money terms
 The length of the period of the exposure, up to the date for payment
For example, suppose that the AU dollar/US dollar rate is fairly stable, and the most likely change in the
spot rate is that the US dollar will weaken in value against the AU dollar. If an Australian company
imports goods priced in US dollars, it may decide that the currency risk is not significant. It may even
hope to benefit from a favourable movement in the spot exchange rate (a weaker US dollar).

Similarly, an importer may have purchased goods costing US$100, payable within two weeks. The small
amount of the payment and the short time period until payment means that the currency risk is small.
A company should consider a measure to hedge its exposure to currency risk only if:
 An exposure exists;
 It is significant, so that an adverse movement in the exchange rate is possible and, if it happens,
it may affect the company’s costs or profits from trading.

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13.2 Deciding how to hedge an exposure to currency risk

If a company decides that it has significant exposures to currency risk, it should consider taking
measures to hedge the risk. The various methods that could be used have been described already in this
chapter. They include:
 For exporters, pricing the exports in their domestic currency; for importers, trying to price the
purchases in their domestic currency.
 For companies that export and import regularly in a foreign currency, maintaining foreign
currency accounts in their most frequently traded currencies.
When the future date of payment is known, a forward contract can be used to fix the rate for the foreign
exchange transaction. This is considered in more detail below.
Occasionally, companies may consider other methods of hedging a currency risk exposure, such as a
currency option or a range forward contract. However, these contracts have a purchase cost and are
probably useful only if the exchange rate is very volatile.

13.3 Hedging an exposure to currency risk with a forward exchange

contract
A company may use a forward exchange contract to hedge an exposure to currency risk in a trading
transaction. To hedge the risk, it needs to arrange a suitable forward contract with its bank. To do this, it
is necessary to decide what the foreign exchange transaction should be.

C A S E S T U D Y

A European company is buying goods from an Australian supplier, at a cost of 60,000 Australian dollars
(AU$60,000) payable in three months’ time. The three month forward rate available from the bank is:

1.5150 – 1.5250 (AUD per EUR1)

If the company uses a forward contract to hedge the exposure to currency risk, it will need to buy
A$60,000 in order to pay the supplier, and so must buy AUD in exchange for EUR. The bank will quote
the rate more favourable to itself, which is the bid rate, and the cost of buying AU$60,000 at the forward
rate will be:

60,000/1.5150 = €39,603.96

C A S E S T U D Y

An American company has secured a contract to sell goods to South Africa. However, the goods are
priced in South African rand (SAR) and the sale price is SAR250,000, payable in 90 days’ time.

A bank is offering three month forward rates of 10.3555 – 10.3565 (SAR per USD1)

If the company uses a forward contract to hedge the exposure to currency risk, it will need to sell SAR in
three months’ time in exchange for US dollars, to convert its foreign currency income into US dollars. The
bank will quote the rate more favourable to itself, which is the offer rate, and the income from selling the
SAR will be:

250,000/10.3565 = US$24,139.43.

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C A S E S T U D Y

A Canadian company is buying goods from a European supplier, at a cost of 50,000 euro (€50,000)
payable in two months’ time. The two month forward rate available from the bank is:

1.4580 – 1.4590 (CAD per EUR1).

If the company uses a forward contract to hedge the exposure to currency risk, it will need to buy
€50,000 in order to pay the supplier, and so must buy EUR in exchange for CAD. The bank will quote the
rate more favourable to itself, which is the offer rate. The cost of buying the euro will be:

50,000 × 1.4590 = C$72,950.

In this example, Canadian dollars are quoted as the variable currency in the exchange rate. In the
previous examples, Canadian dollars was the base currency. It is important to recognise how the
exchange rate is quoted in order to identify which rate, the bid or the offer rate, applies to a forward
transaction.

13.4 Translational FX exposure

All of the examples so far have looked at the economic risk of FX exposure, i.e. how a company’s
cashflows will be affected by movements in FX rates. However, it is important to also consider
translational FX exposure, which is how FX movements affect a company’s reported financial figures.

C A S E S T U D Y
Suppose an American company has a subsidiary in Hong Kong. The Hong Kong subsidiary has made a
profit of HK$25,000,000 this year. The profits made by the Hong Kong branch will be reported in the
group accounts of the American company in US dollars in one month’s time. The USD:HKD exchange
rate is currently 7.75, so the value of the profits from the Hong Kong subsidiary are now valued at
3,225,806. Suppose that in one month’s time:
 USD:HKD exchange rate is now 7.9. The value of the profits from the Hong Kong subsidiary are
now valued at US$3,164,556. Therefore due to translational FX exposure there is a loss of
US$61,250 (3,164,556 – 3,225,806).
 USD:HKD exchange rate is now 7.6. The value of the profits from the Hong Kong branch are now
valued at US$3,289,474. Due to translational FX exposure there is a gain of US$63,668
(3,289,474 – 3,225,806).
Just as a company may decide to hedge its economic FX exposure, it may also decide to hedge its
translational FX exposure. In the example above, the American company could have hedged its
HKD exposure by selling HKD against USD with a one month forward contract – they then would
have locked in the US$10,288,065 profit from the Hong Kong subsidiary.

14 Exchange controls
Exchange controls are measures intended to place controls over currency transactions. They apply to
matters such as dealings in foreign currency, domestic accounts of non-residents, foreign currency
accounts of residents, foreign payments, credit facilities to non-residents and investment abroad.

One objective of exchange control is to ensure that the country’s limited financial resources are used for
purposes that will benefit the country’s economy and earn foreign exchange.

Another purpose of exchange controls is to protect the country’s economy from damage that might be
caused by currency transactions. However, it is also recognised that exchange controls should not be too
restrictive, so that the economy is unable to develop and grow. For this reason exchange controls have
been made less restrictive in recent years.

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A 2007 International Monetary Fund report into the effect of exchange controls on international trade
concluded that there was statistically significant evidence that exchange controls had a negative effect
on international trade. The imposition of exchange controls was found to have the same effect as an
increase in tariffs.

15 Malaysian exchange control legislation

Historically the Exchange Control Act 1953 gave powers to the BNM as Controller of Foreign Currency
to impose restrictions on currency transactions. The responsibilities and powers of BNM in respect of
foreign exchange administration (exchange controls) are now consolidated within the Financial
Services Act 2013.

This change reduced the impact of exchange controls in Malaysia. BNM’s website quotes the following:

‘Malaysia continues to maintain liberal Foreign Exchange Administration (FEA) rules which are mainly
prudential measures to support the overall macroeconomic objective of maintaining monetary and
financial stability.

The Bank is committed in ensuring the FEA rules continue to support and enhance the competitiveness
of the economy through the creation of a more supportive and facilitative environment for trade,
business and investment activities.’

One of the rules imposed under the FSA is that foreign currency dealings must be made through either
person who is licensed under the Money Services Business Act 2011 or a bank licensed under the
Financial Services Act/Islamic Financial Services Act.

15.1 Exchange Control of Malaysia Notices

In the past, control was exercised by BNM under the Exchange Control Act 1953 through the issuance of
Exchange Control Notices, however with the implementation of the Financial Services Act 2013 and the
Islamic Financial Services Act 2013, the Controller of Foreign Exchange revoked all 15 existing Exchange
Control Notices with effect from 30 June 2013.

On this date Foreign Exchange Administration of BNM published seven new Exchange Control Notices
which detail categories of foreign exchange transactions that are permitted which would otherwise be
prohibited by FSA/IFSA. A person must obtain approval of BNM to undertake or engage in any
transactions that are not allowed under any of these seven notices.

15.2 Residents and non-residents

The exchange control regulations apply different rules to residents and non-residents.

Residents are:

 Malaysian citizens.

 Businesses and other enterprises established and operating in Malaysia.

 Malaysian citizens who have acquired ‘permanent residence’ status in another country, but who
are living in Malaysia.

 Non-Malaysian citizens who have acquired ‘permanent residence’ status in Malaysia and are living
in Malaysia.

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Non-residents are:

 Non-Malaysian citizens.

 Businesses and other entities established abroad.

 Malaysian citizens who have acquired ‘permanent residence’ status in another country, and who
are living abroad.

 Foreign embassies and High Commissions and foreign central banks.

15.3 External accounts and foreign currency accounts

Exchange control rules apply to external accounts and foreign currency accounts with banks.

 An external account is a ringgit account with a bank in Malaysia which is maintained by a non-
resident (or where the beneficial owner of the ringgits in the account is a non-resident).

 A foreign currency account is an account with a bank in any currency other than ringgit. It is
defined as:

– An account maintained by residents in a foreign currency with licensed onshore banks,

licensed offshore banks and overseas banks.

– An account maintained by a non-resident in foreign currency with a licensed onshore bank.

15.4 Exchange control rules applying to residents

Residents may freely undertake any amount of investment in foreign currency assets offered in Malaysia
by a resident or to invest abroad using foreign currency funds sourced from abroad. Residents without
domestic ringgit borrowing are free to invest abroad, however those with domestic ringgit borrowing who
are converting ringgit into foreign currency are only free to invest abroad up to RM1m p.a. and RM50m
in aggregate.

Investment funds may invest up to 100% of the net assets of residents without ringgit borrowings
overseas but only up to 50% of net assets of residents with ringgit borrowings.

Residents are free to obtain any amount of foreign currency borrowings from non-resident sources or up
to RM10m (equivalent) from resident sources.

Residents may obtain any amount of ringgit borrowings from non-resident group sources for investment
in Malaysia or up to RM1m from other sources.

Residents may exchange money with a licenced onshore bank and are free to open foreign currency
accounts with either onshore or offshore financial institutions.

15.5 Exchange control rules applying to non-residents

Non-residents are free to invest in any form of ringgit assets irrespective of the finance source. Any
profits, dividends, sale proceeds etc. remitted out must, however, be paid in a foreign currency.

Non-residents may exchange ringgit with a licenced onshore bank on either a spot or forward basis.

Non-residents may freely open foreign currency or ringgit accounts with on-shore banks.

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Chapter roundup

 Banks settle foreign currency payments or receipts for customers through the accounts that they hold
with a branch or correspondent bank in the country of origin of the currency.

 Banks hold their foreign currency in an account with a branch or correspondent bank in the country of
origin of the currency, known as a nostro account.

 Banks also hold bank accounts in their domestic currency for foreign bank customers. These are known
as vostro accounts.

 There is a large international market for trading in foreign currencies, where the main participants are
banks

 A spot foreign exchange (FX) transaction is a transaction by a bank to buy or sell a quantity of one
currency in exchange for another for ‘immediate’ settlement, at a spot rate of exchange.

 An exchange rate is quoted as a quantity of units of one currency (the variable currency) in exchange for
one unit of the other currency (the base currency).

 Banks quote a bid rate and an offer rate (or ask rate) for FX transactions.

 A cross rate is a rate of exchange for a pair of currencies that is derived from the exchange rate for each
currency against a third currency, typically the US dollar.

 Banks display spot rates in their branches.

 For larger foreign exchange transactions, a bank will quote a specific exchange rate to the customer for
the transaction.

 Currency risk is the risk that arises from exchange rate volatility and movements in exchange rates.

 Exposures to currency risk for exporters and importers can be contained (‘hedged’) by means of forward
FX contracts.

 A forward FX contract is a contract made now for the purchase/sale of one currency in exchange for
another, for settlement at a future date and at a rate of exchange that is fixed now in the forward
contract.

 Banks apply bid and offer rates for forward transactions..

 A forward contract may be settled either at a specific future date (a fixed forward contract) or at any
time between an earliest and latest date in the future (an option forward contract).

 If a customer no longer needs a forward contract, a bank will close out the contract. Close-out involves a
net payment between the bank and the customer.

 If a customer wants to delay the settlement date for a forward contract, the bank will agree to extend
the forward contract, by closing out the existing forward contract and creating a new contract at a
different forward rate.

 Forward FX contracts are one method of hedging exposures to currency risk. Other methods may be
used. These include currency options, range forward options and participating forward contracts.

 To decide whether to hedge an exposure to currency risk, an exporter or importer should consider
whether it has significant exposures to currency risk.

 Exchange controls are applied in Malaysia in order to protect the Malaysian economy from the risk of
damage due to currency transactions and currency movements.

 The Exchange Control Act 1953 gives the Controller of Foreign Currency (= the Governor of BNM)
responsibility for the administration of the Act. The Act is applied by means of Exchange Control of
Malaysia Notices (ECMs).

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 Exchange controls differ for residents and non-residents.

 ECMs cover aspects of foreign currency transactions such as dealings in foreign currency, external
accounts and foreign currency accounts, general payments, exports of goods and investment abroad.

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TRADE FINANCE

Contents
1 Trade finance: import financing and export financing .................................................. 165
2 Finance from conventional sources............................................................................ 166
3 Negotiation and discounting of bills ........................................................................... 167
4 Structured trade finance .......................................................................................... 168
5 Import financing: trust receipts ................................................................................ 171
6 Banker’s acceptances (BAs) ...................................................................................... 174
7 Liquidation of a BA.................................................................................................. 178
8 BNM Guidelines on Bankers Acceptances .................................................................... 178
9 Vendor financing (invoice financing).......................................................................... 181
10 Export factoring ...................................................................................................... 181
11 Invoice discounting ................................................................................................. 183
12 Forfaiting ............................................................................................................... 184

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13 The nature of STCF ................................................................................................. 185

14 Tolling finance ........................................................................................................ 187
15 Structured commodity financing models..................................................................... 188
Chapter roundup.......................................................................................................... 192

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Learning outcomes
On completion of this chapter you should be able to:
 Examine of the uses and limitations of the various forms of trade finance.
 Analyse the characteristics, discounting, risks and regulations applicable to bills of exchange and
banker’s acceptances.

Learning objectives
While working through this chapter you will learn how to:
 Analyse the stages of the working capital cycle.
 Explain the negotiation and discounting of bills.
 Distinguish between structured trade finance and conventional banking finance.
 Appraise the nature of structured trade finance and structured trade commodities finance.
 Describe methods of import financing, including trust receipts and banker’s acceptances
(BAs).
 Analyse the advantages and risks of trust receipt financing for a bank.
 Describe methods of export financing, including banker’s acceptances, export factoring,
invoice discounting and forfaiting.
 Calculate amount receivable from a discounted BA.
 Calculate the amount payable for early redemption of a BA.
 Examine methods of structured trade commodities financing, including escrow accounts, off-
balance sheet financing, asset-backed financing and tolling finance.
 Analyse the nature of structured trade commodity financing models, including export
receivables-backed finance, pre-payment financing and warehouse receipt financing.

Introduction
The term ‘trade finance’ is used to describe the provision of finance to support international trade. All
business activities must be financed, by owners’ capital, long-term debt, or credit facilities. With
international trade there is a longer trade cycle, meaning the need for finance is often greater.
For an exporter, the trade cycle begins with the production of goods and the expenses incurred in this
process. The goods are then shipped to the buyer, which can be a very lengthy process. On receiving the
goods, the buyer may be given a period of credit and may not pay for some time after delivery. The
exporter’s trade cycle therefore refers to the start of production through to receiving payment. Trade
finance may be needed from a bank to cover the exporter’s costs, with the bank being paid eventually
from the proceeds of the sale.
For a buyer, the trade cycle begins on receipt of the goods from the exporter (or, when payment is
made to the exporter in advance of shipment). The buyer may intend to recoup the cost of the imported
goods from the profit made from re-selling them, (or from the sale of goods that are manufactured using
the imported goods). The buyer may require finance from the due date of the payment made to the
exporter, to the eventual re-sale or use of the goods.

1 Trade finance: import financing and export financing

Trade finance is provided to assist a business organisation with the financing of its trading activities. In
international trade, this is often called import and export financing.

Import financing (which may also be called ‘buyer financing’) is finance provided to an importer.

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 Buyers are often able to obtain credit from the supplier (exporter) in that, the supplier allows the
buyer a period of time (credit) before having to pay for the goods.

 A supplier may ask for payment at sight, and the buyer may need more time to pay than the
supplier is prepared to allow. In these situations, the buyer may have to obtain finance from its
bank in order to pay for the imported goods.

Export financing is financing to help an exporter to prepare goods for export, ship them to the foreign
buyer and allow a period of credit to the buyer, before receipt of payment. Export finance can be divided
into pre-shipment and post-shipment finance.

1.1 The working capital cycle or cash cycle

The working capital cycle, also known as the cash cycle or trade cycle, refers to the way in which a
business has to invest in current assets, and pay for materials, labour and other expenses, before it is
able to sell goods and then obtain payment from the customer. Simple trading cycles for a trading or
commodity company and for a manufacturing company are as follows.

Figure 7.1: The working capital cycle

Trading Manufacturing
company/commodity company
company

Start Purchase goods/produce Purchase raw

of commodities materials/components
cycle

Production cycle Possible need for

pre-shipment
(Work in progress)
finance to cover
costs in this period

Hold in inventory Hold finished goods in

inventory

Sell goods or Sell goods/ship to buyer

commodities/ship to buyer
Possible need for
post-shipment
finance between
shipment and receipt
of payment
End of Receive payment Receive payment
cycle
Pre-shipment finance and post-shipment finance helps an exporter to fund the current assets
for its export trade – raw material inventory, work-in-progress, finished goods inventory and trade
receivables, as well as paying for some operating costs (such as warehousing costs and shipping costs).

The cash cycle for an importer starts with the payment for imported goods and ends with receiving
payment from the re-sale of the goods or from selling the finished products that the imported goods are
used to produce.

2 Finance from conventional sources

Exporters and importers may be able to arrange conventional financing from their bank in support of
their trading activities. This may take the form of an overdraft facility or an unsecured or a secured loan.

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When a bank is considering the provision of credit facilities to a customer, it carries out a credit
assessment and evaluation. This text does not cover credit analysis and lending decisions, but
conventional bank lending may take the following forms:

Key term
An overdraft is an extension of credit from a lending institution when an account reaches zero. It allows
the individual to continue withdrawing money even if the account has no funds in it. Basically the bank
allows people to borrow a set amount of money.

 An overdraft facility. This may be provided to a customer whose cash position varies so that
their current account moves continually between a debit and a credit balance. The customer is
allowed to incur an overdraft (debit balance) on the account up to an agreed limit, with
repayment coming from the cash flows from the customer’s regular business operations.

 Asset conversion financing. A customer may produce an item for which supply or demand is
seasonal. A commodity producer, for example, may supply the commodity during a limited time
period (e.g. a harvest period) each year, but demand for the item may be fairly constant
throughout the year, meaning that most sales occur within a limited time period. Each year, the
producer expects to make and sell the produce at a profit, but for a large part of the year, he may
incur costs of production or warehousing without receiving any revenues from sales. This annual
trade cycle means that the producer may need financial support during the period when he is
incurring costs but earning little or no revenue. Banks may be willing to provide short-term loans
to finance the producer’s business, expecting repayment from the money that is earned when the
goods are eventually sold.

 Cash flow financing. A business buys capital equipment, with the expectation that the
equipment will help the business to operate and make profits over a period of several years. A
business may borrow from a bank to finance purchases of capital assets, expecting to repay the
loan from future profits/cash flows of the business. Banks will often provide secured loans to
finance ‘fixed’ asset purchases.

 A bank may also provide short-term finance for working capital, even when the borrower’s
business is not cyclical.

This type of lending by a bank is based on a credit evaluation of the customer’s request for a loan or
overdraft, and the bank’s assessment of the customer’s business and cash flows.

There are other (less ‘conventional’) ways in which a bank may be willing to provide finance to an
exporter or importer.

3 Negotiation and discounting of bills

Financial documents such as cheques, promissory notes, and bills of exchange may be negotiable.
Negotiation is the transfer of the right to payment. For example, when a bill of exchange is negotiated,
the drawer of the bill transfers the ‘right to payment’ to another person.

 A bank may negotiate a bill of exchange by purchasing the right to payment from the current
payee/beneficiary.

 When a usance/time bill of exchange is negotiated, the negotiating bank will pay a price that is at
a discount to the face value of the bill (the amount payable at maturity).

The terms ‘purchase’, ‘negotiate’ and ‘discount’ are all used to describe this type of transaction.

The effect of negotiation is to provide immediate (lower) payment for the original payee/beneficiary. For
example, if an exporter negotiates a bill of exchange with a bank and receives a discounted value of the
bill, it receives immediate payment instead of having to wait until maturity of the bill for payment. (The
cost is the amount of the discount, plus the bank’s negotiation fee.)

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Negotiation of bills is therefore a method of providing finance to exporters. Negotiation of bills may be
negotiation of a:

 Trade bill (bill drawn on the buyer).

 Bank bill (bill drawn on a bank).

A letter of credit may provide for negotiation of a bank bill. Financing importers or exporters by means of
Banker’s acceptances is explained later.

3.1 Purchase and collections

Key term
Usance is the allowable period of time, permitted by custom, between the date of a bill and its payment.
The usance of a bill varies between countries, often ranging from two weeks to two months. Usance is
derived from the action of usury.

When an exporter sells on sight terms, there may be a delay of several days before payment is received
from the buyer. When an export sale is on a ‘usance basis’ and the buyer is given credit, the waiting
period before payment is much longer.

A bank may be willing to finance these export transactions by purchasing the shipping documents and
the bill of exchange payable by the buyer.

The exporter receives immediate payment and the bank’s loan to the exporter is liquidated by the
eventual payment from the buyer.

This method of financing may be in domestic or foreign currency. The financing may also be for just a
percentage of the value of the export documents, for example 90% of their value. When this type of
financing is liquidated with payment from the buyer, the surplus proceeds are paid to the exporter.

4 Structured trade finance

In some situations, a bank may be unwilling to provide a normal overdraft facility or term loan to an
importer or exporter, but it may be willing to provide finance for specific trading transactions.

Structured trade finance (STF) is a term that is used for arrangements to finance trading activities,
especially in emerging markets, where the intention is that the lending will be repaid from the cash flows
from the trading transaction for which the finance has been provided. For example, in a structured
agreement to provide finance to an exporter to enable the exporter to make an export sale, the intention
should be that the exporter will repay the borrowed funds from the cash it receives when the buyer pays
for the goods.

STF is normally associated with financing international trade transactions.

STF may be provided to exporters to cover an entire export trade transaction, or it may be provided
at different stages of the export transaction.

 Pre-shipment finance may be provided to help the exporter produce the goods for export. This
may include finance to cover costs up to the time of shipment of the goods from the exporter’s
country.

 Warehousing finance may be provided under a separate agreement, to cover the costs of
holding the goods in store after they have been produced, but before they are shipped to the
buyer’s country.

 Post-shipment finance, also called accounts receivable financing, provides an exporter with
finance to cover the credit period between the time the goods are shipped to the buyer’s country
and the time that the buyer pays for them.

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4.1 Structured trade finance and conventional bank financing

STF differs from conventional bank finance because the financing is structured in a way that repayment
will come from the specific transaction that is financed. With conventional bank finance, a bank gives
credit facilities, such as a bank loan, that the customer can use to finance its international trade
operations, but:

 The finance is not provided for specific transactions.

 Repayment is expected from the cash flows of the customer’s general business, and not
necessarily from the cash from specific transactions.

A company conducting export business together with a strong all-round business does not need to obtain
STF, because it can apply for conventional financing, such as a bank overdraft or a revolving loan facility.

On the other hand, some exporters (or importers) may be unable to borrow through conventional
means, possibly because they do not have a sufficiently good credit grading, or because they are unable
to provide any collateral or security other than what is in the foreign trade transaction itself.

STF may therefore be seen as a way of providing finance for exporters and importers to enable them to
engage in international trade contracts and develop their business, relying on future cash flows arising
from the transaction itself, when financing through other methods may be difficult or impractical.

4.2 Structured trade and commodity finance (STCF)

Structured trade and commodity finance (STCF) is structured trade financing where the underlying
trade involves commodities such as agricultural products and metals.

Commodity trading has several characteristics that need to be understood.

 Commodities are sold in global markets. The eventual buyers of commodities often pay for their
purchases in hard currency, such as US dollars and yen. Payments may be made into an escrow
account.

 Many traders in commodities have large short-term financing requirements, compared to the size
of their own capital, because of the large quantities of commodities that they trade.

 Commodity traders are often high credit risks. This is partly because they may not be large
businesses, and there is also risk in the volatility of commodity prices. For example, a trader may
buy a quantity of a commodity, and the market price may fall before the trader is able to re-sell
the goods.

In Malaysia, a considerable amount of export finance is provided for commodity producers in the form of
an STCF arrangement.

STCF is covered in more detail in sections 13, 14 and 15 of this chapter.

4.3 Examples of STF and STCF

A structured trade finance arrangement is arranged by a bank to meet the particular requirements of the
bank’s customer. Each arrangement is structured individually. There is no universally accepted definition
of STF, and opinions may differ about what is a structured finance agreement. However, the following
types of arrangement are generally classified as STF.

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Table 7.1: Import and export finance examples

Import finance Export finance

 Trust receipts  Banker’s acceptances (BAs)

 Banker’s acceptances (BAs)  Documentary credit arrangements, including

 Counter trade transferable credits and back-to-back credits,

red clause credits and green clause credits

 Vendor financing

 Export factoring

 Invoice discounting

 Forfaiting

 Tolling finance

 Warehouse receipt finance

 Counter trade

Importers are often granted credit by an exporter because the exporter has obtained post-shipment
finance for their transaction. Importers therefore benefit indirectly from export trade finance.

The methods of financing available depend partly on the method of payment for a transaction.

In Malaysia, structured export finance may be available through the Export-Import Bank of Malaysia
(Exim Bank) or through a bilateral payment arrangement by Bank Negara Malaysia (BNM). These are
explained in the next chapter. Exim Bank is one of Malaysia's Development Finance Institutions.

 Bills of exchange (BAs and bill discounting or negotiation) may be used for any method of
payment, including trade on open account terms. However bank bills (and bill finance) are used
with letters of credit and collections.

 Trust receipts as a method of import finance are more likely to be used with letters of credit.

 Export factoring may be used when trade is on open account, as a method of financing
receivables.

4.4 Non-cash trade finance facilities

Trade finance is generally associated with the provision of import or export finance. However some
structured facilities are provided to assist with specific transactions for importers or exporters without
providing any cash.

Examples of non-cash facilities are bank guarantees and standby credits, and commercial letters of credit
where the only use of the L/C is to provide the exporter/beneficiary with the bank’s guarantee of
payment.

The methods of trade finance described in this chapter are mainly short-term financing arrangements.
For some international trade transactions, such as the purchase of capital equipment, medium-term or
long-term finance (and different financing arrangements) are needed.

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5 Import financing: trust receipts

Key term
A trust receipt is notice of the release of merchandise to a buyer from a bank, with the bank retaining
the ownership title to the released assets. In an arrangement involving a trust receipt, the bank remains
the owner of the merchandise, but the buyer is allowed to hold the merchandise in trust for the bank, for
manufacturing or sales purposes.

A trust receipt (TR) is a ‘traditional’ method of import financing. It is no longer used as frequently,
because BAs are now more common, especially for larger importing companies. Even so, TRs remain a
common method of import financing for:

 Businesses that import only in small amounts, and/or

 Where the import value is less than the minimum amount required for BA financing.

A TR may be needed by an importer for ‘sight imports’, when payment to the supplier is required
against sight of appropriate documents, such as with a letter of credit arrangement, but does not yet
have the money to make the payment. (TRs are most commonly used with letters of credit, but may also
be used when the method of payment is a collection or on open account terms.)

The importer may intend to pay for the goods out of the sales proceeds from the re-sale of them.

With a trust receipt arrangement, the importer asks its bank to release the documents of title so that it
can take possession of the goods and re-sell or use them. To obtain the goods, the importer executes a
trust receipt. This is a written undertaking by the importer to hold the goods in trust for the bank, sell
them, and then pay the bank out of the proceeds of the sale.

If the importer is required to pay for the goods at sight, the bank will make the payment, and the
importer owes this money to the bank.

A trust receipt therefore includes the following terms and conditions:

 The importer acknowledges receipt from the bank of the documents of title to the goods.

 It undertakes to hold and then sell the goods as trustees for the bank.

 It also undertakes as trustees for the bank to receive payment from the sale of the goods and
then pay the money to the bank.

 The importer acknowledges that the bank is the legal owner of the goods and it will act as agent
for the bank in these transactions.

 The importer undertakes to insure the goods until they are sold and promises not to negotiate
further credit against the security (collateral) of the goods.

 The agreement also specifies the period of time within which the importer will pay the bank.

An example of a trust receipt is shown in the following page.

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Figure 7.2: Trust receipt

To: HSBC bank

Date:
TRUST RECEIPT

Dear Sirs,

In consideration of you having this day handed over to us shipping documents representing goods as follows:

B/L No Marks & Numbers No. of Package Description Vessel

We hereby undertake and agree as follows:

1. To land store hold and deliver to purchasers the said goods and receive their proceeds as Trustee(s) for
you and as Agent(s) on your behalf and not otherwise and in the event of the said goods or any portion
thereof sold and cleared before full and complete payment of the said draft(s). We pledge ourselves that
the proceeds of such sales shall be received and retained by us as Trustee(s) for you and that they shall
be kept separate and apart from our other monies, and to pay to you the proceeds of such sales as soon
as the goods are realised as and when received by us, in order that the same may be applied in or
towards payment of the drafts. We at the same time furnishing to you all necessary particulars to enable
you to apply the same to the relative draft in each case.
2. That you remain the Owners of the goods and that we are to be and we hereby undertake to act as your
Agent(s) for the sale of the said goods and to receive and account to you for the proceeds thereof and
that they shall be open to inspection at all times by you or your duly accredited representative and you
are at liberty at our expense if you think fit to do so to take possession of them without any reference to
or consent from us and to remove some or any part of them from the place where they have been stored
to any other place you may choose and place under the care of anyone you select and to dispose of them
by sale or otherwise if so required.
3. To keep the goods referred to fully insured against all risks and to hand over to you the amount of any
claims on the underwriters; the Insurance Policies being held by us as Trustee(s) for and on behalf of the
Bank.
4. Not to charge the goods or the proceeds of sale thereof with the payment of any monies to any person or
to use the same as security for the performance of any obligation whatsoever.
5. That you shall be entitled and are hereby authorised by us to debit our account(s) with you for the
amount of the Trust Receipt, the particulars of which as stated below together with interest thereon and
other relevant Bank charges on maturity.
6. Not to sell the goods or any part thereof on credit unless with your prior consent in writing.
7. That no failure of the Bank to take advantage of any current failure or omission on our part to carry out
fully any of the provisions of this or any similar receipts or agreement, or of the agreement under which
the Bank issued the Documentary Credit under which the said goods were purchased, shall be deemed to
be waiver by the Bank of its rights or remedies under either or any of the said papers, unless the said
waiver shall be in writing endorsed hereon and signed by the Bank or its authorised agent.

Yours faithfully,

……………………………………………….
Authorised Signatory(ies)
DETAILS
TR NO: F.CCY: TENOR:
LC NO: RATE: DUE DATE:
BR NO: MYR:

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C A S E S T U D Y

An importer has agreed to a documentary credit arrangement for the purchase of imported goods, where
the importer’s bank will be required to pay a bill of exchange (a bank bill) at sight.

The importer also makes a trust receipt arrangement with the bank, whereby it takes possession of the
goods, sells them and pays the proceeds from the sale to the bank, as settlement for the bank’s payment
of the sight bill.

A bank will not usually agree to release goods under a TR arrangement where the import is ‘under
usance’ – in other words, when the importer is given a period of credit to make the payment. However,
where the importer needs a period of financing that is longer than the period of credit from the exporter,
the bank may agree to provide TR financing for the difference between the credit period from the
exporter and the credit period required by the importer.

C A S E S T U D Y

A bank agrees a credit line with an importer whereby the bank will provide finance against a trust receipt
for up to a maximum of 120 days.

The importer buys goods from a supplier where a letter of credit is used, and the bank is required to
accept a letter of credit for payment at 60 days after sight.

The bank accepts the bill of exchange on 15 September and the bill has a maturity date of 14 November.
On 14 November, the bank honours its bill and makes the payment.

If the importer is unable to raise the money to repay the bank on 14 November, it may ask the bank to
provide TR financing for up to 60 more days (120 days approved by the bank for the credit facility, minus
the 60 days credit provided by the bill of exchange).

5.1 Advantages and risks of TR financing for a bank

A trust receipt has several advantages for a bank as a method of import financing:

 A trust receipt is a simple legal document that does not require the use of solicitors and (when
the borrower is a company) does not require registration under the Companies Act.

 The legal ownership of the goods remains with the bank.

 If the borrower becomes insolvent and goes into liquidation, the liquidators would not have a
claim over the goods (because they are owned by the bank).

There are some risks for the bank with a trust receipt:

 The bank gives control over the goods to the borrower/importer, and is unable to monitor the
actual movement of the goods.

 If the bank needed to take possession of the goods, there might be no way of identifying them,
especially if the borrower has mixed these with other goods for which it is the legal owner.

The bank therefore relies on the honesty and ability of the borrower. Since the amount of financing may
be quite small, the risk for the bank should not be high (because the potential bad debt is relatively
small).

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5.2 Settlement of a trust receipt

Finance provided in a trust receipt arrangement is direct lending from the bank to the borrower/importer.

Interest is charged on a per day basis for the term of the arrangement, and this is payable at maturity. A
borrower may repay the money before maturity if it has the funds, in order to save interest charges or to
reduce the total borrowing under its TR limit in order to make room for new TR borrowing.

C A S E S T U D Y

TR details
Amount US$ 500,000
Tenor (maturity) 90 days
Date of TR 6 April
Maturity date of TR 5 June
Interest rate BLR + 2%
BLR = 5% for the full duration of the borrowing

If settlement takes place at maturity on 5 June, the amount of the settlement will be as follows:

US$
TR amount 500,000.00
Interest for 90 days (500,000 × 7% × 90/365) 8,630.14
Total settlement amount 508,630.14

If a borrower fails to make settlement in full by the maturity date, the loan becomes ‘overdue’ and
subsequently it is classified as a ‘non-performing loan’ or NPL if still not paid. When a TR loan is overdue
or a NPL, the bank may not extend new TR lending to the customer until the overdue position has been
settled.

6 Banker’s acceptances (BAs)

Banker’s acceptances are a method of:

 Import finance (BA purchase)

 Export finance (BA sale)
They are similar, and so are described together below.

Key term
A Banker’s acceptance (BA) is a short term debt instrument issued by a company that is guaranteed
by a commercial bank. BA’s are issued by companies as part of a commercial transaction, regularly used
in international trade. They are similar to T-bills (short term debt instruments backed by the US
government) and are frequently used in money market funds. They are traded at a discount from face
value which means that they do not need to be held until maturity.

They can vary in amount depending on the size of the transaction, with maturity dates generally
between 30 and 180 days from the date of issue. These are considered to be ‘safe’ investments as the
bank and borrower are liable for the amount due at maturity.

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6.1 The features of a banker’s acceptance

A conventional banker’s acceptance is a bill of exchange drawn on a bank and accepted by the bank. The
bill must be payable at a future date and may therefore be called a ‘usance bill’, which means a bill that
allows a period of time for payment, in accordance with custom and usage.

 A BA is drawn by the bank’s customer (an exporter or an importer) on its bank, to the customer’s
order. The bill is payable on a specified future date.
 The bill is accepted by the bank, which means that the bank undertakes to pay the bill on the due
date.
 The accepted bill is then ‘discounted’. This means that it is sold at a discount to face value. The
buyer may be the accepting bank itself, or another financial institution. The money from the sale
of the bill is paid to the exporter or customer of the bank.
 At maturity the exporter or importer must make a payment to the bank to enable the bank to pay
the maturing bill. The bank pays the bill.
A BA can be drawn on a bank only when it is based on an underlying commercial trading transaction,
and the drawer of the bill must provide documents to the bank as evidence of this transaction.

An importer or exporter arranges a BA line of credit or BA limit with its bank. This is a credit limit for
the amount of financing the bank will provide by accepting bills drawn on it.

In Malaysia, BNM has issued Guidelines on Bankers Acceptances. These will be described later.

6.2 Using a BA to finance sight imports

When a BA is used for financing of sight imports, a bill of exchange is drawn by the importer on its bank.
The importer’s bank (the accepting bank) will discount the accepted bill on behalf of the importer, so that
the exporter can be paid.

After the importer has agreed a BA line of credit with its bank, the procedures are as follows:

1 The exporter ships the goods to the buyer.

2 The exporter presents shipping documents to its bank, with instructions to deliver these
documents to the importer’s bank against payment for the goods. (The arrangement could be a
documentary collection on D/P terms, or a letter of credit where payment is required on sight of
the specified documents.)

3 The exporter’s bank forwards the documents to the importer’s bank, with instructions to deliver
the documents on D/P terms.

4 The importer’s bank notifies the importer that the documents have been received with a
requirement for payment.

5 The importer draws a BA on the bank for acceptance and discount.

6 The importer’s bank accepts the bill and discounts it. The proceeds from the discounting of the bill
are used to pay the importer’s bank. The payment will exceed the proceeds from discounting the
BA, so there must be a top-up payment, from the importer’s own funds or as additional credit
from the bank.

7 The importer’s bank releases the documents to the importer and the importer takes possession of
the goods.

8 The exporter’s bank receives the payment from the importer’s bank, and pays the money to the
exporter.

9 At maturity date for the BA, the importer must have sufficient funds to pay its bank, to enable the
bank to liquidate the BA.

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The first eight stages in this procedure are illustrated in the following diagram.

Figure 7.3: Banker’s acceptance for imports process

Importer 1. Shipment of goods Exporter

5. Draws 2.
BA on Presents
bank shipping
documents

7. Release
shipping
documents

4. Notify 8. Payment
receipt of
documents

3. Forwards
Importer’s bank documents for
delivery on D/P terms Exporter’s bank

6. Accepts and
discounts bill. Makes
payment.

E X A M P L E

A BA is drawn for US$ 200,000 by an importer on its bank, with instructions to discount the bill and use
the proceeds (plus a top-up amount from the importer’s own funds) to pay for imported goods. The
tenor of the bill is 90 days.

The bank charges the importer a commission for accepting the bill. Acceptance commission is calculated
at a rate of 2.5% for the 90 days.

The bank discounts the bill and the discount rate is 3.6%.

 On discounting the bill, the amount of the discount is US$ 1775.34 (= US$200,000 × 3.6% ×
90/365).

 The proceeds from discounting the bill are therefore US$ 198,224.66 (= US$200,000 –
US$1775.34).

 The acceptance commission is US$1232.88 (= US$200,000 × 2.5% × 90/365). The bank takes
this commission from the proceeds from the discounted bill.

The money available to pay the exporter is US$(198,224 – 1232.88) = US$196,991.12. The actual
payment to the exporter will be more than this amount, so the payment must be topped up, either from
the importer’s own funds or by means of additional credit from the bank.

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6.3 Using a BA to finance exports (BA sale)

When a BA is used for financing of exports, a bill of exchange is drawn by the exporter on its bank. The
exporter’s bank (the accepting bank) will discount the accepted bill on behalf of the exporter, so that the
exporter receives finance in advance of actual payment by the importer.

After the exporter has agreed a BA line of credit with its bank, the procedures are as follows:

1 The exporter ships the goods to the buyer.

2 The exporter presents shipping documents to its bank, with instructions to deliver these
documents on D/A terms.

3 The exporter’s bank forwards the documents to the importer’s bank, with instructions to deliver
on D/A terms.

4 The importer may be required to accept a term bill of exchange (a trade bill). Its bank will present
the bill for acceptance.

5 The importer accepts the bill and the bank releases the shipping documents to the importer. The
importer takes possession of the goods.

6 The importer’s bank notifies the exporter’s bank of the maturity date for the importer’s bill. (This
is necessary when the bill is payable a fixed number of days after sight.)

7 The exporter draws a BA on its bank, with instructions to discount the bill after acceptance.

8 The exporter’s bank accepts and discounts the bill, and pays the proceeds to the exporter.

9 At maturity, the importer pays its bank, which remits the payment to the exporter’s bank. The
money is used to liquidate the bank’s BA. If payment is not received from the importer by the
maturity date, the exporter’s bank will require the exporter to liquidate the BA with its own funds.

The first eight stages in this procedure are illustrated in the following diagram.

Figure 7.4: Banker’s acceptance for exports process

Exporter 1. Shipment of Importer

goods

7. Draws BA 4. Presents bill

on bank for acceptance
8. Bank
accepts bill 2. Present
and pays documents
proceeds to
exporter
5. Importer
6b. Notify accepts bill.
maturity date Bank delivers
documents

Exporter’s bank 3. Forwards Importer’s bank

documents for
delivery on D/A
terms

6a. Advises
maturity date

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7 Liquidation of a BA
The liquidation of a BA is the payment or settlement of a BA at maturity.

The maturity date for a BA cannot be extended and the BA must be liquidated at this maturity date.

At maturity, the holder of the bill (which is transferable) presents it to a paying bank for payment.

A discounted BA may be purchased by the accepting bank itself. When this occurs, the bill is liquidated at
maturity by the payment from the importer (when the importer’s bank is the accepting bank) or the
importer’s bank (when the exporter’s bank is the accepting bank).

8 BNM Guidelines on Bankers Acceptances

Note: due to the nature of this section, we have not individually identified Malaysia specific content as
this applies throughout.

Bank Negara Malaysia issued Guidelines on Bankers Acceptances in 2004. These guidelines were
subsequently updated in 2007.

 The purpose of the Guidelines is to provide a uniform set of procedures and practices for the
creation and trading of BAs in Malaysia. The Guidelines therefore define a BA as ‘a bill of
exchange drawn on and accepted by a bank in Malaysia in accordance with these Guidelines.’

 The Guidelines apply to BAs denominated in ringgit and drawn on and accepted by a bank in
Malaysia. They apply to BAs for purchases and BAs for sales, and to the use of BAs for trading
between Malaysian residents as well as for international trade.

Some of the Guidelines are described below.

8.1 Procedures for the creation of a BA

The general procedure for creating a BA is as follows:

 An acceptance credit facility (BA line of credit) is arranged with a bank.

 The required documentary evidence of a commercial trading transaction is presented to the bank,
for the purpose of drawing a BA on the bank.

 The bank checks that the documents are in order and that the BA complies with the terms of the
BA acceptance credit facility. It accepts the bill.

8.2 Conditions for creating a BA

Within an acceptance credit facility, a BA may only be drawn on and accepted by a bank to finance:

 The drawer’s business-related purchase of goods, or

 A sale of goods by the drawer.

This transaction in goods must be evidenced by ‘proper and adequate documentation’. Except where
special approval has been given by BNM, the sale or purchase of services is not eligible for BA
financing.

The maturity of a BA cannot be extended beyond its original maturity date, and a new BA cannot be
created to repay the finance provided by an existing (and maturing BA) using the same documentary
evidence of the transaction.

8.3 Amount eligible for BA financing

The Guidelines specify the amount that is eligible for BA financing.

 For BA financing to be available, the invoice must be for at least RM50,000

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 The bill of exchange must be for a multiple of RM1,000

 The face value of the bill (the amount payable at maturity) must not exceed the financial
value of the trade transaction whose details are provided in the supporting documentary
evidence of the trading transaction.

The financial value of the trade transaction is:

 For purchases/imports, the amount of money payable by the drawer of the BA to the supplier
of the goods for settlement of the trading transaction, plus the cost of separate payments that are
needed to enable the drawer to accept delivery of the goods (such as import duties payable to
the government, transportation charges payable to carriers and insurance premiums payable to
insurance companies).

 For sales/exports, the amount receivable by the drawer of the BA from the buyer for
settlement of the trade.

Two or more BAs (with the same or different maturity dates) may be drawn to finance one trading
transaction, but the aggregate face value of all the bills must not exceed the financial value of the trade
transaction. The ‘multiple BAs’ must be accepted on the same day, even if they mature on different
dates, and they need not be discounted on the same day.

8.4 Acceptance commission

An accepting bank may charge an acceptance commission to the drawer of a BA. The rate of commission
must be decided by the bank on the basis of an agreed proportion of the value of the BA, expressed in
per cent per annum. For example, acceptance commission may be fixed at 2.5% per annum on the face
value of the BA, but the commission is then calculated on a daily basis (the term or tenor of the bill from
acceptance to maturity).

8.5 Specifications for a BA

BNM’s Guidelines also specify the size and format for a BA, which must be payable in ringgit to the order
of the drawer:

 On a specified future date, which cannot be earlier than 21 days from the date of acceptance of
the BA;

 In an amount of not less than RM50,000 and in multiples of RM1,000, and

 At the Head Office, Main Office or Central Office of a commercial bank in Kuala Lumpur.

The BA must also state that the bill is drawn to finance the purchase from of sale of goods to:

 A resident, or
 A non-resident.

An example of a banker’s acceptance is shown here.

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Figure 7.5: Banker’s acceptance form

UNITED ASIAN BANK BANKERS ACCEPTANCE

UNITED ASIAN BANK BERHAD (2XXXX9-T)
Due Date

UNITED ASIAN BANK BERHAD

UNITED ASIAN BANK BERHAD

cawangan Pusat, Kuala Lumpur
At ............ days after sight ????? days of grace pay to the order of ourselves the sum of RINGGIT
for and on behalf of MALAYSIA

RM

???????????
Goods described in the records of the accepting bank.
Accepted on

Payable at

For and on behalf of

Dated

PLEASE DO NOT SIGN BELOW THIS LINE

8.6 Discounting a BA
Guidelines state that the drawer of a BA may discount the BA (sell the BA at a discount to its face value)
with any person, including the accepting bank. However, where the BA is drawn to finance purchases
and payment has not yet been made, the first person to discount the BA must be the accepting bank.

The bearer of a BA may re-discount the BA with any other person.

The proceeds from the discounting or re-discounting of a BA are determined by the following formula:

 rt 
P = FV 1 – 
 36,500 

Where:
P = Proceeds from discounting the BA
FV = Face value of the BA
r = Rate of discount (in per cent per annum)
t = Number of days remaining to maturity

C A S E S T U D Y

An exporter draws a BA on its bank under an agreed BA line of credit for US$1,000,000. The maturity
date for the bill is in 90 days’ time. The rate of discount is 5.75%

The proceeds from discounting the bill will be:

 5.75 × 9 
P = US$1,000,000 1 – 
 36,500 

= US$1,000,000 (1 – 0.0141781)

= US$1,000,000 × 0.9858219

= US$985,821.92

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8.7 Redemption before maturity date

A BA may be liquidated before its maturity date, but only if the accepting bank is the bearer of the
BA. The BA is liquidated by a payment to the bank by the drawer of the bill. The payment for early
redemption of the bill is calculated as follows:

 rt 
RA = FV 1 – 
 36,500 

Where:
RA = Redemption amount
FV = Face value
r = Mutually agreed redemption rate (in per cent per annum)
t = Number of days remaining to maturity

Once redeemed, the BA is liquidated, and the obligations of the accepting bank and the drawer are
discharged.

9 Vendor financing (invoice financing)

Vendor financing is an arrangement where an importer’s bank finances the exporter (the ‘vendor’ or
seller) where the importer makes a purchase on a credit basis with a series of payments that are payable
on a succession of due dates.

Based on a credit assessment of the importer, the bank may finance the invoices.

 The bank makes an immediate and full payment to the supplier for all the invoices.

 The supplier therefore receives ‘sight’ payment but bears the cost, fees and charges of the bank.

 The invoices are assigned to the bank, and payments by the importer become payable to the
bank. In effect, credit from the supplier to the importer is replaced by credit from the importer’s
bank.

 A benefit for the importer is that the supplier has been paid, and the importer may therefore be
able to get more credit from the supplier for further purchases.

10 Export factoring
Export factoring is a method for an exporter to obtain short-term finance on the basis of export
receivables (invoices to customers in other countries). Essentially, it is the sale of receivables by an
exporter, at a discount to face value.

A finance company purchases the exporter’s receivables. Typically, payment is in two stages.

 There is an initial payment by the factor to the exporter, when the exporter submits a copy of the
invoice to the buyer. This may be for up to 90% of the value of the invoice. The amount of this
payment is less than the face value of the invoice by an agreed rate of discount and a reserve or
provision to cover the factor’s charges and risks, such as the risk of late payment by the buyer.

 The balance is paid, less the factor’s charges and costs, when the invoice is eventually paid by the
importer. This payment is the amount of the reserve or provision, less the factor’s charges.

Factoring arrangements do not cover individual invoices. An exporter will enter into an arrangement for
factoring all of its export invoices on a continuing basis.

Factoring may be with recourse or without recourse.

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 Factoring with recourse means that the credit risk remains with the exporter. If the buyer
does not pay the invoice, the factor reclaims the initial payment that it made to the exporter. The
exporter suffers the bad debt loss.

 Factoring without recourse, for which the factor’s fees are higher, means that the factor takes
on the credit risk. If the buyer fails to pay the invoice, the factor suffers the loss and does not
claim back any money from the exporter. With this arrangement, the factor has the right to take
legal action itself against the buyer for non-payment.

With a factoring arrangement, the buyer/importer pays the invoice to a factor in its own country. The
invoice is not paid to the exporter. When the exporter sends the invoice to the buyer, it includes a
notification that the invoice is payable to a named factor and instructions about how payment should be
made.

In some arrangements, the exporter does not send an invoice to the buyer. Instead, it sends copies of
the invoice together with the shipping documents to the factor, and the factor sends the invoice to the
buyer, with a notification that payment should be made to the factor.

Export factoring involves two factor organisations, one in the exporter’s country and one in the buyer’s
country.

 The factor in the exporter’s country agrees the terms of the factoring arrangements for an
exporter’s invoices to different countries.

 The factor in the exporter’s country may then arrange with a factor organisation in each country
for collecting payments from buyers in that country.

Where there is a network of ‘correspondent’ factoring organisations in different countries, factoring may
be called ‘two-factor export factoring’. When the same factor organisation operates in different
countries and deals directly with both the exporter and the buyers, factoring is ‘direct export
factoring’.

An export factoring arrangement is illustrated in the following diagram. In this arrangement, the exporter
sends a copy of the invoice to the buyer but, as indicated above, the factor may send the invoice and
shipping documents to the factor; a factor in the buyer’s country deals with the release of the goods to
the buyer and the delivery of the invoice.

Figure 7.6: Export factoring process

Exporter 1. Invoice Buyer

2/7. 1. Copy of 4. Advice of 5. Payment

Invoice invoice payment at maturity
payment
(two
stages)

3. Copy of invoice
Factor in exporter’s country Factor in buyer’s country
6. Payment/settlement

10.1 Factor’s charges

A factor is effectively providing the exporter with short-term finance in advance of payment of export
invoices. The factor’s charges, therefore, include an interest charge for the finance between the date of
providing the finance and the date that payment is received (through the factor in the buyer’s country)
from the buyer.

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The exporter will also be charged for the administration costs of both factor organisations, which may be
agreed either as a percentage amount of the value of the invoices handled or as a fixed fee for each
invoice handled. The administration costs cover the costs of collecting payment and also accounting
procedures and other tasks.

For ‘without recourse’ or ‘no recourse’ factoring, the factor will also make a charge for taking on the
credit risk (or the cost of credit insurance).

10.2 Making a factoring arrangement for export receivables

When an exporter applies to a factor organisation for a factoring agreement, the factor will make an
assessment of:

 The exporter, including the nature and structure of the exporter’s trade and its previous export
experience.

 The different buyers to which the exporter sells.

The assessment considers the creditworthiness of the exporter’s receivables/customers, as well as an

assessment of the exporter itself. This assessment is used by the factoring organisation to decide both
an overall credit limit for the exporter (ie the maximum amount of finance the factor will provide to the
exporter), and also individual limits for the exporter’s customers (ie the maximum value of invoices for an
individual customer for which the factor will provide finance to the exporter).

10.3 Advantages of export factoring for an exporter

Factoring may seem expensive, because of the factor’s charges. However, there may be advantages for
an exporter in a factoring arrangement.

 Factors may be more successful in collecting payments from buyers in their own country, when
payment is due. An exporter may have much greater difficulty in collecting overdue payments
from customers in another country.

 The factor takes away some of the administrative workload from the exporter.

 ‘Without recourse’ factoring takes away the credit risk from the exporter, although at a cost. Even
when factoring is ‘with recourse’, a factor’s assessment of the creditworthiness of individual
buyers may be useful information for the exporter.

 Export factoring is a method of raising short-term export finance when other methods of export
financing (for example, within a letter of credit arrangement) are not available. Factoring can be
used when the exporter’s trade is on open account.

 Export factoring is also a way of obtaining finance without the need for an overdraft facility.

11 Invoice discounting
A feature of export factoring is that the buyer makes its payment to the factor, not the exporter. The
buyer is made aware that the exporter is using a factor to collect its receivables.

Invoice discounting, also called invoice finance or invoice lending, is similar to factoring except that it
is a confidential service.

Invoice discounting is the provision of finance against the security of a quantity of receivables. As with
factoring, the finance provider pays a percentage of the invoice amount (perhaps 70 – 80%) when it
receives a copy of the invoice(s) and a final payment is made for the balance (less charges) when the
buyer eventually pays. However, there are some differences between invoice discounting and factoring.

With invoice discounting, ownership of the invoice and the right to payment remain with the exporter.

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The exporter delivers the invoice to the buyer and payment is made to the exporter (although possibly
into a separate designated bank account, which is in the name of the exporter, but held with the bank
that is providing the finance). The buyer is therefore unaware of the invoice discounting arrangement.

The tasks of sales ledger administration (accounting) and collecting payment remain with the exporter.

Invoice discounting is with recourse. If the buyer fails to pay, the invoice discounter will demand
payment of the finance provided, including interest, from the exporter.

11.1 Administration of invoice discounting

When an exporter arranges invoice discounting for its export invoices, the arrangement will usually cover
all the exporter’s invoices.

 The finance provider arranges the opening of a separate bank account in the name of the
exporter. Payments of all invoices covered by the arrangement must be made into this account.
The account (and the invoices) may be pledged as security to the finance provider.

 The exporter must send copies of invoices to the finance provider. New invoices are added
regularly to the ‘pool’ and paid invoices are deleted.

 The finance provider will provide finance to the exporter for an agreed percentage of the value of
the invoices in the pool. The amount of finance for the exporter therefore rises and falls regularly,
according to the value of its unpaid export receivables.

 The finance provider sends regular statements to the exporter, to check that its records agree
with the exporter’s export receivables ledger. The exporter is also required to send copies of its
export ledger periodically to the finance provider, so that the finance provider can check that the
exporter’s records agree with its own.

12 Forfaiting
Key term
Forfaiting is the purchasing of an exporter's receivables (the amount importers owe the exporter) at a
discount by paying cash. The forfaiter (the purchaser of the receivables) becomes the entity to whom the
importer is obliged to pay its debt.

Forfaiting is a form of medium-term export finance. It involves the discounting of a series of trade-
related bills of exchange or promissory notes by a bank. These have different maturity dates, and so
represent a series of due payments over a period of time, normally several years. The bills or notes must
be negotiable, so that they can be traded (sold on to another buyer) in the period up to their maturity.

A bank will buy these bills of exchange or promissory notes on a non-recourse (without recourse) basis,
so the exporter receives immediate payment for future receivables.

The bank needs to be satisfied about the quality of the bills or notes that it is discounting, and it may
demand:

 A bank guarantee or standby letter of credit drawn on another bank.

 In the case of a sovereign buyer (such as a government agency or authority), a guarantee from
the buyer to pay the bills at their maturity.

 Where appropriate, an undertaking by the central bank in the buyer’s country that there will be
no exchange control restrictions to prevent payment.

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A forfaiting arrangement may be agreed, for example, where an exporter sells capital equipment to a
buyer, with payment to be made in several stages over a period of several years. For each payment, the
buyer accepts a bill of exchange or provides a promissory note. The bank then buys the bills or notes
from the exporter at a discount, so that the exporter receives immediate payment. The bank could hold
the bills or notes to maturity, but may also sell them (as negotiable instruments) in the discount market.

12.1 Example of promissory notes and forfaiting

An example of forfaiting by discounting a series of promissory notes may be as follows.

 There may be a series of ten promissory notes covering a period of five years, with the notes
payable (with interest) on a specified date every six months over the five-year period.

 For example, if the total payment (excluding interest) is for US$200,000, each of the ten
promissory notes might be for US$20,000.

 The promissory note would be an undertaking by the buyer (issuer of the note) to pay the
exporter, and specify the bank where the payment should be made.

 Each promissory note will provide details of the underlying trade contract, and specify that it is
one of a series of ten notes, totalling US$200,000 in payment for capital goods (including a
description of those goods and the contract number of the trade agreement).

 Each promissory note may also state that the series of notes is covered by a separate guarantee
issued by the buyer’s bank.

 Each promissory note may also include a statement that it is also covered by a currency transfer
guarantee from the central bank of the buyer’s country.

 Each note will also specify the national law that governs the note and that will be used in the
event of any legal dispute about payment.

Instead of promissory notes, the forfaiting arrangement could cover a series of bills of exchange drawn
on the buyer, but covered by a bank guarantee.

13 The nature of STCF

Commodity financing is a method of financing where the lender provides finance against collateral in
the form of commodities. With structured trade and commodity financing, the bank plans to obtain
repayment of the finance it provides from the payments received from the sale of the commodities.

STCF is based mainly on a bank’s assessment of the supplier’s performance risk. In other words, the
bank considers the ability of the exporter to:

 Produce or distribute the commodity, in terms of operational and management ability.

 Finance its operations, except for the commodities that are financed.

The bank will look at the source of the commodities, where they will be sold and how they will be paid
for. With many commodity-trading transactions, the commodities are sold to a major buyer who is able
to pay:

 In advance of shipment or at the time of delivery

 In a hard currency
 Often, into an offshore account, which may be an escrow account

A common feature of STCF arrangements is that the bank provides finance to the commodity producer or
trader, but receives payment, possibly through an offshore account and in hard currency, from a major
foreign buyer.

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The main risk for the bank, in providing finance, is that the supplier of the commodities might fail to
deliver the commodities as agreed. If the supplier succeeds in delivering the commodities, the bank
expects to obtain repayment to the sale of the commodities in the international market. However, if the
commodities market is very volatile, the bank might not recover the full amount that they originally lent
out as part of the STCF agreement.

Asset-backed financing is similar to STCF, but the collateral used is not just commodities – a company
could post accounts receivable, inventory, machinery (and indeed any form of asset that a lender will
accept) as collateral for a loan. A lender can tailor specific financing solutions based on the working
capital resources and requirements of a company.

13.1 Escrow accounts

Key term
An escrow is a financial instrument held by a third party, on behalf of the other two parties in a
transaction. The funds are held by the escrow service, until it receives the appropriate oral or written
communication, or until obligations have been fulfilled. Securities, bank funds and other assets can be
held in escrow.

Escrow is a contractual agreement between two parties, a seller and a buyer, where an independent
third party (an ‘escrow agent’, such as a bank) receives and disburses money for the transacting parties
in accordance with the terms of their agreement. The money received by the independent third party is
‘put into escrow’.

An escrow account is a bank account under the control of the third party, such as a bank or a specialist
provider of escrow services. Payment is made into the escrow account by a buyer of goods, and payment
from the account to the exporter is made only when the exporter and buyer declare themselves satisfied
that the goods have been delivered as agreed.

Escrow accounts are an alternative method of arranging for payments for exported goods, in particular
when the exporter and buyer do not know each other well and so do not have complete trust in each
other to fulfil their obligations under the terms of their trading agreement.

An escrow account removes the risk for both the exporter and the buyer, but it is not a method of
financing trade since an escrow agreement involves payment in advance by the buyer. However, when a
buyer has paid in advance into an escrow account, a bank may be prepared to provide finance to the
exporter in a structured financing agreement, in which the bank will be repaid from the money in the
escrow account.

An arrangement for payment using an escrow account operates as follows:

STEP 1 An exporter and buyer agree on a trading transaction, and agree that the payment will be
made through an escrow account.

STEP 2 They arrange for a bank to establish an escrow account. This may be a bank in the
country of the currency of payment.

STEP 3 The buyer pays for the goods, in accordance with the terms of the trading agreement, into
the escrow account. Escrow agent notifies exporter that payment has been received.

STEP 4 The exporter ships the goods. The buyer receives them and acknowledges receipt.

STEP 5 The bank pays the exporter from the escrow account.

For the buyer, this arrangement provides protection against the risk that the exporter will fail to deliver
the goods as agreed, because the money will not be paid to the exporter until the goods have been
received. For the exporter, there is protection against the risk that the buyer will not pay for the goods,
because the money is paid into the escrow account before the goods are shipped.

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13.2 Off-balance sheet financing

The majority of trade finance techniques are all recorded in a company’s financial statements. Therefore,
if more financing is utilised, this will appear in the balance sheet of the company. This could prevent a
company from obtaining trade financing, as lenders may not be willing to lend to a highly leveraged
company. This problem can be avoided by obtaining off-balance sheet financing. These are financing
arrangements that are not recorded on a company’s balance sheet, therefore in accounting terms they
do not affect the leverage of a company. Two common forms of off-balance sheet financing are take-or
pay contracts and operating leases:

 Take or pay contracts involve a party agreeing to pay for a commodity, regardless of whether
they actually take delivery of the commodity.

E X A M P L E

A natural gas importer may use a take or pay contract to guarantee their gas supply. If they do not
require the natural gas and advise the seller that the natural gas is no longer required, they still have to
pay the seller. Such an agreement is not recorded on the balance sheet.

 Operating leases involve a company leasing machinery and equipment. The cost of the lease is
recognised in the profit and loss statement, but the operating lease is not recorded on the
balance sheet. Therefore a company using operating leases is avoiding leverage on the balance
sheet. This provides more flexibility on the balance sheet to finance trade.

14 Tolling finance
Tolling finance is a method of providing structured trade finance for exports of commodities. It may
therefore be called an example of structured trade and commodity finance or STCF. STCF is a structured
agreement for financing where the intention is that the finance provided by a bank will be repaid out of
the cash flows from a quantity of commodities.

Tolling finance provides finance from a bank for a tolling agreement between an exporter of raw
materials and a buyer which processes the raw materials. In a tolling agreement:

STEP 1 The exporter produces or obtains the raw materials, which may be a quantity of a
commodity.

STEP 2 The raw materials are delivered to the processing plant of a foreign buyer.

STEP 3 The buyer processes the raw material to produce a finished or semi-finished product.

STEP 4 This is then sold back to the exporter under a formal agreement for their re-purchase at an
agreed price. (This repurchase arrangement may be called an ‘offtake’ agreement and the
exporter who buys back the processed raw materials may be called an ‘offtaker’.)

STEP 5 The exporter of the raw materials, having purchased the processed raw materials, then
sells the processed materials.

Throughout these transactions, the exporter of the raw materials may retain legal title to the raw
materials. Alternatively, the tolling agreement must provide for an undertaking by the foreign
buyer/processor to sell the processed items back to the raw material supplier.

Tolling finance is an arrangement in which a bank provides finance to an exporter to support the
conversion of a quantity of raw materials (such as a quantity of a commodity) into a finished or semi-
finished product. It provides finance to the raw material exporter to cover the period up to the time that
the processed items are delivered back from the foreign processor.

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A bank will provide finance up to a percentage amount of the value of the exported raw materials.
Repayment should come from the payment by the foreign buyer/reseller for the raw materials. In the
agreement to provide tolling finance, the raw material exporter gives an undertaking to repay the bank
from the payments eventually received from the foreign processor.

Having received the processed materials, the raw material exporter may then need finance to cover the
period up to the receipt of payments from re-selling the processed materials. This is a different
arrangement from the tolling finance agreement.

15 Structured commodity financing models

Structured trade and commodity financing deals are negotiated to meet the specific requirements and
circumstances of the parties involved, so each STCF arrangement is non-standard. However, most STCF
arrangements can be classified into three general types or models:

 Export receivables-backed finance

 Pre-payment financing
 Warehouse receipt financing

15.1 Export receivables-backed finance

This type of financing arrangement provides an exporter with pre-export finance or advance payment
finance, with repayment coming from the eventual payment by the buyer (the exporter’s receivables).
The finance may be both pre-shipment and post-shipment finance.

The bank will normally take the following measures:

 For pre-shipment finance it will take security over the commodities, in the form of collateral or a
pledge. This may involve the pledge of warehouse receipts when the commodities are delivered
into a warehouse prior to shipment.

 For post-shipment finance, the exporter will assign to the bank the rights to the receivables from
selling the commodities.

 As indicated earlier, an escrow account may be established, possibly in an offshore location, and
purchasers of the commodity are instructed to pay in hard currency into the escrow account.

 The bank will receive repayment from the money paid into the escrow account.

The main risk for the bank is that the exporter will fail to deliver the commodities or sell the commodities
to foreign buyers.

15.2 Pre-payment financing

This type of arrangement is structured as:

 A purchase of goods, with

 Payment in advance.

A buyer arranges a trading agreement to purchase a quantity of commodities (to ‘offtake’ some of the
commodity producer’s goods) for delivery at a future date.

The bank provides finance to the buyer to enable it to pay for the commodities in advance.

The advance payment may be made into an escrow account in hard currency. If so, the exporter should
be able to raise finance from its own bank against the security of this advance payment, if it needs pre-
shipment finance.

The bank will expect repayment from the buyer out of the proceeds from re-selling the commodities,
when they are delivered by the exporter.

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The risk for the bank is performance risk – the risk that the buyer will fail to deliver the goods as agreed.
However, if the advance payment has been made into an escrow account, this will provide the bank with
some protection.

15.3 Warehouse receipt financing

Warehouse receipt financing is another form of STCF. It can be used to provide finance to an exporter of
commodities that are awaiting shipment for export in an independently-controlled warehouse, such as a
bonded warehouse.

A warehouse receipt is issued to the farmer or trading company that delivers the goods into the
warehouse. The receipt acknowledges that the warehouse has taken possession of the goods, giving
details of their quantity and possibly also their quality or grade.

Warehouse receipt financing is the provision of finance by a bank to the person who has deposited
the goods in the warehouse. The bank provides finance up to a percentage (perhaps 70% or 80%) of
the current market value of the goods. Commodities are therefore suitable goods for this type of
financing because they have a readily-identifiable market price. The farmer or trader must deposit the
warehouse receipt with the bank. Repayment of the finance will come from the eventual proceeds from
selling the goods.

A warehouse receipt may be non-negotiable, which means that the receipt is made out to a specific
person (individual or organisation). Only this person can authorise the release of the goods from the
warehouse. The receipt can be assigned to a bank, but the warehouse must be informed of this
arrangement. The receipt does not give legal title to its holder, and in the event of default by the farmer
or trader, the bank cannot take possession of the goods and sell them.

Alternatively, the receipt may be negotiable, so that the holder of the receipt is able to obtain
possession of the goods by presenting the receipt to the warehouse. For warehouse receipt financing,
negotiable receipts are usually required. A negotiable warehouse receipt may be made out to a specific
person ‘or bearer’.

 The original holder can endorse the receipt to another person (a bank), and the receipt can be
used to take possession and dispose of the goods in the event of default by the farmer or trader.

 The bank can later endorse the receipt to the buyer of the commodities, to enable the buyer to
take possession of the goods by presenting the receipt to the warehouse.

A warehouse financing arrangement is illustrated in the following diagram.

Figure 7.7: Warehouse receipt financing process

4. Provide credit

3. Lodge receipts with bank

Farmers/small producers/ Bank
small traders
1. Deposit
commodities

5. Sales 2. Issue receipts

agreement
Warehouse company

Large trader

6. Bank reimbursed from payment by trader: bank transfers receipt to trader

Note: When a warehouse financing arrangement is supported by a government department or agency,

the government department will approve warehouse companies for inclusion in the financing scheme.

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E X A M P L E

An example of warehouse receipt financing is a scheme organised by an export company.

 The export company identifies secure independent warehouses for their scheme.

 A farmer delivers a quantity of produce into an approved warehouse, which issues a warehouse
receipt.

 The farmer presents the warehouse receipt to a bank, which takes possession of it and provides
the farmer with short-term finance up to a percentage of the current market value of the
produce.

 The farmer arranges to sell the produce to a trader and arranges payment from the trader.

 The trader pays the bank for the goods.

 On payment the bank releases the warehouse receipt to the trader. Payment from the trader is
used to repay the bank finance.

 The trader presents the warehouse receipt to the warehouse and obtains possession of the
goods.

 Proceeds from the payment to the bank are used to repay the loan to the farmer. The balance is
credited to the farmer’s account with the bank.

15.3.1 Using warehouse receipt finance

Warehouse receipt finance may be appropriate for a farmer or trader in either of the following
circumstances:

 A farmer needs finance to support his business operations; the commodities he has produced are
the only collateral he can provide for a loan.

 A farmer or trader may not have a buyer for the commodities and may want to hold on to the
commodities for some time after they have been delivered into the warehouse – until a buyer is
found or until the market price of the commodity has improved.

15.3.2 Advantages of warehouse receipt financing for a bank

For a bank providing commodity finance, warehouse receipt financing has several advantages.

 The bank does not need to rely on the borrower’s promise that the commodities exist, because
the warehouse receipt provides documentary evidence of their existence (and condition).

 The warehouse operator is legally responsible for goods that it stores, and a lender can claim
against the warehouse company in the event of loss or damage to the goods in storage.

 The warehousing companies whose receipts a bank will accept for financing arrangements are
usually reliable organisations. The bank has the assurance that the commodities are ‘safe’ and
that production risk and transport risk have been eliminated by putting the commodities into
store.

 The commodities given as collateral through the warehouse receipt can be sold in the market in
the event of default by the farmer or trader.

As with most types of commodity financing, the bank needs to have some understanding of and
expertise in the commodity markets, so that it is able to follow the market, value loans properly and
respond to changes in the market price for a commodity (as a fall in value will affect the value of the
bank’s collateral).

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15.3.3 Warehouse receipt finance as a source of import finance

Warehouse receipt finance can also be provided to importers of commodities. Commodities imported into
a country may be delivered into a secure warehouse, to be stored until they are sold to buyers who will
process the commodities into a finished product. A bank may be willing to provide the importer with
finance, against collateral provided by the warehouse receipt, until the commodities are sold.

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Chapter roundup

 Banks may use normal methods for providing finance to customers to finance their export or import
activities. In addition, other methods of financing may be used.

 Methods of import financing include trust receipts and banker’s acceptances.

 Methods of export financing include banker’s acceptances, export factoring, vendor financing (invoice
financing), invoice discounting and forfaiting.

 Export finance can be divided into pre-shipment finance, which is finance to enable the exporter to
produce goods for shipment, and post-shipment finance to support the exporter from the time of
shipment to the time that payment is eventually received.

 Structured trade finance (STF) is financing trading activities, especially in emerging markets, where the
intention is that the lending/finance will be repaid from the cash flows from the trading transaction for
which the finance has been provided.

 Examples of STF are arrangements involving documentary credits and banker’s acceptances, back-to-
back credits, tolling and warehouse receipt financing.

 Structured trade and commodity finance (STCF) is structured trade financing where the underlying trade
involves commodities, such as agricultural products and metals.

 Trust receipt financing is an arrangement for providing import finance. A trust receipt is a written
undertaking from an importer in order to take early possession of goods that have been delivered into
the country before the importer has the documents of title to the goods.

 With a trust receipt the importer undertakes to hold and sell the goods as trustee for the bank, and to
deliver the proceeds from the sale of the goods to the bank.

 Banker’s acceptances are used as a method of import and export financing. A banker’s acceptance is a
bill of exchange drawn on the bank by the exporter or importer.

 The bill is discounted and the cash is made available to the exporter or for payment of the importer’s
supplier. At maturity of the BA, the exporter or importer must reimburse the bank.

 BNM has issued Guidelines on Bankers Acceptances, for BAs denominated in ringgit and drawn on a
Malaysian bank.

 Export factoring is an arrangement between an exporter and an export factor, in which the factor will
provide finance to the exporter against export receivables (up to 90% of invoice value). The export
factor will also collect payment from the exporter’s customers.

 Factoring may be on either a ‘with recourse’ or ‘without recourse’ basis.

 Invoice factoring is an arrangement between an exporter and a financial institution to finance the
exporter’s export receivables. The financial institution will provide finance for up to 70% or 80% of the
invoice value.

 With invoice discounting, the exporter collects payment from its customers, and pays the money received
into a special bank account, from which the invoice discounter is repaid with interest.

 Forfaiting is a method of medium-term financing, in which a bank discounts a series of bills of exchange
or promissory notes (linked to an underlying medium-term trading transaction) in order to provide
immediate finance for an exporter.

 STCF arrangements can be classified into three types or models: export receivables-backed finance,
warehouse receipt financing and pre-payment financing. Payment is often arranged through an escrow
account.

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TRADE SUPPORT FROM

GOVERNMENT AGENCIES

Contents
1 Direct and indirect exporters .................................................................................... 194
2 Export financing schemes ........................................................................................ 194
3 Pre-shipment finance............................................................................................... 195
4 Post-shipment finance under the Export Financing Scheme .......................................... 198
5 Other conventional banking services ......................................................................... 200
6 Export credit insurance and takaful ........................................................................... 201
7 Bilateral Payments Arrangement (BPA) Agreement ...................................................... 204
Chapter roundup.......................................................................................................... 206

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Learning outcomes
On completion of this chapter you should be able to:
 Analyse the services offered by government agencies in facilitating and controlling the risk
inherent in international trade.

Learning objectives
While working through this chapter you will learn how to:
 Describe the banking and insurance services provided by government agencies to support exports
and foreign trade.
 Explain the difference between the different types of export credit risk.
 Compare the costs and benefits of export credit insurance.
 Analyse the purpose and benefits of the Bilateral Payments Arrangement (BPA)
Agreement.

Introduction
Many countries have central banks that are wholly-owned by their Government, which are Development
Financial Institutions (DFIs). The role of which is to provide financing and insurance services for their
export-oriented companies. DFIs are generally known as specialised financial institutions, with a specific
mandate to develop and promote key sectors, that are considered of strategic importance to the overall
socio-economic development objectives of the country. These strategic sectors include the export-import
oriented sector.
As a DFI, the main objective of the bank is to enable companies to engage in export business, directly or
indirectly, by providing and supporting services that might not be readily available from commercial
banks. However, they also provide a range of specialised financial products and services to suit the
specific needs of the targeted strategic sectors, and act as a strategic conduit to bridge the gaps in the
supply of financial products and services to the identified strategic areas for the purpose of long-term
economic development.’
The purpose of this chapter is to describe the financing and insurance services provided by banks,
supported by an export financing scheme. The chapter begins by describing financing facilities and
banking arrangements available through DFIs and then goes on to consider insurance, and in particular
export credit insurance services.

1 Direct and indirect exporters

DFI banks provide and support banking and insurance services for direct and indirect exporters.

 A direct exporter is someone who sells directly to a foreign buyer, known as an actual exporter.

 An indirect exporter is someone who supplies goods to a direct exporter, who will use these
goods for making direct exports. An indirect exporter is therefore a supplier to an exporter.

2 Export financing schemes

Key term
Export financing schemes provide all the finance support services exporters need, to develop
business in foreign markets.

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Most DFI banks offer an Export financing Scheme, with the aim of providing alternative short-term
financing for both direct and indirect exporters, in order to promote the export of manufactured goods,
agricultural products and primary commodities.

Finance can be made available to any companies involved directly or indirectly in export activity. This can
be both pre-shipment and post-shipment finance.

Pre-shipment finance is intended to:

 Finance the production of goods for export prior to shipment.

 Promote the ‘backward linkages’ between direct exporters and their suppliers (indirect exporters)
in export-oriented industries.

Post-shipment finance is to finance an exporter after shipment of the goods. It is a facility for
providing finance by discounting bills, to meet the funding needs of the exporter between shipment of
the goods and payment of the export bill.

Financing under both the pre-shipment and post-shipment schemes is arranged through nominated
banks, and usually carries some guarantees from the national government via the central bank.

3 Pre-shipment finance
Pre-shipment financing under an export financing scheme, is the financing required prior to shipment of
the goods, to support pre-export activities such as production costs, overheads, and wages. It is
provided in the form of short-term financing. There are two methods of financing direct and indirect
exporters under the pre-shipment facility:

 Order-based method
 Certificate of Performance (CP) method

3.1 Order-based method

With the order-based method of pre-shipment financing, the financing is based on the evidence of an
export order. This export order may be an export letter of credit, or a domestic purchase order (in the
case of an indirect exporter) or a foreign purchase order (from a foreign buyer).

The maximum amount of financing available under the order-based method is a pre-determined
percentage of the value of the order. (Currently, the maximum limit is 95% of the order value.)

The term or tenor of financing is usually up to a maximum of 120 days, but agreed on an individual
basis between the lender and the borrower.

Repayment of the pre-shipment finance will be expected, in the case of an indirect exporter, from
the proceeds of the sale to the direct exporter. In the case of a direct exporter, repayment will be
expected from either:

 Proceeds from the export sale;

 Post-shipment finance (from the export financing scheme), obtained after the goods have been
shipped.

3.1.1 How the order-based method of financing works

A company having a line of credit with its commercial bank, under the export financing scheme, asks for
pre-shipment finance, and provides an export letter of credit or a buyer’s order as evidence of the order
and the order value.

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The bank finances up to a certain percentage of the order, generally a maximum of 95% as the ‘eligible
amount’ for borrowing. Disbursement of the finance by the bank is made against three types of
expenses:

 Domestic purchases (DP) from another business

 Foreign purchases (FP) of goods from a foreign buyer
 Overhead expenses (OE)

Manufacturing companies can usually borrow a maximum of 30% of the eligible finance by way of
financing overhead expenses, whereas trading companies can generally borrow a maximum of 10% of
the eligible finance to cover overhead expenses. In addition, the direct/indirect exporter may draw down
borrowed funds for OE only when drawdown for DP and/or FP is up to 20% of the facility.

E X A M P L E

A direct exporter based in Malaysia, a manufacturing company, obtains a financing facility under the
order method of the (export financing scheme) pre-shipment scheme. The underlying export order is for
RM1,000,000. The bank agrees to provide a pre-shipment facility for up to RM950,000 which is 95% of
the value of the order. The exporter is able to borrow to cover overhead expenses, up to a maximum of
RM285,000 (= 30% of the eligible facility) but borrowing to cover overhead expenses cannot begin until
the exporter has drawn down RM190,000 to cover purchases of materials/goods by way of DP and/or FP.

3.2 Certificate of Performance-based method

A Certificate of Performance or CP is a certificate issued by a central bank, under an export financing
scheme, to direct and indirect exporters, to enable them to obtain finance under the export financing
scheme pre-shipment facility. Companies that are given a CP do not need to provide evidence of an
order to obtain access to pre-shipment finance.
However, to draw down funds under the facility, the exporter must subsequently provide evidence of
orders in the form of an export letter of credit, a foreign purchase order or, in the case of indirect
exporters, a domestic purchase order.
The maximum total amount of eligible funding under the CP method is specified in the CP as an annual
amount:

 For direct exporters, this maximum annual total is 100% of exports value in the previous
12 months.

 For indirect exporters, the maximum total is 80% of local sales in the previous 12 months.

The tenor of financing under the CP method of pre-shipment finance is generally 120 days (four
months), the same as for the order method. Since the CP specifies an annual eligible amount for
financing, the annual amount is divided into three equal portions, spread over three validity periods of
four months each.

In the event that the CP amount is fully utilised by the exporter before the expiry of the validity period,
the exporter can apply for early renewal or ‘rollover’ of the CP facility.

E X A M P L E

A direct exporter based in Malaysia receives a CP from its central bank, which it can use to obtain finance
under an export financing scheme line of credit, that it has arranged with its bank. Exports for the
company in the previous 12 months were RM6,000,000. The total eligible finance in the CP is
RM6,000,000, divided into three periods of four months, each with an eligible funding amount of
RM2,000,000.

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To draw down funds under this facility, the exporter must provide evidence of an export order, and the
maximum eligible finance for the individual order is up to 95% of the order value.
Disbursement of the financing facility by the bank is made against three types of expenses:
 Domestic purchases (DP) from another business.
 Foreign purchases (FP) of goods from a foreign buyer.
 Overhead expenses (OE).
The rules on draw down are the same as for the order-based method.
Repayment of the pre-shipment will be expected, in the case of an indirect exporter, from the proceeds
of the sale to the direct exporter. In the case of lending to a direct exporter, repayment will be expected
from either:
 Proceeds from the export sale;
 Post-shipment (export financing scheme) finance, obtained after the goods have been shipped.
Repayment arrangements are, therefore, also the same as for the order-based method.

E X A M P L E

It may be useful to illustrate a pre-shipment financing arrangement with an example. In this example,
the order-based method is used.

1 A company has an export financing scheme line of credit with its bank, and it applies for
financing under the pre-shipment scheme for an export order valued at RM1,000,000. Evidence of
the export order is provided in the form of an export letter of credit or a purchase order from the
foreign buyer.

2 The bank agrees to pre-shipment financing under the export financing scheme, of RM950,000 (=
95% of the order value). The exporter draws a bill of exchange on the bank, which the bank
accepts.

3 The bank pledges its accepted bill with the central bank of its country, who then issue a reference
number for the bill.

4 The bank can now issue letters of credit for foreign purchases by the exporter and domestic
purchase orders (DPOs) under the export financing scheme. It can also issue Local Purchase
Orders (LPOs) for domestic purchases from suppliers that are not within the export financing
scheme. These items issued by the bank are for purchase of materials for the export order. (They
are designated as L/Cs, DPOs and LPOs respectively.)

5 When documents are presented for payment under the DL/Cs, (documentary letters of credit)
DPOs and LPOs and honoured by the export financing scheme bank, the central bank will
reimburse the amount of the payment to the commercial bank. In this way the central bank
therefore provides the pre-shipment financing for the direct exporter.

As an example, the commercial bank may issue the following to the exporter’s suppliers, in
connection with the export order:

 An (export financing scheme) letter of credit for RM300,000 to a foreign supplier.

 A DPO to a domestic supplier for RM400,000. This supplier can use the DPO as evidence of
an order, and apply to its own bank involved in the export financing scheme, for pre-
shipment finance (up to 95% of RM400,000 = RM380,000) under the export financing
scheme facility. The indirect exporter can draw a bill for RM380,000 on its bank and, after
the bank has accepted this bill and pledged it to the Central Bank, the bank can issue
export financing scheme letters of credit, DPOs, or LPOs, within the financing facility.

 An LPO to a domestic supplier for RM40,000.

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6 When at least 20% of the financing has been utilised for DP and/or FP, the exporter can apply for
financing for overhead expenses, which cannot exceed 30% of the total facility.

Figure 8.1: CP process

Foreign buyer Direct exporter

1. Export L/C or order
2. Draw bill
for
RM950,000
for
acceptance
(pre-
shipment
finance)

Central BANK 3. Pledge accepted bill for RM950,000 DIRECT EXPORTER’S

Commercial BANK

6. Pledge Supplier A:
pre-
Indirect exporter 4a: DL/C
shipment for RM
bill 300,000

Supplier B:
Indirect exporter
4b: LPO for
RM40,000

Supplier C:
INDIRECT 5. Draw bill for Indirect exporter 4c: DPO
EXPORTER’S BANK RM380,000 for for
acceptance (pre- RM400,000
shipment finance)

7a. DPO 7b. LPO for

for RM50,000
RM150,000
Supplier 2 to indirect Supplier 2 to indirect
exporter exporter

4 Post-shipment finance under the Export Financing Scheme

The Post-shipment facility is available to direct exporters.

Financing is provided against export documents (expected customer payments), and the amount of
eligible financing is generally 100% of the value of the exported goods. The value of each post-shipment
arrangement is negotiated between lender and borrower, usually with a minimum and maximum level.

The method of financing is a bill of exchange, which the exporter draws on his commercial bank.

The minimum tenor for financing is seven days. The maximum tenor is:

 183 days (six months) for exports where payment will be at a future date after presentation of
the documents and delivery of the goods.

 60 days for export on sight payment terms.

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4.1 Payment
Post-shipment financing must be liquidated at the earlier of the following dates:

 Receipt of the proceeds from the export sale.

 Maturity of the post-shipment bill of exchange.

4.2 Interest charges

The funding rate for pre-shipment and post-shipment finance, under an export financing scheme is
determined by the central bank of the participating country, which may change the interest rate from
time to time.

Banks may also add a margin or service fees to the interest rate, which is also determined by the
individual bank.

Interest on pre-shipment finance is calculated on the daily outstanding balance. This interest is
payable on the last day of each month and at maturity. The amount of interest is calculated on a simple
interest basis as follows:

P × T ×R
I=
365

Where
I = Interest
P = Pre-shipment loan outstanding
T = Number of days
R = Annual interest rate

For post-shipment finance, interest is deducted ‘up-front’ at the beginning of the financing, in a similar
way to a bills discounting facility. The exporter receives the discounted amount (= the amount of the
financing less the discount), and the discount represents the interest charged.

The proceeds for the exporter from discounting are calculated as follows:

NV
P=
1+ rt / 36,500 

Where
P = Discounted proceeds
NV = Nominal value or maturity value
r = Rate of interest as a percentage per annum
t = Number of days to maturity

E X A M P L E

An exporter obtains post-shipment finance in the form of a bill of exchange for RM500,000 with a tenor
of 120 days. The interest rate for the financing is 6% per annum. The proceeds received by the exporter
from discounting the bill will be:

RM500,000
P=
1+ (6 ×120) / 36500

= RM500,000/1.019726

= RM490,327.78

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5 Other conventional banking services

Central banks also offer support for a range of other conventional banking services, all intended to
promote the export sector of their country’s economy, some with emphasis on ‘non-traditional markets’
and the entry of companies into new export markets. Central banks also provide financing for imports,
for example by issuing letters of credit for importers, in cases where:

 The imported goods or raw materials will be processed for the purpose of re-export, or

 The imported goods are ‘strategic goods’ that are unavailable from suppliers in their own country,
and ‘high tech’ in nature, so that their import will help the development of companies and the
economy.

Some of the support for trade financing arrangements offered by central banks are described briefly
below.

5.1 Supplier credit facility

The export financing schemes are supported by the central banks, but some independent banks offer
their own supplier credit facility for pre-shipment and post-shipment finance for exporters.
This facility is available to manufacturers and traders to finance:
 Working capital for the production of goods for export (pre-shipment finance), usually for up to
120 days.
 Post-shipment finance, usually for up to 180 days.
The financing is related to specific export orders, with terms and condition of the finance set out for each
individual transaction. The banks operating this type of scheme will provide finance for up to 85% of the
export order value as pre-shipment finance, and up to 100% of the value of the export bill as post-
shipment finance.
Repayment is expected from the eventual proceeds from the export order.
The benefits are:

 The exporter is paid as soon as the goods have been shipped

 The buyer/borrower has time to pay, at either a fixed or variable rate of interest
 The bank receives a ‘guarantee’ from the government of the country for the amounts due

5.2 Export of services

Many central banks offer support for an export of services facility, to companies engaged in the provision
of services to the global market, such as information technology services and engineering architecture
services.
Exporters of services may be able to obtain finance for working capital or asset purchases, or a bank
guarantee (backed by a government), to support specific export orders. The margin of financing is
generally up to 75% of the order value, with a tenor of up to five years (depending on the nature of the
export order).
Repayment is required from the proceeds of the export contract or by means of fixed monthly or
quarterly payments.

5.3 Import financing

Central banks are also prepared to provide support for import financing for companies which:
 Trade in both export and domestic markets.
 Need specialised finished or intermediary goods which are unavailable in the companies’ own
country.

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The purpose of the import financing facility is to ‘finance imports of capital goods, raw materials and
related goods for the development, upgrading expansion of infrastructure facilities or other expenses
related to the client’s business activities.’

Governments have realised that trade policies are good for domestic consumers, workers, and
businesses, as it has led to the revitalisation of some countries’ economies.

Finance is available for imports for up to 90% of the import order value, where payment for the goods
can be tailored to suit the importer’s needs.

Banks are also able to issue letters of credit (a formal bank letter issued for a bank’s customer) to enable
importers to negotiate the best price for the goods.

5.4 ADB Trade Finance Program

The Asian Development Bank’s (ADB) Trade Finance Program is an arrangement between participating
banks in 43 developing countries in Asia, with the purpose of increasing trade between these countries
(and where the currency of payment is US dollars, yen or euro).

The Trade Finance Program offers exporters a ‘guarantee’ of up to 100% of the value of export orders by
providing confirmation of letters of credit. A company wishing to export goods to a customer in one of
the developing countries in Asia can arrange for the buyer to apply for a letter of credit to be issued by a
participating bank in the program. The central bank will then confirm the letter of credit.

For example, a Vietnamese company may arrange to sell goods to a customer in the Philippines. The
buyer may arrange for the Philippines National Bank, a participating bank in the program, to issue a
letter of credit. Within the Trade Finance Program, the central bank will be asked to confirm the letter of
credit, which should provide assurance to the Vietnamese company that it will receive payment for the
goods (provided that it complies with the terms and conditions of the letter of credit).

5.5 Bank guarantee

The guarantee facility of central banks is available to facilitate the issue of bonds (such as bid bonds and
performance bonds) for overseas contracts undertaken by domestic contractors.

6 Export credit insurance and takaful

Key term
Takaful is a type of Islamic insurance, where members contribute money into a pooling system in order
to guarantee each other against loss or damage. It is based on Shariah, Islamic religious law, and
explains how it is the responsibility of individuals to co-operate and protect each other.

Export credit is the granting of credit by an exporter to a foreign buyer, giving the buyer time after
shipment and delivery of the goods before having to pay for them. With many export credit
arrangements, there is some risk of non-payment. This credit risk is greater than for domestic market
sales, because:

 The period of credit for the buyer is often longer than for domestic sales.

 The buyer may become insolvent.

 Political events or government action in the buyer’s country (such as the sudden imposition of
exchange controls) may prevent importers from paying for their imported goods.

If a buyer refuses to pay for goods, the exporter has the problem of taking legal action against a
customer in a different country.

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Exporters can try to reduce the risk of non-payment, for example by asking for payment in advance of
shipment or asking for payment by means of a confirmed letter of credit. However, this is not always
possible. In some countries, there may also be some credit risk with an issuing bank, even when the
buyer agrees to a documentary credit.

The export credit risk may be so great for some companies that they are reluctant to export. Similarly
the export credit risk in some countries may be so great that exporters choose not to export to buyers in
those countries.

Export credit insurance is an insurance policy that provides protection for an exporter against the risk of
non-payment due to certain insured risks. If the exporter is not paid for any reason covered by the
insurance policy, the insurance provider will pay instead.

Export credit insurance can be arranged by most banks, supported by central banks participating in
import/export financing.

6.1 Risks covered

Export credit risks can be classified into two types:

 Commercial risks
 Country risks (economic and political risks)

Commercial risks are risks of non-payment due to:

 Insolvency of the buyer.

 Default by the buyer, so that payment has not been received by a certain number of days after
the due date for payment (as specified in the insurance policy).

 The buyer’s failure to accept the goods.

Country risks are risks of non-payment due to:

 The unexpected imposition of an import licence.

 The cancellation of an import licence.
 War between the two trading countries.
 War, revolution or civil disturbances in the buyer’s country.
 Default by a government buyer.
 Blockage or delay in the transfer of payment, for unexpected regulatory reasons.

6.2 Costs and benefits of export credit insurance

Exporters must pay a premium to obtain export credit insurance. The amount of the premium depends
on the size of the credit risk. The size of the credit risk depends on factors such as the credit risk of the
buyer, the length of the credit period before payment, and conditions in the buyer’s country.

The benefits of export credit insurance are as follows:

 The insurer provides protection against the risk of non-payment and will pay a percentage of the
amount owed, in the event of non-payment to the exporter. Export credit insurance from most
banks, supported by central banks, provides cover for 90% to 95% of the amount due from the
foreign buyer.
 Insurance therefore reduces significantly the credit risk for an exporter.
 This may encourage more companies to export into unfamiliar foreign markets.
 It may also enable exporters to sell more exports on credit terms, because banks will be more
willing to provide finance to exporters with credit insurance.

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6.3 Export credit insurance: comprehensive policy

An example of a comprehensive policy is for exporters who make regular exports on credit of up to 180
days. It also covers exports of goods arranged by a company from one country directly to another
country, without passing through a third country (‘third country exports’). Exports concluded on payment
terms of irrevocable letter of credit, documentary collection and open account are all insurable.

A comprehensive policy provides cover against commercial and country risks.

The cover provided is generally up to:

 90% of the amount of the due payment, where non-payment is due to a commercial risk factor.
 95% of the amount of the due payment, where non-payment is due to a country risk factor.
In the event of non-payment, banks, supported by central banks, will pay a claim as follows:

Reason for non-payment Loss recognised and claim payable

Buyer’s insolvency Immediately

Default in payment 6 months after due date for payment

Non-acceptance of goods 1 month after goods are re-sold

Other reasons Four months after the event

6.4 Specific export credit insurance policies

Banks will also provide credit insurance policies for exporters who undertake contracts for the exports of
capital goods, for construction work overseas or providing services in another country.

Export contracts that may be eligible for ‘specific policy’ cover usually have the following characteristics:

 The contract is non-repetitive and ‘once only’.

 It is a long-term contract, for example a contract where the manufacture of the goods for export
will take a long time (such as shipbuilding) or a large foreign construction project.
A specific policy covers both commercial and country risks. Commercial risks include the risk of failure by
the buyer to pay within six months of the due date for goods delivered to and accepted by him.

6.5 Bank Letter of Credit Policy

A Bank Letter of Credit Policy (BLCP) is available to exporters who export on documentary credit
terms and want to obtain security of payment against the risk of default by the issuing bank in the
buyer’s country.

The BLCP covers participating banks that negotiate bills of exchange for most exporters, where:

 A bill of exchange has been issued by a foreign issuing bank, and

 The issuing bank has failed to reimburse the negotiating bank.
Without the insurance policy, the negotiating bank would have recourse to the exporter for payment.
With the BCLP, the central bank provides the commercial bank with indemnity for up to 95% of the
value of the letter of credit.

The ‘claims waiting period’ before default is recognised and the insurance claim becomes payable not
earlier than four months after the due date for payment of the letter of credit.

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6.6 Multi-Currency Trade Finance (MCTF) scheme

MCTF is a facility provided by participating commercial banks to SME exporters to finance the production
of goods or provision of services (in any major foreign currency) against irrevocable letters of credit
issued by a foreign bank. Under this scheme, the SME exporters are not required to provide any
collateral (security) for the finance provided to them. (Note: SME stands for ‘small or medium-sized
enterprise’.)

The SME exporters are not required to provide collateral because the participating bank, supported by its
central bank, provides insurance cover for the exporter’s bank under its MCTF Insurance Policy against
the following risks:

 Pre-shipment risk: the risk of non-payment by the exporter of finance/credits provided against
an export letter of credit, due to insolvency of the exporter.

 Post-shipment risk: the risk that a letter of credit will not be honoured by the issuing bank.
Bank supported insurance cover for this risk means that the exporter’s bank will not be required
to seek recourse from the SME exporter.

The insurance policy therefore reduces the credit risk for participating banks of providing finance to SME
exporters. The objective of this scheme is to encourage banks to provide pre-shipment and post-
shipment finance to SME exporters, without demanding collateral.

6.7 Export credit takaful

Export credit takaful is the Shariah-compliant equivalent to conventional export credit insurance,
based on the Shariah concepts of ‘wakalah’ (agency) and ‘mudharabah’ (a cost-plus selling
arrangement).

Takaful is an arrangement in which money is pooled by participants and invested. This investment fund
then provides for mutual financial aid for the participants in case of need. A takaful company or operator
acts as mediator, managing the participants’ fund and receiving remuneration for its services.

Credit takaful provides the participants with protection against the risk of non-payment as a result of
commercial risks (including default by ‘approved’ buyers) or country risks. Exporters participating in the
scheme contribute to a fund which is managed by nominated banks as the takaful operator, and the fund
is used to underwrite risks of non-payment.

The size of contributions by participants varies according to the volume of their export sales, the risk in
the markets where they sell and the credit terms they give to buyers. Banks charge fees for its service,
including a wakalah or agency fee equal to 35% of the contribution of each participant.

In most respects, banks’ credit takaful arrangements are similar to its ‘conventional’ comprehensive
policies and specific policies for export credit insurance.

7 Bilateral Payments Arrangement (BPA) Agreement

Another arrangement with a similar objective of encouraging imports and exports, is the Bilateral
Payments Arrangement Agreement, which is operated by many international banks.
Bilateral payments arrangements are agreements made between international banks, for the purpose of
effecting and guaranteeing the settlement of financial claims arising from exports and imports of goods
between the two countries.
The objective of such an arrangement is to promote trade between countries and encourage banks to
provide their support for this trade.

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Under a bilateral payment arrangement:

 The central bank of one country pays its exporters to the other country, the value of their
exported goods, in the domestic currency of the exporter. Payment is made through designated
domestic banks.

 The other central bank undertakes to discharge the financial obligations of its importers by
reimbursing the exporters’ central bank.

 This is a reciprocal arrangement for exports and imports between the two countries.

 The central banks settle the net amount due between them in an agreed currency, on a periodic
basis. This net payment is made through inter-central bank accounts established under the
bilateral payment arrangement.

 The central bank for the importers has the responsibility for claiming the payments for the
imported goods from its importers. Payment by the importers is in their domestic currency and
through designated domestic banks.

The effect of a bilateral payments arrangement is to convert commercial risk in export/import

transactions into sovereign risk. The risk is a risk of failure by a central bank to honour its undertaking to
ensure payment.

To be eligible for protection under such an arrangement:

 An export transaction must be between two participating countries within a specific arrangement.

 Only products manufactured in the respective countries are eligible.

 Commercial settlement must be arranged by way of a letter of credit issued by a designated bank,
or guaranteed by a standby letter of credit issued by a designated bank.

Countries participating in the arrangements include (as at June 2012) Albania, Algeria, Argentina, Chile,
Indonesia, Kyrgyzstan, Laos, Malaysia, Mexico, Peru, Philippines, Seychelles, Thailand, Tunisia, Vietnam
and Zimbabwe.

Exporters can apply for this facility from most domestic banks.

7.1 Benefits of the arrangements

The benefits of these arrangements for exporters and importers are as follows:

 The bilateral payments arrangements enable importers and exporters to venture into new and
emerging markets.

 The guarantee of payment by the importers’ central bank converts commercial risk into sovereign
risk, and so reduces the risk for exporters.

 The arrangements develop new trade links at a lower cost. For example, exporters will not require
confirmation of letters of credit issued by designated banks in the importer’s country.

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Chapter roundup

 As a Development Financial Institution, its main objective is to enable companies engaged in export
business to obtain financing or insurance facilities that might otherwise by unavailable to them from
commercial banks.

 National banks assist both direct and indirect exporters.

 Export financing schemes are operated through participating banks. A bank involved in an export
financing scheme provides a line of credit, which exporters can then use to obtain finance by drawing a
bill of exchange on the bank.

 The schemes provide pre-shipment finance to direct or indirect exporters. A bank bill drawn by the
exporter on the participating bank is accepted by the bank, and pledged by the national bank. The
export financing scheme bank can then issue letters of credit or purchase orders in favour of the direct
exporter’s suppliers. National banks will reimburse the participating scheme bank when the bank honours
its payment obligations.

 Pre-shipment finance in the participating export financing scheme, is available through: the order-based
method and the Certificate of Performance (CP) method.

 Export financing schemes also make post-shipment finance available to direct exporters.

 National banks support other financing schemes for exporters, including an import financing scheme that
enables exporters to acquire goods that cannot be obtained in their own domestic country.

 Export credit insurance and export credit takaful is also available as protection to exporters against credit
risk. These are available as a comprehensive policy for exports or for specific longer-term export
contracts.

 Bilateral payments arrangement agreements exist between the central banks of some developing
countries. Under these agreements, the central banks pay exporters of goods from their country (in
domestic currency) and take payments from importers of goods from the other country (in domestic
currency). The central banks then settle net payments between the two countries periodically, in an
agreed currency. These arrangements have the effect of changing commercial credit risk for exporters
into sovereign risk.

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chapter 9

INTERNATIONAL TRADE FINANCE

AND ISLAMIC BANKING

Contents
1 Letter of credit-i ..................................................................................................... 208
2 Trust receipt-i ........................................................................................................ 210
3 Accepted bills-i (AB-i) .............................................................................................. 210
4 AB-i for imports (AB-i purchase) ............................................................................... 211
5 AB-i for exports (AB-i sale)....................................................................................... 212
6 Working capital financing-i ....................................................................................... 214
7 Islamic FX forward .................................................................................................. 214
8 Guarantees ............................................................................................................ 216
Chapter roundup.......................................................................................................... 217

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Learning outcomes
On completion of this chapter you should be able to:
 Examine the principles and products of Islamic trade finance and banking.
 Differentiate between conventional and Islamic financial systems and arrangements.

Learning objectives
While working through this chapter you will learn how to:
 Analyse the nature of Shariah-compliant arrangements for export and import financing.
 Compare Islamic and conventional trade finance and banking products.
 Analyse the nature of Shariah-compliant forward foreign exchange transactions and bank
guarantees.
 Compare Islamic and conventional financial systems and arrangements.

Introduction
Conventional banking arrangements are consistent with Shariah principles in some respects, but in there
are some notable differences.
Foreign trade based on open account terms, payment through documentary collection and payment
through documentary credits are all consistent with Shariah principles, and Islamic banks apply the
Uniform Rules for Collections (URC522) and Uniform Customs and Practice for Documentary Collections
(UCP600).
Where conventional banking arrangements are not Shariah-compliant, alternative arrangements have
been developed, similar to conventional banking but consistent with Shariah principles. This chapter
explains the arrangements available from Islamic banks, and Shariah-compliant schemes used in Islamic
trade finance.

1 Letter of credit-i
Letters of credit when used by Islamic banks for export/import financing, are not treated as a guarantee,
but rather as a fee based banking service to facilitate trade. All types of issued L/Cs-i must fulfil the
requirements of the Shariah.

Key term
A Letter of Credit-i is a letter of credit issued by an Islamic bank that guarantees payment by a buyer
(the applicant for the L/C), provided that the supplier complies with the terms and conditions of the L/C.
If the buyer does not honour the payment, the bank will.

A Letter of Credit-i is therefore the same as a conventional letter of credit, except that it is based on one
of two Shariah principles, Wakalah or Murabahah.

1.1 Letter of credit-i based on wakalah principle

Key term
Wakalah refers to an arrangement in which one person (the principal) empowers another person (an
agent) to perform an act for him. The agent stands in the place of the principal in the performance of the
act.

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When a bank issues a letter of credit-i based on the wakalah principle, the bank becomes the agent of its
customer (the importer) with authority to deal with the advising bank for the letter of credit. (As an
agent of the importer, the bank can charge a fee for this service.)

A L/C using the wakalah principle is appropriate when the only purpose of the letter of credit is to
provide a guarantee of payment from the issuing bank.

1.2 Letter of credit-i based on murabahah principle

Key term
Murabahah is an acceptable form of credit sale under Shariah law where the intermediary retains
ownership of the property until the loan is repaid in full.

A contract based on the murabahah principle involves the sale of goods from one person to another,
where the sale price includes a profit margin agreed in advance between the two parties.

A L/C using the murabahah principle is appropriate when the letter of credit is structured to
accommodate the buyer’s need to finance the purchase of the goods.

A letter of credit-i based on the murabahah principle enables the buyer/importer to obtain finance for the
purchase of goods by arranging a murabahah contract with its bank.

The arrangement involves an initial purchase of the imported goods by the bank, which then re-sells the
goods to the importer at a price that includes an agreed margin of profit. The bank pays for the
purchased goods immediately, but re-sells them to the importer on deferred payment terms. This allows
the importer time (credit) to pay for the goods.

The procedures in this type of arrangement are as follows:

1 The bank appoints its customer, the importer, as its purchasing agent.

2 The customer identifies the goods for purchase.

3 The bank issues a LC-i to the beneficiary, the exporter/supplier. This is advised to the beneficiary
through the beneficiary’s bank.

4 The beneficiary/exporter ships the goods to the required destination and presents the required
documents, including the bill of lading, to the nominated negotiating bank (which may also be the
advising bank).

5 The negotiating bank checks the documents; if they comply with the terms and conditions of the
credit, it sends them to the issuing bank.

6 The issuing bank pays the negotiating bank, and the negotiating bank makes a payment to the
exporter/beneficiary. The issuing bank is now the owner of the goods.

7 The issuing bank re-sells the goods to the importer at a price that includes a profit margin on top
of the exporter’s price (the murabahah contract) on deferred payment terms. The bank releases
the documents to the importer, who takes possession of the goods.

8 The importer pays the bank on the due date for payment.

This arrangement is illustrated in the diagram below.

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Figure 9.1: Letter of credit-i process

6. Ship goods
EXPORTER IMPORTER
2. Identify goods
for purchase

10. 7. Present 5. 1. Appoint 3. 11. Sell

Payment documents Advise customer Apply goods via
as for LC-i murabahah
purchasing contract on
agent 12. deferred
Pays payment
bank terms
on due
date
4. Issue LC-i
ADVISING/NEGOTIATING BANK ISSUING BANK
8. Send
documents

9. Payment

2 Trust receipt-i
A trust receipt-i is similar to a conventional trust receipt. It is a document of trust signed by an importer.
On the basis of the undertaking given by the importer in this document, to pay for imported goods at a
later date, the bank allows the importer to take possession of the imported goods immediately.

A trust receipt-i is usually based on the murabahah principle. The procedure is as follows:

1 The importer informs its bank that it wants to arrange for the purchase of goods using a letter of
credit arrangement (LC-i).

2 The bank agrees, and appoints the importer as its purchasing agent, to buy the goods on behalf
of the bank.

3 The goods are purchased by the importer as agent for the bank, and the supplier ships them to
their destination.

4 The supplier presents the shipping documents to the negotiating bank, which checks them for
compliance and then sends them to the issuing bank. The issuing bank pays for the goods and
becomes the owner of the goods.

5 A trust receipt-i is arranged with the importer. This enables the importer to take early
possession of the goods, against an undertaking to buy them and pay for them.

6 The bank re-sells the goods to the importer via a murabahah contract, at a price that includes an
agreed profit margin, with payment on deferred terms.

3 Accepted bills-i (AB-i)

An Islamic accepted bill (AB-i) is similar to a conventional banker’s acceptance (BA), but with some
differences.

An AB-i is a bill of exchange drawn either on a bank or by a bank, payable at a specific date in the
future. The purpose of the AB-i is to ‘securitise’ a debt arising out of a trading transaction. This
securitised debt can be sold in the market at a discounted value, under the Shariah principle of
bai al dayn (or bai’ dayn). Bai al-dayn is the sale of a debt for cash or on a deferred payment basis.

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Islamic accepted bills are normally drawn in order to finance trading in tangible goods. The main
elements in the arrangement are:

 A trade in goods on deferred payment terms.

 The creation of a debt, arising from this sale.

 Securitisation of the debt through the creation of an AB-i.

 Sale of the AB-i at a discount to obtain immediate cash to finance the trade. The sale of the bill at
a discounted value is based on the principle of bai al-dayn.

Bank Negara Malaysia has issued Guidelines on Accepted Bills-i. These guidelines apply to AB-i
denominated in ringgit and drawn and accepted in Malaysia. A requirement is that the customer should
agree an AB-i financing facility in advance with the bank, and that there must be documentary evidence
of an underlying trade transaction for each AB-i transaction.

The guidelines differ between the use of AB-i to finance imports and AB-i to finance exports.

4 AB-i for imports (AB-i purchase)

When an AB-i is used to enable an importer to finance the purchase of imported goods, the murabahah
principle is applied to the arrangement. The bank buys the imported goods from the foreign supplier and
re-sells the goods to the importer at a cost-plus price via a murabahah agreement. This creates a debt,
payable by the importer to the bank. This is securitised through the creation of an AB-i, payable at a
future date, which is then sold in the secondary market.

The arrangement is as follows:

1 The bank appoints the importer as its purchasing agent.

2 The importer purchases the goods, as agent for the bank.

3 The seller ships the goods, and the bank pays for them.

4 The bank re-sells the goods to the importer with a profit mark-up in the price (murabahah) on
deferred payment terms.

5 Payment for the re-sold goods is by means of a bill of exchange, drawn by the bank on the
importer, with maturity at a future date. (Payment may be deferred by up to 365 days.) This bill
of exchange is the securitisation of the debt owed by the importer to the bank.

6 The bank can sell the bill in the secondary market at a discount to its face value.

A significant difference between AB-i for imports and conventional banker’s acceptances for imports is
that the arrangement involves a bill of exchange drawn by the bank on the importer, and not a bill drawn
on the bank.

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E X A M P L E

Let's consider an AB-i drawn to finance purchases:

 Payable in ringgit to the order of the drawer (the bank).

 On a specified future date (not earlier than 21 days from the date of acceptance).

 For a specified amount amount of not less than RM50,000.

 Payable at the Head Office, Central Office or Main Office of an Islamic bank or commercial bank in
Kuala Lumpur.

Where the AB-i is drawn to finance imported goods, the AB-i should also contain a statement that it was
drawn to finance the purchase of goods from a non-resident, and that details are in the records of the
drawing bank.

Since the AB-i is denominated in ringgit, if the imports are priced in a foreign currency, the amount is
converted into an equivalent ringgit value for the purpose of the AB-i. The formula shown below is used
to achieve this.

The face value of AB-i purchase is calculated using the following formula:

 rt 
FV = IV 1  
 36,500 

Where:
FV = Face or maturity value of the bill (re-sale price)
IV = Invoice value for original cost of goods
r = Annual rate of profit (per cent per annum)
t = Number of days remaining to maturity

E X A M P L E

Goods costing the equivalent value of US$1,000,000 are purchased under an AB-i purchase arrangement.
The AB-i of US$1,000,000 is financed under an AB-i-purchase for 120 days at 5.0% per annum. The face
value of the AB-i is calculated as follows:

 5.0  120 
FV = IV 1  
 36,500 

= US$1,000,000 (1 + 0.0164384)
= US$1,000,000 (1.0164384)
= US$1,016,438.36

This is the amount of the AB-i that the bank should draw on the importer for the re-sale of the imported
goods, with maturity 120 days after acceptance.

5 AB-i for exports (AB-i sale)

An arrangement for providing finance to an exporter is different. It does not involve the re-sale of goods
under a murabahah agreement, and the bill of exchange is drawn by the exporter on the bank.

The arrangement is as follows:

1 An exporter requires financing for the export of goods to a foreign buyer.

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2 The exporter arranges for the sale of the goods to the buyer on deferred payment terms. (The
sale to the foreign buyer may be on documentary credit terms.)

3 The exporter submits required documents to the bank, and the bank buys the documents. This
gives the bank the right to receive the eventual proceeds of the payment by the importer. This
creates a debt, owed by the bank to the exporter.

4 The debt is securitised by means of a bill of exchange-i, drawn by the exporter on the bank.

In Malaysia, this must be for a specified amount in ringgit, and for a multiple of RM1,000.

5 The bill is accepted by the bank and sold at a discount in the secondary market under the
bai al-dayn principle. The proceeds from this sale are paid to the exporter.

E X A M P L E

Let's consider an AB-i drawn to finance sales:

 Payable in ringgit to the order of the drawer and should be payable.

 Payable on a specified future date, not earlier than 21 days from the date of acceptance.

 For a specified amount of not less than RM50,000 and in multiples of RM1,000.

 At the Head Office, Central Office or Main Office of an Islamic bank or a commercial bank in Kuala
Lumpur.

Where the AB-i is to finance exports, it should also contain a statement that it was drawn to finance the
sale of goods to a non-resident and details of the sale are in the records of the accepting bank.

The usance period of the AB-i must not exceed the remaining credit period extended by the
drawer (exporter) to the purchaser of the goods.

The trading proceeds from the sale of an AB-i (under bai al-dayn) are calculated as follows:

 rt 
P = FV 1  
 36,500 

Where
P = Market price/trading proceeds
FV = Face or maturity value of the bill
r = Annual rate of profit (per cent per annum)
t = Number of days remaining to maturity

E X A M P L E

An exporter sells goods to a foreign buyer and under an AB-I sale agreement, draws an AB-i of
US$1,000,000 with 120 days to maturity. This is sold in the secondary bills market at 5.0% per annum.
The sale proceeds will be:

 5.0 × 12 
P = US$1,000,000 1 – 
 36,500 

= US$1,000,000 (1 – 0.0164384)
= US$1,000,000 × 0.9835616
= US$983,561.60

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5.1 Purchasing outward bills of exchange

In addition to financing exporters under an AB-i arrangement, a bank will also purchase outward bills for
collection on an open account basis, and credit the exporter’s account immediately with the proceeds.

6 Working capital financing-i

Islamic banks will provide finance for working capital.

The arrangement may be called murabahah working capital, and it involves:

 A property purchase agreement (PPA) for cash.

 A property sale agreement (PSA) on deferred terms at a higher price.

A specific commodity or item is identified as the underlying asset for the transaction, such as a quantity
of zinc, tin, lead, palm oil or wheat. The bank buys this asset for cash and re-sells it at a price that
includes a profit margin.

Figure 9.2: Working capital financing-i arrangements

Arrangement 1 Arrangement 2

Customer Seller Customer/buyer

Bank Bank re-sells goods at Bank buys Bank re-sells

purchases agreed mark-up, say regular at a profit
goods 10%, on deferred deliveries of (murabahah)
payment terms goods for cash
(say 3 months)

Bank Bank

7 Islamic FX forward
Conventional forward foreign exchange contracts do not comply with the Shariah rule that the exchange
of two currencies should be made on a spot basis.

There are two Shariah-compliant alternatives for arranging a forward transaction, to buy or sell currency
in order to hedge the currency risk in a trading transaction:

 Islamic forward based on wa’d

 Islamic forward based on tawarruq

7.1 Islamic forward based on wa’d

Wa’d is a unilateral promise, given by one person to another. (It differs from a contract, where the two
parties each give a promise to the other.)
When a forward transaction is based on wa’d, the customer makes a unilateral promise to buy or sell a
quantity of currency, for settlement at a future value date.
For example, a customer may give a unilateral promise to its bank that it will buy US$1,000,000 at a
specified future date and pay €1,374,400 in exchange.
At settlement/value date, the customer is required to fulfil its promise.

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7.2 Islamic forward based on tawarruq

Tawarruq usually involves an arrangement where a buyer purchases an asset from a seller on deferred
payment terms and then:

 Sells the asset to a third party for cash at a price that is lower than the deferred payment price in
the first transaction.

 Uses the cash raised by selling the asset to a third party to make the deferred payments to the
seller.

This concept is applied to forward currency transactions as described in the following case study.

C A S E S T U D Y

Suppose that a customer wants to buy €13.5million in exchange for US$10 million, for settlement at a
future date.

The customer will be receiving US$10 million for the sale of goods at that future date, so there is an
underlying transaction in goods, and an exposure to currency risk that the customer wishes to hedge.

The forward transaction can be arranged as follows:

1 The customer buys commodity goods valued at US$10 million from Broker A on deferred payment
terms.

2 The customer sells the commodity goods to its bank for €13.5 million, on deferred payment terms
and for the same value date.

3 The bank re-sells the goods to Broker B for US$10 million, on deferred payment terms and for the
same value date.

At value date:

 The bank receives $10 million from Broker B.

 The bank pays €13.5 million to the customer, and the customer receives the €13.5 million.

 The customer receives US$10 million from the sale to the foreign buyer, and uses this money to
pay Broker A.

This is illustrated in the following diagrams.

Figure 9.3: Islamic forward based on tawarruq process

1: Arranging the transaction (all transactions on deferred payment terms)

Broker A Customer
Buy goods for US$10 million

Sell goods for €13.5

million

Broker B Sell goods for US$10 million Bank

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2: Settlement

Broker A Customer
US$10 million

€13.5 million

Broker B US$10 million Bank

8 Guarantees
An Islamic bank can provide guarantees on the basis of kafalah. Kafalah is a pledge given by a
guarantor to a creditor on behalf of a third party. This concept provides the basis for Shariah-compliant
guarantees from an Islamic bank, such as:

 Shipping guarantees-i
 Bank guarantees-i

The bank undertakes responsibility in case of default or non-performance by the third party.

With convention (non-Islamic) bank guarantees, the bank’s charge for commission depends on the
perceived risk that the beneficiary will make a demand for payment under the terms of the guarantee,
the amount of the payment guarantee and the length of time to expiry of the guarantee. With Islamic
bank guarantees (guarantees-i) the commission charged by a bank does not vary with the duration or
time to expiry of the guarantee.

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Chapter roundup

 Islamic banks provide Shariah-compliant financing and foreign exchange transactions that are similar to
conventional banking arrangements.

 A letter of credit-i is similar to conventional letter of credit. A L/C-i is based on either the wakalah
principle (where the only requirement is for a guarantee of payment from the importer’s bank) or the
murabahah principle (where the letter of credit is also required to provide finance for the purchase of
imported goods).

 Accepted bills-i are similar to conventional bankers’ acceptances. However an arrangement for providing
import finance involves the re-sale of goods to the importer by the bank (under a murabahah
arrangement) and a bill of exchange drawn by the bank on the importer.

 An AB-i arrangement for providing export credit to the exporter involves a letter of credit drawn by the
exporter on the bank.

 Spot foreign exchange transactions are Shariah-compliant but transitional forward foreign exchange
contracts are not. Islamic banks can arrange FX forwards based on either the principle of wa’d (unilateral
promise by the bank’s customer) or tarrawuq.

 A forward based on tarrawuq involves the customer and the bank making a transaction in a commodity
on deferred payment terms with a third party dealer or broker.

 Islamic banks provide guarantees, including shipping guarantees, in arrangements based on the concept
of kafalah.

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218
GLOSSARY

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220
 GLOSSARY

Glossary
Arbitration A form of alternative dispute resolution (ADR), is a technique
for the resolution of disputes outside the courts, where the
parties to a dispute refer it to one or more persons, by whose
decision they agree to be bound.

Aval A guarantee added to a debt obligation by a third party who is

not the payee or the holder, but who ensures payment should
the issuing party default. The debt obligation could be a note,
bond, promissory note, bill of exchange or draft. The third
party providing the aval is usually a bank or other lending
institution.

Bank bill A bill of exchange that is drawn on a bank. In international

trade, banks will often allow a customer to draw a bill on the
bank, as an arrangement for providing export or import
(buyer) finance. Bank bills are used with documentary credits,
which are described in the next chapter.

Bank guarantee A guarantee from a lending institution (bank) ensuring that

the liabilities of a debtor will be met. In other words, if the
debtor fails to settle a debt, the bank will cover it.

Banker’s acceptance (BA) A short term debt instrument issued by a company that is
guaranteed by a commercial bank. BA’s are issued by
companies as part of a commercial transaction, regularly used
in international trade. They are similar to T-bills (short term
debt instruments backed by the US government) and are
frequently used in money market funds. They are traded at a
discount from face value which means that they do not need
to be held until maturity.

Banker’s draft A bank cheque where the funds are taken directly from the
financial institution rather than the individual drawer's
account.

Bid bond A debt secured by a bidder for a construction job, or a similar

selection process for the purpose of providing a guarantee to
the project owner that the bidder will take on the job if
selected. The existence of a bid bond provides the owner with
assurance that the bidder has the financial means to accept
the job for the price quoted in the bid.

Bill of Lading A legal document between an exporter and the carrier

detailing the type, quantity and destination of the goods being
carried. It also serves as a receipt of shipment when the
goods are delivered to a pre-determined destination, and must
be signed by an authorised representative of the exporter,
carrier, and receiver.

Call option Gives its holder the right to buy, but not the obligation, a
specified quantity of an underlying item on or before a
specified future date (the expiry date for the option) at a fixed
price; this is known as the exercise price or strike price for the
option.

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Currency risk A form of risk that arises from the change in price of one
currency against another. Whenever investors or companies
have assets or business operations across national borders,
they face currency risk.

Demand guarantee A type of protection that one party in a transaction can

impose on another party in the event that the second party
does not perform according to predefined specifications. In
the event that the second party does not perform as
promised, the first party will receive a predefined amount of
compensation by the guarantor, which the second party will
be required to repay.

Escrow A financial instrument held by a third party, on behalf of the

other two parties in a transaction. The funds are held by the
escrow service, until it receives the appropriate oral or written
communication, or until obligations have been fulfilled.
Securities, bank funds and other assets can be held in escrow.

Export financing schemes Provide all the finance support services exporters need, to
develop business in foreign markets.

Financing risk The risk that an exporter or importer may be unable to

finance their transactions.

Forex Trading Often abbreviated to FX. Trading currencies from different

countries against each other. Forex is acronym of Foreign
Exchange.

Forfaiting The purchasing of an exporter's receivables (the amount

importers owe the exporter) at a discount by paying cash. The
forfaiter, (the purchaser of the receivables) becomes the
entity to whom the importer is obliged to pay its debt.

Hedging The process of making an investment to reduce the risk of

adverse price movements in an asset. Normally, a hedge
consists of taking an offsetting position in a related security,
such as a futures contract.

Letter of credit (L/C) Letter from a bank guaranteeing that a buyer's payment to a
seller will be received on time and for the correct amount. In
the event that the buyer is unable to make payment on the
purchase, the bank will be required to cover the full or
remaining amount of the purchase.

Letter of Credit-i A letter of credit issued by an Islamic bank that guarantees

payment by a buyer (the applicant for the L/C), provided that
the supplier complies with the terms and conditions of the
L/C. If the buyer does not honour the payment, the bank will.

Most-favoured-nation (MFN) This is the principle of treating countries equally.

principle

Murabahah An acceptable form of credit sale under Shari’ah law, where

the intermediary retains ownership of the property until the
loan is repaid in full.

National treatment This is the principle that countries should treat imported
goods and domestically-produced goods equally.

222
 GLOSSARY

Nostro account A bank account held in a foreign country by a domestic bank,

denominated in the currency of that country. Nostro accounts
are used to facilitate settlement of foreign exchange and trade
transactions. The term is derived from the Latin word for
'ours'.

Open account A method of settling payment for trade transactions. The

supplier ships the required goods to the buyer who, after
receiving and checking the related shipping documents,
credits the supplier's account in their books with the invoice
amount. Over 80% of global trade is now conducted on ‘open
account’. This is the same method of conducting trade as in
domestic trading.

Overdraft An extension of credit from a lending institution when an

account reaches zero. It allows the individual to continue
withdrawing money even if the account has no funds in it.
Basically the bank allows people to borrow a set amount of
money.

Performance bond A bond issued to one party of a contract as a guarantee

against the failure of the other party to meet obligations
specified in the contract.

Political risk The risk that political events, such as war, may disrupt
international trade, making it impossible for exporters to
deliver goods to buyers in a country where the events occur.

Protesting A more formal process than noting. The ‘notary public’ issues
a formal deed of protest. This document provides formal
evidence of the presentation of the bill to the drawee and the
reason for dishonouring the bill.

Put option Gives its holder the right, but not the obligation, to sell a
specified quantity of an underlying item on or before a
specified future date (the expiry date for the option) at a fixed
price; this is known as the exercise price or strike price.

Regulatory risk The risk that:

 The seller or the buyer fails to comply with regulatory
requirements.
 New regulations may be introduced that make
international trade more difficult or more expensive.

Sight bill A bill that must be paid immediately on presentation to the

drawee. It is payable ‘at sight’. The drawee demonstrates his
willingness to pay the bill by making the immediate payment.

Sight payment letter of credit A letter of credit that is payable once it is presented along
with the necessary documents. An organisation offering a
sight letter of credit commits itself to paying the agreed
amount of funds, provided the provisions of the letter of credit
are met.

SWIFTnet (TSU) The TSU provides a service that will allow the financial supply
chain to mirror the physical supply chain.

223
 INTERNATIONAL TRADE FINANCE

Takaful A type of Islamic insurance, where members contribute

money into a pooling system in order to guarantee each other
against loss or damage. It is based on Shari’ah, Islamic
religious law, and explains how it is the responsibility of
individuals to co-operate and protect each other.

Tested Teletransmission (T/T) An electronic means of transferring funds overseas. By using

this method, the funds are generally available within 24 hours,
and can be tracked in the meantime.

Trade bill A bill of exchange which is a demand for the payment of a

trade debt, where the drawee is a non-bank organisation. In
international trade, a trade bill would be drawn by the
exporter on the importer, as an order to make a payment.

Trust receipt Notice of the release of merchandise to a buyer from a bank,

with the bank retaining the ownership title to the released
assets. In an arrangement involving a trust receipt, the bank
remains the owner of the merchandise, but the buyer is
allowed to hold the merchandise in trust for the bank, for
manufacturing or sales purposes.

Usance The allowable period of time, permitted by custom, between

the date of a bill and its payment. The usance of a bill varies
between countries, often ranging from two weeks to two
months. Usance is derived from the action of usury.

Usance bill (or term bill/time bill) A bill that is presented to the drawee for payment at a future
date. When it is drawn, a bill is an order to pay, and not a
promise by the drawee to make the payment. The drawee is
required to indicate his willingness to make the payment by
‘accepting the bill’.

Value date A future date used in determining the value of a product that
fluctuates in price. Typically, you will see the use of value
dates in determining the payment of products and accounts
where there is a possibility for discrepancies due to
differences in the timing of valuation. Such products include
forward currency contracts, option contracts, and the interest
payable or receivable on personal accounts. Also referred to
as 'valuta'.

Vostro account Accounts that are held by the domestic bank in its home
country for foreign banks. The term is derived from the Latin
word for 'yours'.

Wakalah An arrangement in which one person (the principal) empowers

another person (an agent) to perform an act for him. The
agent stands in the place of the principal in the performance
of the act.

Waybill A receipt for goods and a contract for carriage of the goods. It
is used for the purpose of transporting the goods and is not a
document of title to the goods.

224
INDEX

225
 INTERNATIONAL TRADE FINANCE

226
 INDEX

AB-i for exports (AB-i sale), 212 Cheque, 35

Clean bill of lading, 13
AB-i for imports (AB-i purchase), 211 Clean collection, 48
Acceptance letter of credit, 76 Clean payments, 35
Accepted bills-i (AB-i), 210 Close out of forward contract, 150
Advance payment guarantee, 119 Collection, 41
Advantages of documentary collection, 64 Collection account, 39
Advising bank, 82 Collection instruction, 57
Anti-money laundering, 102 Collection order, 57
Anti-Terrorism Financing Act 2001, 102 Combined transport bill of lading, 14
Applicant or principal, 115 Commencement date for a guarantee, 124
Application for a letter of credit, 83 Commercial invoice, 19
Arbitration, 3 Competition in foreign markets, 2
Ask rate, 141 Complying demand, 126
Asset conversion financing, 167 Conditional guarantee, 116
Asset-backed financing, 186 Confirming bank, 82
Asymmetrical return, 153 Consular invoice, 19
Aval, 122 Cost, insurance and freight value (CIF), 20
Costs of transportation, 23
BA purchase, 174 Counter-guarantee, 116, 123
Counter-purchase agreement, 43
BA sale, 174, 177
Countertrade, 42
Back-to-back credits, 97
Credit risk, 4
Bank bill, 54
Credit takaful, 204
Bank guarantee, 113
Cross rates, 142
Bank guarantees-i, 216
Currency option, 152
Bank letter of credit policy (BLCP), 203
Currency risk, 5, 8, 144
Bank transfers, 37
Currency risk on foreign trade transactions, 147
Banker’s acceptance (BA), 174
Banker’s draft, 40
Barter, 43 Dealing in foreign currencies, 139
Base currency, 140 Deferred payment letter of credit, 76
Beneficiary, 115 Demand guarantee, 117, 126
Bid bond, 119 Demurrage charges, 132
Bid rate, 141 Development financial institution (DFI), 194
Bid-offer spread, 141 Direct export factoring, 182
Bilateral payments arrangement agreement, Direct guarantee, 115
204 Discounting a BA, 180
Bill of exchange, 54 Discounting of bills, 167
Bill of exchange-i, 213 Discrepancies in the documentation, 90
Bill of Lading, 12 Documentary collection, 35, 48, 49, 107
Buyer financing, 165 Documentary collection process, 49
Buying rates, 142 Documentary credit (L/C), 72
Documentary letter of credit, 35
Call option, 152 Documentary payment, 35
Documents against acceptance (D/A), 56
Card payments, 38
Documents against payment (D/P), 56
Carriage and insurance paid to (CIP) value, 20
Domestic trade, 2
Carriers, 10
Drawee, 49
Case of need, 58
Duty-exempt guarantee, 122
Cash cycle, 166
Cash flow financing, 167
Certificate of inspection, 23 Electronic bills of lading, 19
Certificate of origin, 22 Electronic documentation, 90
Certificate of performance, 196 Escrow, 186
Charter party bill of lading, 14

227
 INTERNATIONAL TRADE FINANCE

Escrow accounts, 186 Incoterm definitions, 25

eUCP 600, 90 Incoterm specifications, 26
Exchange Control Act 1953, 159 Incoterms, 24
Exchange control of Malaysia notices (ECMs), Indirect exporter, 194
160 Indirect guarantee, 116
Exchange controls, 5, 158 Instalment drawings and shipments, 84
Exchange rate volatility, 143 Insurance certificate, 20
Exchange rates and margins (spreads), 142 Insurance policy, 20
Exim bank, 194 International chamber of commerce (ICC), 24,
Expiry of a guarantee, 125 58
Export credit insurance, 201 International standby practices, ICC publication
Export credit risks, 202 number 590 (ISP98), 128
Export credit takaful, 204 International trade, 2
Export factoring, 181 International trade transactions, 10
Export financing, 165, 166 International v Domestic trade, 2
Export financing schemes, 194 Invoice discounting, 183
Export receivables-backed finance, 188 Islamic forward based on tawarruq, 215
Exporter, 2 Islamic forward based on wa’d, 214
Extension of a guarantee, 126 Islamic FX forward, 214
Extension of forward contract, 151 ISP98: Examination of documents, 130
ISP98: General principles, 128

Factoring without recourse, 182 ISP98: Notice, 130

ISP98: Obligations, 128
Finance for operations, 4 ISP98: Presentation, 129
Financing risk, 8 Issuing bank, 82
Fixed forward contract, 148
Force majeure, 126
Foreign currency accounts, 39 Kafalah, 216
Foreign currency options, 152 Know your customer, 102
Forex Trading, 139
Forfaiting, 184
Forward foreign exchange contract, 145
Letter of credit (L/C), 72
Forward rates, 145 Letter of credit available by negotiation, 76
Foul bills of lading, 13 Letter of credit with recourse, 76
Freight charges, 15 Letter of Credit-i, 208
Freight cost, 23 Liquidation of a BA, 178
Freight forwarders, 10
Freight prepaid, 15 Methods of payment, 34
Freight to collect, 15
Mid-point rate, 141
Most-favoured-nation (MFN) principle, 7
General agreement on trade and tariffs Multi-currency trade finance (MCTF) scheme,
(GATT), 6 204
Green clause letters of credit, 100 Multilateral agreements, 6
Guaranteed acceptance, 122 Multimodal bill of lading, 14
Guarantor, 115 Murabahah, 209

Hedging, 155 National treatment, 7

Negotiable bills of lading, 13
Negotiating bank, 82
ICC rules for guarantees, 123 Negotiation of bills, 168
ICC uniform customs and practice for Non-complying demand, 126
documentary credits: UCP 600, 92 Nostro account, 139
Import financing, 165 Notice of dishonour, 130
Importer, 2

228
 INDEX

Ocean bill of lading, 14 Selling rates, 142

Off-balance sheet financing, 187 Settlement of sight bills, 93
Offer rate, 141 Settlement of usance bills, 93
Offset, 43 Shipment of the goods, 3
Offset arrangement, 43 Shipping guarantees, 132
Offtake agreement, 187 Shipping guarantees-i, 216
Offtaker, 187 Sight bill, 54
On board bill of lading, 14 Sight imports, 171
Open account, 34, 35 Sight payment letter of credit, 75
Option forward contracts, 148 Silent confirmation, 81
Order-based method of pre-shipment financing, Society for Worldwide Interbank Financial
195 Telecommunication (SWIFT), 38
Overdraft, 167 Spot FX transaction, 140
Overdraft facility, 167 Spot rates, 141
Stale bill of lading, 15

Packing list, 23 Standby letter of credit, 114, 127

Straight bill of lading, 13
Participation forward contract, 154 Structured trade and commodity finance
Paying bank, 82 (STCF), 169
Payment by cheque, 40 Structured trade finance (STF), 168
Payment by collection, 41 SWIFT message, 86
Payment by negotiation, 41 SWIFT messaging system, 39
Payment guarantee, 122 SWIFTnet Trade Service Utility (TSU), 39
Performance bond, 119 Symmetrical return, 153
Political risk, 9
Port-to-port bill of lading, 14
Post-shipment finance, 168, 195 T/T reimbursement, 83
Pre-payment financing, 188 Takaful, 201
Presentation of documents, 92 Tawarruq, 214
Pre-shipment finance, 168 Term bill, 54
Problems with documentary collections, 63 Tested Teletransmission (T/T), 83
Promissory note, 185 Through bill of lading, 14
Protesting, 62 Time bill, 54
Purchased with recourse, 41 Tolling agreement, 187
Put option, 152 Tolling finance, 187
Trade bill, 54

Range forward option, 153 Trade cycle, 166

Trade-based money laundering, 103
Received for shipment bill of lading, 14 Trading on open account terms, 103
Recourse, 41 Transaction currency, 4
Red clause letter of credit, 99 Transferable credit, 94
Regulations on foreign trade, 5 Transferable standby, 130
Regulatory risk, 9 Translational FX exposure, 158
Reimbursing bank, 83 Transport documents, 12
Reporting suspicious transactions, 102 Trust receipt, 171
Repurchase arrangement, 187 Trust receipt-i, 210
Resolution of disputes, 3 Two-factor export factoring, 182
Retention money guarantee, 120
Revolving letter of credit, 101
Risk-based approach to anti-money laundering, Uniform customs and practice UCP 600, 73, 88
104 Uniform rules for collections (URC 522), 58, 65
Risks in international trade, 8 Uniform rules for contract guarantees (URCG
Roll on, roll off (RORO) transportation, 11 325), 123
Uniform rules for demand guarantees: URDG
758, 123

229
 INTERNATIONAL TRADE FINANCE

Usance, 168
Usance bill, 54, 175
Wa'd, 214
Usance letters of credit, 93 Wakalah, 208
Usance/time bill, 76 Warehouse receipt financing, 189
Warehousing finance, 168
Warranty guarantee/maintenance bond, 120
Value date, 149 Waybill, 13, 17
Value date option contract, 149 Wolfsberg trade finance principles, 103
Variable currency, 140 Working capital cycle, 166
Vendor financing, 181 Working capital financing-i, 214
Vostro accounts, 139 World trade organisation (WTO), 6

230
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