Appendix 16 Trade Finance

Appendix 16 Trade Finance Trade finance is the term used to describe the means by which companies finance and secure payment for the provision of goods and services. It is usually used to describe international import/export activity but can equally be used to cover domestic trade. Most people are familiar with the use of invoices you buy something, you get an invoice, and then you pay. Trade finance of course is based on these principles but innumerable ways have been invented to help people get over the tricky period of uncertainty between the issue of the invoice, delivery and payment. There are always worried exporters concerned that an importer will not pay them, or who can no longer wait for payment in 6 months time, and importers worried that the goods they receive will not be those they have paid for or that they may not turn up at all. So Enter the banks, who for a fee are willing to absorb these risks, or at least make them easier to manage and/or less likely to materialize. The transactions involved in this area of finance generally incorporate one or more of the following arrangements: payment terms and arrangements dictating when payments can be released; payment structures describing the route that funds take to move from the importer to the exporter; financing arrangements allowing for deferred payment; guarantees providing comfort to the creditor that the bank s customer will pay the creditor the funds he is owed; products designed to represent the above arrangements in more or less standard terms that are familiar to market participants; and/or arrangements designed to accelerate payments to suppliers without impacting the purchaser. The various trade finance instruments offer different levels of security in terms of securing payment for delivery of goods and vice versa. In descending order of security, payment for goods can be made in the following way: Payment Pre-payment Letter of Credit Promissory note, bill of exchange (payable by a bank) Documentary collection, promissory notes and bills of exchange (not payable by a bank) Open account Comment Payment is received by the supplier before goods are sent, no need for bank intervention See below. See below. See below. Goods are shipped before payment is received. The remainder of this appendix describes the main trade finance instruments and services before going on to consider some of the key areas of interest for Compliance 1

Officers. Note that surety bonds are also covered in this section as they are generally considered to fall within the scope of trade finance even though their usage is somewhat different from the other products and services in this field. Product Bill of exchange Basic characteristics What is a bill of exchange? A bill of exchange is an unconditional order, written by one person (the drawer) and addressed to another person (the drawee) to pay a specified sum of money. A bill of exchange is sometimes referred to as a draft. Bills of exchange may be payable on demand (i.e. whenever they are presented for payment) in which case they are referred to as sight bills. Other bills of exchange incorporate deferred payment terms and are payable on a specified date in the future, in which case they are referred to as term bills. These are with recourse documents which means that if the person from whom the holder was due to received funds does not pay, any of the previous holders (persons to whom the paper has been endorsed) may be approached for payment (unless this has been specifically waived on the document). Contrast this with promissory notes (see below) which are similar documents, but without recourse. Purpose Bills of exchange are used to help to secure payment for goods Who issues bills of exchange? Who buys bills of exchange? How does a bill of exchange work? delivered ahead of payment. Bills of exchange are issued or drawn by a company, known as the drawer, that is supplying good or services to a customer. (Note how this differs from promissory notes (see below) which are prepared by the buyer, rather than the supplier.) When bills of exchange are traded on the secondary market trading is largely restricted to financial institutions. For a bill of exchange to be valid it must be accepted by the drawee, which involves the drawee signing the bill and placing his stamp on it. Such bills will normally be used in conjunction with another trade product such as a letter of credit (see below) to provide third party security. Alternatively, the bill of exchange may initially be drawn up with the buyer s bank as the payor (drawee), in which case the bank will need to accept the bill. This sort of bill of exchange is known as a banker s acceptance. As bills of exchange are unconditional undertakings to pay, they are not dependent on any conditions being met by the seller even if the seller does not deliver the goods the payment must still be made on the date specified. This is clearly risky so they are generally used in conjunction with other supporting documentation such as a bill of lading (see below) to evidence that goods have been despatched. The seller will only release the relevant supporting documentation to the buyer once the buyer has accepted the bill of exchange. 2

Risk profile Regulated status under FSMA (RAO) Sometimes bills of exchange are avalized or endorsed by a bank which means that the bank has taken on the responsibility to pay the sum that the bill represents if the drawee cannot meet his payment obligation. This happens when the drawer is not confident of the drawee s ability to pay and requires additional comfort that the debt will be honoured. The bill of exchange does not necessarily bind the drawee to pay the actual provider of goods or services as the bill may be traded in the secondary market. In this instance the funds will be paid to a third party who was not involved with the transaction to which the bill relates. The holder of a bill of exchange may decide that he requires the cash value of the bill prior to maturity in which case he may sell the instrument. Ownership of a bill of exchange is transferred by the endorsement of the back of the document by an authorized employee of the drawer (or bona fides holder if the bill has already been assigned by the drawer) over to the purchaser, who will then receive the face value of the bill at maturity. Bills of exchange do not themselves pay any interest although they may incorporate an amount representing interest in return for credit if there are deferred payment terms. Also, if bills of exchange are traded on the secondary market they are generally sold at a discount to face value with the discount amount representing a form of interest. The risk profile of a bill exchange varies according to the credit rating of the drawee or whether or not the bill has been avalised by a bank (and if so, the credit rating of that bank). Bills of exchange are not designated investments and are regulated under FSMA only if they have been accepted by a bank. Negotiability There is a secondary market for bills of exchange, though only those of good credit worthiness are truly liquid. Trading takes place by means of physically endorsing the back of the bill in favour of the buyer. Exchange involvement Clearing and settlement Evidence of ownership Trade reporting Bills of exchange do not trade on exchange (although there have been some (largely unsuccessful) attempts to establish electronic platforms for market participants to show what they have, what they want and the prices at which they are willing to buy and sell). There is no electronic clearing or settlement system for bills of exchange so when a bill is traded it has to be sent by the seller, along with any accompanying trade documentation, to the buyer. Bills of exchange are physical documents. Each bill clearly shows who it is payable to and if a bill is traded so that the person due to receive the funds changes, this will be noted by endorsing the back of the bill with the new creditor s details. There are no trade reporting requirements. 3

(to exchange) Transaction There are no transaction reporting requirements. reporting (to FSA) Documentation When a bill of exchange is traded on the secondary market it will be sent physically from buyer to seller along with other documentation associated with the transaction, such as: a copy of the contract; the original invoice in relation to which the bill of exchange was drawn; the bill of lading (see below) showing that the goods have been shipped; airway bill (see below) showing that the goods have been placed on the plane; an insurance contract covering the goods in transit; or a certificate of origin confirming that the goods are of the exact nature required by the purchaser. Trades are generally acknowledged in writing by an authenticated SWIFT message. There is an internationally recognised format for bills of exchange Pricing The price of the bill of exchange on the secondary market will depend on the credit worthiness of the issuer and avalising bank (if there is one). The discount from face value will also depend on the margin over LIBOR that could be obtained from other instruments over the same time period. Duration Maturities generally vary between 1 and 12 months although Risks for drawer/ holder/buyer some contracts are very long, extending even over 20 years. The drawee may not be able to meet his payment obligations. The drawer may need his cash prior to the date stipulated on the bill of exchange but may not be able to find a buyer. A secondary market buyer of a bill of exchange may only be willing to purchase it at a very deep discount. Risk for drawee The drawee may not have the funds available when it comes time to meet the payment obligations represented by the bill of exchange. The goods received by the drawee may not meet the exact specifications that were required but the drawee will still have to pay the debt. The drawee would then have to take the supplier to court for breach of contract in order to recover his funds. The drawee may not actually receive the goods ordered but will still be obliged to pay when the bill of exchange payment date is reached. The drawee would then have to take the supplier to court for breach of contract in order to recover his funds. Benefit for drawer/holder/ The exporter benefits from a bill of exchange by gaining more security that the importer s debt will be paid than by 4

buyer Benefit for drawee simply using an invoice. This is because the goods shipped will not be released to the buyer unless they present the documents of title to the shipping company, and the buyer will be given the documents of title by the seller only when the buyer has accepted the bill of exchange. Secondary market buyers of bills of exchange benefit from purchasing the instrument at a discount to the amount that will be received at maturity. With term bills of exchange the drawee benefits from deferred payment terms, thereby obtaining credit he receives the goods today but pays for them in the future. Transactions are supported by underlying documentation. Parties involved with bill of exchange transactions Drawer This is the person who is supplying goods or services and who needs to be paid the creditor. This person draws the bill of exchange. Bills of exchange are often used in international trade in which case the drawer will be the exporter. Drawee This is the person against whom the bill of exchange is written, the person who has bought goods or services and who needs to pay for them the debtor. When bills of exchange are used in international trade this person is the importer or his bank. Exporter When a bill of exchange is used in international trade the Importer exporter will be the drawer the seller of goods. When bills of exchange are used in international trade the importer will be the drawee the buyer of goods. Buyer The buyer is the person buying the goods, often importing them from overseas, who needs to pay for them and whose debt is represented by a bill of exchange. Alternatively, the term buyer may refer to a person who has bought a bill of exchange, at a discount, in the secondary market. Secondary market buyers buy the bill of exchange at a discount to face value in order to profit in future by receiving the full value of the bill at maturity. In the secondary market the buyer is almost invariably a bank. Seller The seller is the person selling the goods, often exporting them overseas, who has extended credit to a buyer and who draws a bill of exchange to represent that debt. Alternatively, the term seller may refer to a person who has sold a bill of exchange, at a discount, in the secondary market. Secondary market sellers need cash now, rather than at the date on which the bill of exchange matures and are therefore 5

Holder Avalising bank willing to accept less than face value for the bill in order to meet their immediate funding needs. The holder of a bill of exchange is either the exporter, drawer, or a person, normally a bank, who has bought the bill on the secondary market. A bank that has avalised a bill of exchange thereby guaranteeing to pay the amount of the bill if the original drawee fails to do so. Product Basic characteristics What is a letter of credit? Letters of credit A letter of credit is a formal undertaking, by a bank, to pay against documents presented in accordance with the terms established by that letter of credit. The term letter of credit is often shortened to L/C. L/Cs are also referred to as documentary credits. Purpose Letters of credit are used by exporters to obtain increased certainty that they will obtain payment for goods that they have exported, providing they present documents in accordance with the terms established in the L/C. Because of this increased certainty of payment, letters of credit are generally used when the seller does not know the buyer well, or when the buyer has no track record with the seller. The increased certainty of payment with an L/C stems from the fact that it is the importer s bank that guarantees payment of the invoice rather than the importer. For added security a bank in the exporter s own jurisdiction may be contracted to confirm the L/C which has the effect of guaranteeing the obligations of the issuing bank. As L/Cs are used in conjunction with documentation to support the underlying trade they can assist in avoiding trade disputes. Who issues letters of credit? Who buys letters of credit? How does a letter of credit work? Letters of credit are issued or opened by an importer s bank, at the request of the importer. Where L/Cs are traded on the secondary market the buyers are almost invariably banks. Although the basic premise of an L/C is simple they are used by an exporter to secure payment - their use can appear complex and involves several parties other than the importer and exporter themselves. An example of how a basic letter of credit arrangement may work is provided below. The importer and exporter agree a transaction and the exporter wants additional comfort that the importer will pay for the goods he receives. The exporter therefore requires the importer to obtain an L/C to ensure payment. The importer instructs his bank to open an L/C in favour of the exporter. This bank is then known as the issuing bank. The L/C will contain the key aspects of the transaction 6

including: the amount to be paid by the issuing bank; the identity of the importer; the identity of the exporter; a payment undertaking from the issuing bank to the exporter; the documentation that must be presented for the payment to take place; key specifications relating to the documentation required to be presented; the place where the documentation must be presented; the timeframe within which the documentation must be presented; and the expiry date of the L/C. The issuing bank opens the L/C and sends it to the exporter s bank of choice. This bank is known as the advising bank. The advising bank then authenticates the L/C, normally using SWIFT authenticated keys, and sends it to the exporter. Once he has the L/C, the exporter ships the goods and sends the required documentation to support the underlying trade to the negotiating and/or confirming bank. The negotiating/confirming bank will review the underlying trade documents to ensure that they comply with the specifications on the L/C. If all is in order, the negotiating or confirming bank will send the documents to the issuing bank. The issuing bank will then confirm details of the L/C, including maturity and amount to the confirming/negotiating bank. This is known as the issuing bank s acceptance. When all the documentation is in order, the importer pays the issuing bank, who will then pass the funds to the exporter, via the confirming/negotiating bank. L/Cs may be payable at sight, when all required documents have been presented to the issuing bank, or they may specify that payment should be made within a certain number of days after the documents have been presented. In this situation, the L/C will be accompanied by a bill of exchange (see above) setting out the payment requirements. The importer and exporter decide between themselves who will pay for the services of the banks involved in the transaction. Risk profile Regulated status under FSMA (RAO) Negotiability The risk profile of the L/C depends on the credit worthiness of the issuing or confirming bank. L/Cs are not designated investments and are not regulated under FSMA. There is an active secondary market in L/Cs which works by either the transfer of rights to payment (using a letter of assignment the arrangement will be disclosed to the issuing 7

Exchange involvement Clearing and settlement Evidence of ownership bank) or through risk participation (using a risk participation agreement the arrangement will not be disclosed to the issuing bank). L/Cs are not traded on an exchange. There is no electronic clearing or settlement system for letters of credit. Evidence of title to the L/C is shown by means of a letter of assignment and/or a Swift message assigning title from one person to another. There are no trade reporting requirements. Trade reporting (to exchange) Transaction There are no transaction reporting requirements. reporting (to FSA) Documentation Internationally recognized L/Cs should contain all the information specified in the International Chamber of Commerce Uniform Customs and Practice for Documentary Credits. In practice, L/Cs are issued in the SWIFT system following a standard format. In order for a payment to be made under an L/C, all the appropriate pieces of documentation supporting the underlying trade must be presented to the paying bank. Further details on documents supporting underlying trades can be found in the section below on documentary collections. Trades are also acknowledged by confirmation notes in which the buyer and seller will confirm the underlying transactional documents that the buyer wants to receive with the letter of credit. Pricing The price of the L/C on the secondary market will depend on the credit worthiness of the issuer and avalising bank (if there is one). The discount from face value will also depend on the margin over LIBOR that could be obtained from other instruments over the same time period. Duration L/C may be of virtually any duration, as agreed between buyer and seller and issuing bank. Longer term L/Cs with a duration of many years may have staggered payment dates. Risk for exporter Letters of credit can be costly to arrange, and the costs could be disproportionate to the amount of funds due to be received as a result of the trade supported by the L/C; the exporter may not be able to get the importer to pay these costs. The exporter may have difficulty assembling the documentation required to secure payment, or he may not present the documentation within the required timeframe. This could lead to payment being made late, or not at all. 8

Benefit for exporter holder The issuing bank or confirming bank may become insolvent and not able to honour their payment obligation under the L/C. If the L/C is revocable, it may be cancelled or amended without reference to the exporter. The exporter, or any subsequent holder of an L/C has a very secure instrument it is unlikely that a bank will become insolvent. The holder or exporter may decide that he needs cash prior to the date he will be paid under the terms of the L/C. If this happens, the L/C can be sold in the secondary market, at a discount to face value. Risk for importer Letters of credit can be costly to arrange, and the costs could be disproportionate to the value of goods due to be received as a result of the trade supported by the L/C; the importer may not be able to get the exporter to pay these costs. The documents presented by the exporter may vary from the exact terms specified on the L/C meaning that there is a delay while the discrepancies are resolved. Benefit for importer The importer has increased confidence that the goods he receives will be of the specification required due to the strict documentation requirements associated with L/Cs. Enables the importer to defer payment, thus gaining a form of credit. Parties involved with L/C transactions Importer The importer is required to pay for goods he has ordered and requests the issuing bank to guarantee payment on his behalf, or to open a letter of credit on behalf of the exporter. The importer is also known as the applicant. Applicant The applicant is another name for the importer. Exporter The exporter is also known as the beneficiary and is the person for whose benefit an L/C is opened. The exporter must ship the goods and supply all the documentation as required in the L/C in order to ensure payment. Beneficiary The beneficiary is the exporter who is due to be paid. Issuing bank Guarantees to make the payment on behalf of the importer, even if the importer itself does not transfer the relevant funds to it. The issuing bank is in the same jurisdiction as the importer and will normally be the buyer s relationship bank. The issuing bank is approached by the importer and asked to open an L/C on his behalf. The issuing bank must check the documentation received under the L/C and if it is in order, they must make the payment required. They will then take payment from the 9

importer and pass it to the confirming/advising/negotiating bank as applicable. The issuing bank may also be referred to as the opening bank. Advising bank The advising bank is in the same jurisdiction as the exporter. The advising bank receives the trade documents from the exporter and forwards them to the issuing bank. The advising bank also receives payment from the issuing bank and credits this to the account of the exporter. The advising bank may also be referred to as the notifying bank. There is not always a separate advising bank this role may also be taken on by the confirming or negotiating bank. Confirming bank The confirming bank is usually, but not always, the advising bank. If the exporter does not like the credit risk of the issuing bank, he may request another bank a confirming bank to guarantee the payment from the issuing bank. That way, even if the issuing bank does not meet its payment obligation the exporter will still receive the money he is due. May also be the negotiating bank see below. Opening bank Another name for the issuing bank. Notifying bank Another name for the advising bank. Negotiating bank Bank responsible for checking the L/C documentation to ensure that it complies with the agreed terms and conditions. May be the same entity as the issuing/confirming/advising bank. Sometimes also called the nominated bank. Nominated bank See negotiating bank. Different types of L/C Standby L/C Standby L/Cs are like guarantees in that a bank guarantees to pay the exporter if the importer does not make his payment in accordance with the invoice. Revocable L/C An L/C that can be amended or cancelled without the prior consent of the exporter. In practice, revocable L/Cs are not often used as they offer no benefits to the seller. Irrevocable L/C An L/C that cannot be amended in any way without the prior consent of the exporter. Confirmed L/C An L/C that has been confirmed or guaranteed by another bank Unconfirmed L/C as well as the issuing bank. An L/C that has not been confirmed or guaranteed by another bank in addition to the issuing bank. Revolving L/Cs Revolving L/Cs are used when a particular type of transaction will be undertaken on a number of occasions between the same importer and exporter. 10

Used to avoid having to implement a new L/C arrangement for each trade. Revolving L/Cs involve either the term or amount of credit relating to the arrangement being extendable either automatically, or when certain conditions are met. Transferable L/Cs L/Cs that are payable in full or in part to a party other than the exporter. May be used if the exporter has to pay a third party for the goods he has exported. Back to back L/Cs An L/C that is opened by an exporter, in favour of his supplier, using as security an L/C that has been received by the exporter from the importer s issuing bank. Have the same end result as transferable L/Cs. Red clause L/Cs Allows for the exporter to receive an initial advance for the goods before they have been shipped and the documents Green clause L/Cs confirmed. Allows for the exporter to receive an initial advance for the goods before they have been shipped and the documents confirmed as well as requiring the importer to pay for the goods to be stored at the port prior to shipment. Import L/C From the point of view of a bank, an import L/C is an L/C that the bank has opened undertaking to make a payment on behalf of one of its customers. The bank is acting on behalf of the importer. Export L/C From the point of view of a bank, an export letter of credit is an L/C that the bank is processing on behalf of an exporter. Sight L/C Deferred payment L/C Usance L/C An L/C that is payable immediately on presentation of documents. Payment will be made at a fixed time after the documents have been presented and approved. Future payment is documented on the L/C itself and a bill of exchange is not used to further evidence payment terms. Same as a usance L/C. See deferred payment L/C. Product Basic characteristics What is a promissory note? Promissory notes A promissory note is a written without recourse undertaking by a buyer of goods, often an importer, to pay a supplier, often an exporter, for goods that have been received. Without recourse means that the holder of the note cannot make a claim for payment from the person they purchased the paper from, or from the persons who were party to the underlying transaction. They have recourse only to the avalising bank (if there is one). Contrast with bills of exchange (above) which are similar documents, but with 11

Purpose Who issues promissory notes? Who buys promissory notes? How does a promissory note work? Risk profile Regulated status under FSMA (RAO) recourse. Promissory notes are frequently likened to cheques in that they are written by the person who has an obligation to pay. The use of a promissory note is a way for a supplier to give credit to a customer so in this way a promissory note is an instrument giving formal acknowledgement to an underlying debt through an internationally recognised debt instrument. Promissory notes are issued by a buyer/importer in order to formally acknowledge his debt to a supplier/exporter. (Note how this differs from bills of exchange (see above) which are drawn by the supplier/exporter, rather than the buyer/importer.) When promissory notes are traded on the secondary market trading is largely restricted to financial institutions. The buyer of goods prepares or issues a promissory note setting out the amount of money that he is undertaking to pay, and the person to whom the money is payable. Promissory notes are unconditional undertakings to pay, so they are not dependent on any conditions having been met by the seller. Even if the seller does not deliver the goods the payment must still be made. Some promissory notes show a specific maturity date when the funds have to be paid, whereas others are demand promissory notes that must be paid whenever the holder requests payment. Promissory notes may be payable in one single payment or are sometimes interest bearing or payable in instalments. If the holder of a promissory note decides that he needs the money prior to the due date on the note, he may sell the note to a third party, at a discount, in order to receive funds immediately. This transfer of the promissory note is undertaken by endorsing the note and changing the details of the previous bona fides holder. Promissory notes may be avalised by banks to give the seller additional security. The risk profile of a promissory note varies depending on the credit worthiness of the issuer, and whether it is avalised by a bank. Promissory notes are not designated investments and are not regulated under FSMA. Negotiability There is an active secondary market in promissory notes. Trading takes place by means of physically endorsing the back of the bill in favour of the buyer. Exchange involvement Clearing and settlement Promissory notes are not exchange-traded instruments. There is generally no electronic clearing or settlement system for promissory notes, so when a note is traded it has to be sent by the seller, along with any accompanying trade 12

documentation, to the buyer. However, some notes may be settled through Euroclear. Sellers have 2 weeks after the trade to provide the buyer with the relevant documents. Trade reporting There are no trade reporting requirements. (to exchange) Transaction There are no transaction reporting requirements. reporting (to FSA) Documentation When a promissory note is traded supporting documentation such as a bill of lading or an airway bill will also be transferred from seller to buyer. There is an internationally recognized standard format for promissory notes. Transactions are also acknowledged by authenticated SWIFT. Pricing The price of the promissory note on the secondary market will depend on the credit worthiness of the issuer and avalising bank (if there is one). The discount from face value will also depend on the margin over LIBOR that could be obtained from other instruments over the same time period. Duration The duration of a promissory note may be anything over a week, depending on the specific requirements of the buyer and seller in each individual transaction, as agreed by an avalising bank (if Risks for the issuer Benefit for the issuer Risk for the holder Benefit for the holder there is one). The issuer of a promissory note is making an unconditional promise to pay out funds at a future date. When payment date comes, the issuer may not have the funds available to pay. The issuer of a promissory note may not have received the goods he purchased but will still be required to pay the sum on the promissory note at maturity. The use of promissory notes enables its issuer to obtain credit. The issuer may not be able to meet his repayment obligation when the note matures. The supplier of goods gains formal confirmation that a debt will be paid rather than simply relying on an invoice. A person holding a promissory note is able to sell it in the secondary market if circumstances change and he requires funds earlier than indicated on the note. Product Surety bonds Basic characteristics What is a surety A surety bond is a type of guarantee involving three different bond? contractual parties: The principal A person who is required to meet a particular contractual obligation. 13

Purpose Who uses surety bonds? How does a surety bond work? The obligee or beneficiary The person who requires the principal to meet a particular contractual obligation. The guarantor or surety The person who agrees to stand in the shoes of the original principal, i.e. to take some form of compensatory action if the principal does not honour his obligation to the obligee. By using a surety bond the obligee or beneficiary is protected in the event that the principal fails to meet his contractual obligations. Surety bonds are used by companies, governments or local authorities relying on a third party to take a particular course of action. Surety bonds generally require the principal to obtain the services of a surety to guarantee his performance or certain contractual terms. It is the principal who pays for the surety guarantee, and where the contractual obligations extend over a number of years, there will normally be recurring annual payments. The mechanism through which they work is best shown through examples. Bid bonds A local authority (the obligee) requiring a road building project to be undertaken may put the work up for tender. A number of contractors may bid to win the tender but as a condition of having their bid considered they may be required to obtain a bid bond which guarantees that they will take the action that they have committed to take in their tender. If the winning bidder (the principal) does not honour the terms of his bid, a claim can be made by the local authority (the obligee) which should be honoured by the surety. The terms of the bid bond may require a variety of actions on the part of the surety such as payment of a compensatory sum or finding another contractor to complete the work. Performance bonds A project sponsor (obligee) who requires a major building project to be undertaken may require the contractor (principal) who will perform the work to provide a performance bond in which the surety guarantees the performance of the contractor. If the contractor (principal) does not honour his obligations under the building contract, the project sponsor (obligee) can seek compensation from the surety, up to a predetermined amount. The surety will then seek payment from the contractor or principal. Note that there are many other types of surety bond than those 14

Risk profile Regulated status under FSMA (RAO) Negotiability Exchange involvement Clearing and settlement Trade reporting (to exchange) Transaction reporting (to FSA) Documentation Pricing Duration Risks for principal Benefit for principal Risk for obligee Benefit for obligee Risk for surety Benefit for surety described above. The risk profile of each bond varies according to the precise nature of the obligations created by that specific arrangement. Some surety bonds are designated investments issued by insurance companies and others are unregulated. Compliance Officers should be clear whether the specific surety bonds provided by their firms are regulated or not. There is no trading of surety bonds. There is no exchange involvement surety bonds are not tradable. There is no clearing or settlement system for surety bonds. There are no trade reporting requirements. There are no transaction reporting requirements. A surety bond will be evidenced by a contract between the parties involved. The price paid for a surety bond will be individually negotiated by the parties involved. The duration of a surety bond will be individually negotiated by the parties involved. May have to pay a large amount of money to obtain a surety bond which will never have to be used. May have to compensate the surety if the latter has to take action under the terms of the bond. The fact that a bidder has obtained a surety bond may be the only way that he can be considered to tender for a project. The surety bond may not provide adequate compensation for loss incurred as a result of a failure on the part of a principal. Ability to be compensated in the event that a principal does not meet his contractual obligations. A large sum of money (the penal sum ) may need to be paid out under the terms of the surety bond. The surety receives a fee for acting as guarantor. Trade finance services The main trade finance services other than those already described in relation to a specific instrument are described below. Documentary collections What are documentary collections? A documentary collection service is a facility offered by a bank to an exporter. With this service a bank undertakes to receive trade documentation on behalf of the exporter, transmit the documents to the importer, receive payment from the importer and pass it to the exporter. The bank does not in any way guarantee that the payment will be made to the exporter by the importer. 15

Problems with trade documentation Exporters usually only choose a documentary collection service rather than use letters of credit when they know the importers and can trust them. As a documentary collection service does not involve any risk for the bank it is much cheaper than using letters of credit. Documentary collections services are covered by UCR rules issued by the ICC (see Appendix 1). The documents described below in relation to documentary collection services are the same as those used in L/C transactions. It is very common for trade documentation presented to a bank not to conform to the exact specifications required by the importer and/or specified on a letter of credit. Some common problems with trade documentation include: there have been changes made to trade documents such as the invoice without the consent of the exporter; the description of the goods shipped is not clear; a required document is missing; the port of shipping or destination is not the same as that required; there are inconsistencies between documents in relation to the description of goods; or the names of the parties involved in the transaction are not correct, or have inconsistencies. Some of the most common types of documentation supporting international transactions are listed below. Bill of lading Used to evidence that specified goods have been loaded onto a ship at a named port, sent to a specified destination and addressed to a named person, or consignee. There are several types of bill of lading. Commercial invoice Airway bill Warranty of title Insurance documentation Letter of indemnity The document used to confirm that goods have been sold by a seller and must be paid for by a buyer. Among other things, contains details of the buyer, the seller and a description of the goods involved. Like a bill of lading, but used for air rather than sea transport. A document confirming that the person selling goods actually has the right to sell them. Confirmation from an insurance company that they have insured the goods for transportation. A letter of indemnity can be used when the goods shipped have arrived at the destination point before the importer has the bill of lading or other transport document. The letter of indemnity is written by a bank and guarantees to compensate the carrier for releasing the goods without the bill of lading if this should cause a problem. 16

Certificate of origin Document confirming the jurisdiction of origin of the goods being shipped. Certificate of inspection Confirms that the goods have been inspected and that they meet the required description. Packing list Details the exact specifications of the goods that have been packed in a particular container in terms of weight, number etc. Also details the type and number of containers used. Railway Like a bill of lading, but used for rail rather than sea transport. consignment note Weight certificate Supplied by the exporter and confirms the exact weight of the goods shipped. Common abbreviations used on trade documentation CIF Stands for cost, insurance and freight. Indicates that the selling price includes the cost of the goods, the cost of transporting the goods and the costs of insuring the goods. CFR Stands for cost and freight. Indicates that the selling price covers the cost of the goods and their transport. CIP Standard for carriage and insurance paid to. The abbreviation is accompanied with the name of the destination to which carriage and insurance has been paid, e.g. CIP Singapore. FOB Stands for free on board. The abbreviation is accompanied with the name of the port from which the goods will be shipped, e.g. FOB Athens. Means that the importer is responsible for the transport and insurance of the goods. Accelerated financing terms A considerable part of trade finance activity involves accelerated payment arrangements. This involves the supplier obtaining payment against an invoice before the payment has fallen due. When this happens a third party, often a bank, will pay a percentage of the payment amount to the supplier and will then have the right to receive the full proceeds of the trade when payment is made by the buyer. Some of the main ways of accelerating payments are described below. Invoice discounting Payment is received from an invoice discounter against a certain amount of the value of outstanding invoices. The creditor remains responsible for collecting payments against the invoiced that have been discounted. Factoring Payment is received from a factor/ factoring house against a certain amount of the value of outstanding invoices. The factor also chases payments from the buyers of the goods subject to the invoice and then collects the payments. Forfaiting Forfaiting is similar to invoice discounting in that it enables a 17

supplier to receive payment for goods (at a discount), from a person other than the buyer, at a date before the buyer is due to pay. There are, however, several key ways in which forfaiting differs from invoice discounting and factoring. Some of these are listed below: Forfaiting documents are usually bills of exchange, letters of credit and promissory notes whereas invoice discounting and factoring involve invoices. There is a secondary market in forfaiting documents but there is not generally a secondary market in invoices. Forfaiting documents generally have some form of bank guarantee to pay whereas invoices do not have this. Forfaiting usually involves longer term arrangements than invoice discounting and factoring; Forfaiting usually involves larger sums than invoice discounting and factoring; Forfaiting is often used for international trade whereas invoice discounting and factoring are more frequently used for domestic trade. Key issues for the Compliance Officer Issue Comment Diversity/complexity The most complex aspect of trade finance arrangements is getting to grips with all of the vocabulary used and the precise roles of all the different parties involved. Regulatory environment Although not regulated under FSMA (see Key sources of legislation, regulation and guidance for trade finance below) trade finance can still be judged to be a fairly highly regulated activity and Compliance Officers should be familiar with the requirements and conventions of the law and other documents mentioned above. Regulated status Trade finance activities do not constitute designated investment business and trade finance instruments are not designated investments. This means that the details rules of the FSA Handbook such as those contained in COBS do not apply. For relevant law and regulation see Key sources of legislation, regulation and guidance for trade finance below. Regulatory status of staff As trade finance is not subject to FSMA staff working in this field do not need to be approved persons or covered by the training and competence rules. Such staff should be very clear about the activities that they could potentially get involved with that do constitute designated investment business and must steer clear of getting involved unless they go on to achieve the appropriate regulatory status. A potential danger area in this respect may be the provision of hedging advice so that an importer can cover his exposure to interest rates or 18

currencies. Market abuse Trade finance instruments are not covered by the Market Abuse Directive (they are not regulated investments traded on a regulated exchange) but this does not mean that the area is risk free from a market abuse perspective. One of the main dangers here is that in the course of trade finance business a staff member will become party to information that could move the market. For example, if a trade finance client is listed on an EU exchange and the news comes through that a major export contract has been terminated, this could have a significant impact on the value of the company s shares. This, of course, is very much within the scope of the Market Abuse Directive. Conflicts of interest There is probably less scope of conflicts of interest to arise with trade finance transactions than there is with other areas of business because it largely involves direct payments for services rendered rather than advice and proprietary trading. This does not mean, however, that the risk of conflicts can be totally discounted with one of the main concerns being that an institution may recommend that a customer use a particular service provider, e.g. a specific advising or confirming bank perhaps, not because that is best for the client but because the institution has a material interest in the other party getting the business it might be a group company, for example. Personal account dealing arrangements Client assets Money laundering/terrorist financing/fraud As trade finance does not involve designated investment business this is one area of a firm where Compliance Officers may feel comfortable with staff not being included by the scope of the firm s internal PA dealing rules. For the sake of simplicity, many firms decide to apply PA dealing control to trade finance staff, so that they are not running two separate regimes in this area. Even if collateral is held in relation to trade finance business, this will not be covered by FSA rules as trade finance is not designated investment business. A complex trade finance transaction involving many different parties can be difficult to follow, especially for people who are not familiar with the terminology and the documentation used. As with any complex transaction this can make money laundering harder to spot as more focus is put on understanding what is going on rather than going one stage further and trying to make a judgement as to whether the transaction has a legitimate purpose or not. With trade finance this is particularly unfortunate as it is readily used by money launderers as a way of processing their criminal funds. As well as the tax-related matters covered below, there are 19

three things that should be of particular interest: with transactions involving many different parties, it can be difficult to determine who is actually the customer from a KYC perspective. Work out first of all who your firm has entered into a direct contractual relationship with, and then determine whether there are any other parties that you will be receiving funds from or paying funds to. You should be happy that you have sufficient knowledge of all of these parties and that there is no concern about doing business with them; when buying a trade finance instrument on the secondary market it can be more difficult to understand the true nature of the underlying deal because a buyer is at a stage removed from the trade underpinning the transaction. Make sure that all documentation is checked meticulously as in some cases the trade does not even exist, or a bill might be bought that is seemingly accepted by a bank, but when presented to that bank for payment, is not known to them the instrument purchased is a forgery; a well-known way that money launderers use trade finance for money laundering is invoice manipulation: the under- or over-invoicing of goods. If a criminal can get a seemingly legitimate trade document to support an illegal purchase or shipment of goods, he will not be too concerned if he has had to pay slightly over the odds, or alternatively received less for the goods than he might otherwise have done. In all cases, knowing the customer and the underlying transaction is key. Tax evasion/fraud Trade finance can frequently be used as a vehicle to commit tax fraud. One of the most common ways of doing this is underinvoicing for goods and the impact that has on VAT. If an invoice is made out for less than the actual value of the goods sold, then the exporter pays less VAT, the importer pays a lower total amount, and the two parties can come to an arrangement between themselves as to how the profit will be split. Another commonly used fraud involving VAT is called Carousel Fraud (also known as Missing Trader Intra- Community (MTIC) VAT fraud) which, in a nutshell, involves companies importing goods VAT free, selling them on at prices including VAT, and disappearing without paying the VAT to the tax authorities. It is vital to make sure that Front Office staff know their clients well and that they know when a suspicion should be 20

reported to the MLRO as tax evasion is a crime and may therefore need to be reported to SOCA. Documentation Trade finance business is very much paper-based and many different types of document are involved, a significant number of which have been described in this section. Anyone involved with trade finance really has to understand what this documentation is all about or else a significant proportion of the business will remain a mystery to them. Industry associations Some of the trade associations covering this area of finance include the: Factors and Discounters Association; Bankers Association for Finance and Trade; Institute of International Banking Law & Practice International Forfaiting Association; and International Factors Group. Key sources of legislation, regulation and guidance for trade finance Trade finance products and arrangements are not specified under the RAO and are therefore not subject to FSMA. However they are not free from regulation and a number of rules and guidance documents apply with which a Compliance Officer should be familiar, as summarized in the following table. Control Coverage Comment The ICC s Uniform Customs and Practices for Documentary Credits (UCP 600), issued in 2007 The ICC s Uniform Rules for Collections (URC 522), issued in 1995 International Standby Practices (ISP 98) issued by the ICC and the Institute of International Banking Law and Practice Convention Providing a Uniform Law for Bills of Exchange and Promissory Notes, signed in Geneva in 1930 Letters of credit International rules for the use of letters of credit. For further information on the ICC see Appendix 1. Documentary collections Stand by letters of credit Bills of exchange and promissory notes International rules for banks undertaking documentary collection work. For further information on the ICC see Appendix 1. International rules for the use of standby letters of credit. For further information on the ICC see Appendix 1. International convention setting out standard arrangements for using bills of exchange and promissory notes. Relevant only to countries that have signed the Convention. 21

The UNCITRAL Convention on International Bills of Exchange and International Promissory Notes Bills of Exchange Act 1882 The Deregulation (Bills of Exchange) Order 1996 Joint Money Laundering Steering Group (JMLSG) Guidance Notes Bills of exchange and promissory notes Bills of exchange and promissory notes All trade finance products and arrangements Another more recent set of international rules applying to the use of bills of exchange and promissory notes. Only applicable if the instrument specifically indicates that the UNCITRAL rules apply. For the rules to apply either the country of payment or the place of issuance of the instrument must be in a country that has adopted the rules. UNCITRAL is the United Nations Commission on International Trade Law. UK law on the use of bills of exchange and promissory notes Includes guidance issued specifically on avoiding money laundering and terrorist financing risk in relation to trade finance activity. For further information on the JMLSG see Appendix 1. 22