The Bank Payment Obligation: Ready to Fulfil its Potential?

The introduction to my recently-published book, The ICC Guide to the Uniform Rules for Bank Payment Obligations, characterised the Letter of Credit (L/C) as a “creation of commerce” whereas the Bank Payment Obligation (BPO) is the “brainchild of bankers”.

This statement is not to denigrate or devalue the BPO in any way. However, the genesis of the BPO as a market instrument does represent an educational challenge. Historically, L/Cs came into the world as a result of sellers of goods identifying a need to mitigate the commercial risks of trading with unknown buyers abroad. The obvious providers of such risk mitigation services came in the form of financial institutions (FIs) acting as trusted third parties. Over the course of several centuries the undisputed versatility and value of the L/C has been extended, not only to provide payment assurance but also to support alternative forms of short-term working capital financing.

By contrast, the birth of the BPO came about as bankers became increasingly concerned that the recent growth in the volume and value of world trade had not been accompanied by a parallel growth in the volume and value of L/C traffic. Indeed, the amount of business conducted on L/C has, at best, remained stagnant for at least the past two decades, thus signalling to the industry that more and more trade is now being conducted on open account and that in relative terms traditional trade finance is diminishing in importance.

Industry estimates suggest that some 82% of world trade is now subject to open account terms and as Figure 1 shows, this percentage is projected to rise further to 89% by 2020.

Figure 1: Projected Growth of World Trade by Value
BPO Figure 1

The BPO was conceived as an instrument that would effectively enable banks to re-intermediate themselves into the open account world by providing tangible bank assistance to these transactions where required.  This presupposes that in the world of open account trade, importers and, in particular, exporters suffer the same risks and seek the same assurances and financing options as they do in the world of documentary trade. The key difference, however, is that rather than the corporates coming to banks with a problem the banks themselves have unilaterally created a solution – the BPO – in the absence of any clear definition as to what the problem is (if any). Therefore, corporates not only need to be educated and convinced as to the potential value of the BPO solution but they must also acknowledge for themselves what the problem is or could be.

As many bankers would themselves agree, a majority of trade conducted on open account is done without the need for any form of bank assistance other than the payment at the end of the transaction. What the BPO seeks to address therefore is an unknown percentage of the open account market where there is a residual need for risk mitigation, payment assurance and/or financing services. This is the space currently occupied by services such as factoring and so-called reverse factoring on the financing side, and standbys/guarantees and credit insurance on the risk mitigation/payment
assurance side. In recent years, there has not only been significant growth in international factoring but the business of reverse factoring, or approved
payables finance, has emerged from almost nowhere to occupy centre stage.

Meanwhile, the limited numbers of corporates to have adopted BPO in support of live commercial transactions have tended to do so not as a means of soliciting bank assistance for open account but rather as a means of reducing the processing and confirmation costs of their residual L/C business.
Therefore, in practice, the banks have so far been unable to reap the intended benefits of BPO in terms of regaining a foothold on open account and are instead suffering a further dilution of their traditional trade business.

In reality, the BPO was never intended to be used as a ‘lite’ substitute for the L/C and this ‘cannibalisation’ of one product in place of another is evidently a not entirely welcome development for the banking industry.

Corporate Appeal

This raises the question of the extent to which the corporate world will eventually acknowledge and embrace the BPO as an open account financing tool and how long the adoption process could take. It also begs the question as to how strong an appetite the banks may have proactively to promote a new instrument such as BPO, faced as they are with the prospect of losing further ground in traditional trade.

Bringing new products and services to market is costly. Where it involves the development and implementation of new rules, new messaging standards, new operating procedures and a new legal framework it is undoubtedly a challenge, especially when the return on investment (RoI) might not be immediately realised. Corporate demand therefore needs to be proven.

On the face of it, if marketed effectively the BPO’s true value should be undisputed. The enforcement of an obligation to pay subject to the electronic matching of compliant data creates opportunity not only to enhance operational efficiency but also to reduce operational cost and risks associated with supply chain processes. It is a win-win proposition.

Recent estimates suggest that the BPO has the potential to obtain a market share similar to that of L/Cs (say around 10%) by the year 2020, as per Figure 2  below. This would be a remarkable achievement for a new financial instrument still in its infancy compared to the centuries-old letter of credit.

Figure 2: Estimated Distribution of Trade/Supply Chain Finance Business by Instrument.

BPOs Figure 2

So what compelling argument will catalyse corporate demand for BPO?

Firstly, there is a need to dispel the image of the BPO as a ‘Lite L/C’. While the BPO is regarded as such, its potential market appeal and application will be limited – as will banks’ appetite to sell.

One area in which the BPO might yet make its mark is in the space currently occupied by approved payables finance/reverse factoring solutions, often referenced by some leading service providers as ‘supply chain finance’ (SCF).

Banks such as Citibank and JP Morgan that have so far made significant inroads in the SCF business are at variance with those that have traditionally led the way in trade finance, such as Wells Fargo and Standard Chartered.

The popular ‘three-corner’ model for SCF undoubtedly favours big banks with a significant global footprint, financial standing and market coverage. In this model, one bank (the bank of the buyer) services the needs of both buyer and suppliers, most commonly placing reliance on the buyer’s credit lines and credit standing to offer finance to the supplier.  Of course, this approach does not come without its issues, the most well-known being supplier on-boarding and related difficulties around know your customer (KYC).

It might be worth bearing in mind that, traditionally, the world of trade finance follows an 80/20 (or arguably even 90/10 rule), in which 80%/90% of the business is managed by 20%/10% of the banks. Given this established hierarchy, it becomes somewhat questionable as to how many banks in the world, regardless of ambition, will realistically have the financial strength, capacity and appetite to compete in the closed world of three-corner SCF.

It seems more likely, therefore, that over time the only way for the next tier of international banks to take advantage of potential SCF opportunities, is to do so in a more open four-corner model in which a buyer’s bank collaborates with the supplier’s bank, perhaps agreeing upon a joint share of both risk and reward/revenue. Indeed, a certain amount of SCF business is already evolving in this manner.

Potential for Development

It is in this area of four-corner SCF business that the BPO has the potential to come into its own. Used as it is, in an automated processing environment, delayed issuance of a BPO is relatively easy to agree and execute. It is also entirely consistent with the common business scenario in which a supplier may experience a very late – and very limited – requirement for financing to plug a short-term working capital deficit.

A BPO can be put in place very quickly and easily, at limited cost, providing an assurance to the seller’s bank that the buyer’s bank will pay on the due date. This enables the seller’s bank to proceed with the financing, relying on the strength of the BPO as collateral. Alternatively, the due date of the BPO can be amended by agreement, so the buyer’s bank is obliged to pay in advance.

There are so many options attached to the issuance and application of the BPO that bank services can be tailored flexibly to match individual needs and circumstances. Missing still are adequate levels of awareness among corporates and, with a few notable exceptions, a strong appetite amongst banks in general to foster that awareness.

Until corporates come knocking at the door demanding BPO from their banks, market uptake will continue to be slow and steady rather than revolutionary in nature.

Also missing today, it must be said, are the technology enablers that will support not only the automated processing of BPO-based transactions within banks’ own back offices but also, more significantly, the ease of communication to support the automated and standardised exchange of data between corporates and banks.

While there are clear advantages in restricting the use of mandatory channels, rules and standards to the exchange of data between banks and the central transaction matching application only, the absence of similar mandatory conditions in relation to the exchange of corporate data creates a
potential gap in the end-to -end automation of information flows.

The banking software industry has an opportunity to exercise a material influence on market adoption of BPO, by bringing to market the platforms and channels that will simplify the required exchange of data between corporates and banks. This kind of development is not so far removed from work already done in recent years to support the exchange of L/C and guarantee related data in the form of the MT798 message. It is realistic to envisage in the near term the emergence of a world in which the corporate will demand a multi-bank delivery channel that supports not only the exchange of MT798 for traditional trade but also the BPO for bank-assisted open account transactions in the context of managing the FSC. This is a natural extension of channels already used today to support complementary services such as payments, cash reporting and foreign exchange (FX) within the broader context of working capital management.


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