The ‘Trade Tilt’ Hypothesis

As the banking and treasury communities know, globalisation has seen open account trade dominate cross-border transactions. In its 2010 report ‘Re-Thinking Trade Finance’, the International Chamber of Commerce (ICC) generally acknowledged that at least 80%-85% of all global trade is settled on open account terms, with traditional trade products such as the letter of credit (L/C) representing the remainder. But an examination of how the dynamics of globalisation are ‘tilting’ suggests that the bank payment obligation (BPO), a new electronic alternative to the L/C and an enhancement to open account, will be an increasingly viable trade instrument.

The developed economies currently face multiple economic challenges and are experiencing slow rates of growth. According to the World Trade Organisation (WTO), in 2009 global trade contracted by approximately 12% and global GDP declined by 2.2%. In contrast, the Asian Development Bank (ADB) estimates Asia expanded by 9.6% in 2011 against a predicted 2.5% expansion in the US and further stagnation in the eurozone.

While some experts suspect the developed nations of considering protectionist policies to safeguard their domestic markets, the world recently saw an increased number of trade agreements signed between Brazil, Russia, India and China (BRIC). These BRIC economies already represent 40% of the world’s population and a quarter of the globe’s land mass. The recent BRIC summits in Brasilia and Sanya also demonstrated that, while the alliance may lack political cohesion, there is nevertheless a clear appetite between developing nations to increase trade with one another.

Changing Dynamics

Perhaps a subtle indicator for a coming change in trade dynamics is the recent article in The Times of India where the Associated Chambers of Commerce and Industry of India (Assocham) assert that trade between China and India will increase from its existing level of US$63bn to the agreed 2010 bi-lateral target of US$100bn by 2015. With both countries established since 1984 as each other’s ‘most favoured trading nation’, there is little doubt that this objective is easily achievable.

Even though some emerging economies experienced short-term contraction followed by talk of ‘over-heating’, the long-term predictions remain optimistic. This view is endorsed by the 2011 predictions made first by PricewaterhouseCoopers (PwC) that China will eclipse the US as the largest global economy by 2030, and then by Standard Chartered Bank who gave their prediction as 2020. These predictions may be combined with those of Goldman Sachs which suggests the BRIC countries will represent 41% of the world’s market capitalisation by 2030, and will become four of the six largest economies by 2050.

Impact of the ‘Trade Tilt’

So what does the accelerated emergence of the BRIC economies mean for the developed nations? ‘Trade shift’ is an over-used, over-hyped idiom and is perhaps an emboldened prediction for the result of unfolding events. It is imprudent to underestimate the fall-out of the current economic climate but a prospective, discrete suggestion is that a ‘trade tilt’ is beginning to occur right now. Initially, the tilt is expected to see a marginal return to the low-risk letter of credit. To date, many BRIC suppliers to developed countries were obliged to accept open account terms as the de facto standard when doing business with their overseas customers. However, a combination of factors is emerging now that may eventually see an accumulative rejection of open account and a consequent move towards other trade instruments such as the BPO.

Under open account terms, the importer takes on the supply risk and is obliged to ‘match’ a purchase order, shipping or warehouse data to the supplier invoice. This is seen as very low risk for the importer as they can reject goods on inspection for various reasons, and payment will only be made if a full match occurs and at conclusion of payment terms. Open account places all credit risk on the exporter and bases the cost of goods on the exporter’s credit rating and their ability to acquire working capital.

With an increasing emphasis on BRIC domestic markets, rising cross-border trade volumes between the BRIC economies, and perceived foreign exchange (FX) risk due to reduced faith in the US dollar and euro, the anticipated trade tilt will see BRIC suppliers prioritise those buyers who are able to offer improved terms of trade. But as L/Cs continue to be associated with increasingly expensive and paper-bound business processes, importers will for the most part resist any demand from overseas suppliers to revert back to documentary trade.

According to the ICC, the pricing of documentary trade finance is in fact substantially higher now than it was pre-crisis, further accentuating the problem of affordability. This increase in pricing is said to reflect higher funding costs, increased capital constraints and greater counterparty risk. Furthermore, the banking industry appears to believe that the prevailing higher fee structures are justifiable, given the additional security that L/Cs offer to trading counterparties.

New Rules and Tools

Enter the BPO as an alternative to the L/C and an enhancement to open account. The BPO is an irrevocable undertaking given by one bank to another bank that payment will be made on a specified date, after a specified event has taken place. This ‘specified event’ is evidenced by feeding the relevant data elements taken from a range of associated open account documentation (purchase orders, commercial invoices, advanced shipment notices, bills of lading, etc) into a shared matching application, which then generates a ‘match’ report to show that the description of goods shipped matches precisely the description of goods ordered.

The BPO places a legal obligation on the issuing bank to pay the recipient bank, subject to successful matching of compliant data. In short, the BPO delivers business benefits and guarantees equivalent to those previously obtained through a commercial L/C, while eliminating the drawbacks of manual processing typically associated with traditional trade finance. Certainty of payment not only facilitates access to flexible forms of financing, but also supports the more efficient management of working capital, enabling the release of substantial volumes of cash which might otherwise be trapped in the supply chain.

When you consider that a supplier’s order-to-cash lifecycle can sometimes exceed 120 days with inherent FX risk, it is not difficult to understand an exporter’s desire to move away from the relatively high-risk open account scenario.

André Casterman, head of trade and supply chain, SWIFT, argues “there has been never been an equivalent instrument to enable an exporter to trade on open account with the same degree of confidence that payment will be executed in accordance with the terms of a L/C.” Where banks attempt to plug the gap through issuance of conditional payment guarantees or standby L/Cs, the BPO acts as an electronic inter-bank conditional promise-to-pay, offering a comprehensive and cost-effective risk mitigation and financing tool to all trading counterparties.

Of course, the BPO does face significant challenges in terms of market acceptance. The modern version of the documentary L/C became established as an accepted market practice thanks largely to the publication and maintenance by the ICC of a set of rules – the Uniform Customs and Practice (UCP). For the BPO to become as widely accepted as the L/C, it will benefit from the backing of a similar set of rules published and maintained by the ICC. SWIFT is currently collaborating with the ICC and its membership to publish ICC rules for the BPO in early 2013. In the meantime, those buyers and sellers keen to take advantage of this new instrument today, can do so by making use of the existing infrastructure, standards and rules developed by SWIFT.

Banks traditionally perceive documentary L/Cs as low risk business and there is no reason to believe they will disappear completely, nor should there be. It is important for the market to support choice, so that those who favour open account can choose open account, and those who favour L/C can choose L/C. For those looking for a hybrid solution which balances the best of both worlds, there is now another option on the menu. As the anticipated tilt materially alters trade dynamics, so we foresee that importers and exporters alike will look to alternative methods of trade finance. Fully electronic trade automates business process and data matching. Apart from the obvious efficiency of removing paper that benefits all counterparties, there are also clear pre- and post-shipment trade finance opportunities that can be supported across the entire transaction lifecycle.

With the BPO offering an assurance of payment upon matching a confirmed purchase order, suppliers can potentially leverage the BPO as collateral for pre-shipment finance. In this scenario, credit risk is transferred to the obligor bank, thus mitigating counterparty risk. The supplier can also issue a BPO in their local currency, mitigating any perceived FX risk from the once stable currencies of the dollar, the euro and sterling.

Goldilocks and the BPO

This ‘Goldilocks scenario’, where L/C are too hard, open account is too soft and BPOs are just right, offers an exciting opportunity for existing global open account networks.

Complex data matching solutions bring together the required electronic data elements consistent with ISO 20022 messaging standards with the ICC BPO rules to provide a solid platform for BPO issuance, acceptance and financing.

Whether importers wish to reduce fees, enhance process efficiency or provide improved terms of trade to their overseas suppliers, existing global electronic networks such as SWIFT and GXS, currently processing billions of transactions and trillions in spend, are ideally placed to propel the BPO forward as the emerging standard for cross-border trade finance and working capital management.

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