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World trade slumped in 2009 and returned to growth, albeit slowly, in 2010 in many economies ¹. Bringing exports back to strength will prove particularly difficult for those exporting to the hardest hit economies ². But wherever they are located, exporters of goods and services know they must offer better value and service than their competitors to survive, and succeed, as the global economy recovers.

Managing the financial supply chain efficiently is an important contributor to a company’s competitiveness, and mitigating financial risks to ensure reliable and speedy receipt of payment is the finance manager’s first concern. In this article, we will consider the risks, how they can be mitigated, and how the supply chain may be made more efficient at the same time.

Considering the spectrum of trade risk for your business

Of course, credit risk – the risk that you will not get paid on time, or paid at all, for your goods and services – is the most obvious concern and one that exists, at least theoretically, in every transaction. The vast majority of trade transactions - around 80-85% ³ - are conducted on ‘open account’ terms, relying on the relationship with the purchaser, supported by a purchase order and invoice with mutually agreed payment terms, as the basis for trust.

The remaining 15% ³ of trade transactions use trade finance instruments such as export letters of credit and export collections. These instruments provide more security against the risk of default by the buyer, or non-payment because of other factors, such as concerns about cross-border risks due to changes in local regulations or even country default. Banks are reporting an increased demand for trade finance services in the current environment as companies seek more protection in volatile trading conditions ⁴.

Term collection – as an exporter, you can keep control over the goods until you receive a legally binding acknowledgment, called an acceptance, from the buyer of their debt to you. Without it, the buyer cannot take possession of the goods. However, this is only applicable where goods have been sent by sea and you are in possession of the full set of bills of lading. If the shipment has been made by any other mode of transport, the buyer may be able to take possession of the goods prior to giving their acceptance.

Sight collection – this enables you, as the exporter, to maintain control of the goods until you receive payment from the importer. Documents are sent via the banking system, and only released once the buyer has paid. As with term collections, control of the goods is dependent on mode of transport.

Unconfirmed letter of credit – this is where you receive an undertaking from the importer’s bank to conditionally guarantee payment to you (subject to the creditworthiness of the bank concerned), providing your documentation complies with the conditions set out in the letter of credit.

Confirmed letter of credit – this works in a similar way to an unconfirmed letter of credit. The key difference is that a domestic bank guarantees to pay (subject to the creditworthiness of the bank concerned), even if the foreign bank subsequently defaults (subject to the same documentary compliance as unconfirmed letter of credit). This is a more secure option but also a more costly one. Exporters need to consult with their bankers before contracts are signed so choices can be made about the sales contract.

Standby letters of credit, guarantees from the buyer or credit risk insurance from a governmental or private source, can also be used to cover the credit risk on open account transactions. Invoice discounting or factoring combined with bad debt protection is another available option.

It is always worthwhile to seek expert advice such as that offered by Institute of Export Certified International Trade Advisors (CITA). The RBS group has the largest team of Institute of Export CITA qualified international advisers in the UK ⁵ and they work actively with our customers to determine the best solution for each transaction.

Managing operational risk in trade transactions

Credit, counterparty and country risk are the most obvious risks associated with international trade transactions. But operational risks, arising from the need to manage multiple complex trade transactions across different geographies, can often lead to delays and seriously impact funding and competitiveness.

Online trade finance services (such as RBS’s TradeFlow) can be particularly helpful in this situation. These services allow clients to initiate, track and monitor the status of trade transactions online. The online channels also provide email alerts and online reporting, increasing visibility and control over the business. In addition, RBS offers a Document Preparation service for exporters resulting in very high compliance with letter of credit terms and conditions. This means that exporters can reduce risks, manage costs and improve cash flow.

Compliance is another area of operational risk to be considered. Exporters must always undertake appropriate due diligence to ensure they are meeting all their regulatory obligations. Mandatory bank processes, such as ‘Know your Customer’, anti-money laundering and Office of Foreign Assets and Control (OFAC) requirements, can also help to safeguard transactions against fraud and misappropriation.

New ways to manage large transaction risk

Sometimes companies need to secure trade finance facilities, such as letter of credit confirmations or pre-export finance, for particularly high-value transactions where the facilities required may be beyond the reach of any one institution. For these cases, a risk-sharing participation agreement in the secondary market can provide a solution. The exporter benefits from a single set of documentation, including pricing and maturity date, even though a number of investors are participating in the risk. Investors gain the opportunity to participate in prime trade finance transactions which carry lower risk weightings than unsecured loans.

Risk mitigation and funding solutions add up to more competitive trading

With the right risk management solutions in place, companies can then add funding solutions to optimise the use of capital across their supply chains. Pre- and post-shipment financing, export invoice discounting and factoring, for example, can dramatically speed up the supply chain and reduce days payable outstanding, easing cash flow and increasing efficiency.

Understanding the risks in the supply chain is the first step to tailoring the right trade finance solution and getting the best fit for the company’s requirements. A foundation of secure financing and available cash flow will play a vital role in ensuring the company trades successfully.

1. The International Monetary Fund’s World Economic Outlook, October 2010 report records an average of annual percentage change for world exports and imports of -14.4 % in 2009 and 0.4% in 2010.
2. “Imports tend to decline sharply in the first two years after a financial crisis and remain depressed even in the medium term, according to 40 years of historical evidence. In contrast, exports are relatively unaffected.” This is an extract from ‘Do financial crises have lasting effects on trade?’ by Abdul Abiad, Prachi Mishra and PetiaTopalova, World Economic Outlook, October 2010
3. According to the World Trade Organisation.
4. 73% of banks reported a substantial increase in commercial L/C requests – ICC Banking Commission Market Intelligence Report, Rethinking Trade Finance, 2010.
5. The RBS group has the largest team of Institute of Export CITA qualified trade advisors in the UK; Institute of Export 2010.