Trade Finance

Companies engage in trade both on a national and international level, which entails a wide variety of impacts and risks. Frequently, trade risks are perceived at the international level, for example, currency fluctuations or political uncertainties. However, there are also corresponding challenges at the national level and, the risk of non-performance or non-payment, for example, is inherent in both national and international trade relations.

To minimize these risks, companies often resort to guarantees and letters of credit - similar to a forward exchange transaction for hedging exchange rate fluctuations. These two terms (guarantees and letters of credit) are summarized under the term trade finance.

The use of trade finance instruments not only allows trade transactions to be hedged, but also financed if needed. Below, we will present some of the most commonly used trade finance instruments and discuss how the corresponding processes are mapped in the system..

Under the generic term "guarantees", sureties and warranties are often lumped together as commonly used instruments.

Surety
A surety is an unilateral obligation that compels the guarantor (e.g., the guaranteeing bank) to fulfill a liability to the beneficiary. Such fulfillment, however, only occurs if the debtor is unable to fulfill his obligations (in full). Sureties are frequently used in connection with rental guarantees or loan guarantees.

Guarantee
A guarantee consists of a written agreement between a guarantor (e.g. a bank) and a beneficiary (e.g. a buyer of goods). The debtor (seller of the goods) requests the guarantor to issue a guarantee. This guarantee indemnifies the beneficiary if the seller fails to fulfill the contractually agreed obligations. Such protection remains valid even if the debtor is no longer solvent. The reason for this is the legally independent character of the guarantee, which is separate from the main debt relationship between the debtor and the beneficiary.

Guarantees can take a variety of forms. Examples of the most common types of guarantees include performance guarantees, warranty guarantees, down payment guarantees, payment guarantees, customs guarantees, and rental guarantees. When it comes to the term, guarantees can also be designed flexibly.

Letter of Credit
A letter of credit is a payment instrument with a security function. Under this instrument, once the contractually agreed documents (e.g. delivery bill) have been presented, a bank is obligated to make payment. For this purpose, the debtor (buyer of the goods) asks the issuing bank to open a letter of credit. The bank in turn gives the beneficiary (seller of the goods) an abstract promise to pay. In parallel, the documents to be presented and their form (e.g. signed delivery bill) are contractually stipulated in the letter of credit. These documents are submitted by the beneficiary to the advising bank, which verifies them. If such verification is successful, payment is made to the beneficiary's account. Subsequent steps include the forwarding of the documents to the issuing bank and the debiting of the debtor's account.

Letters of credit can be structured in a variety of ways. There are, for instance, options for enabling or restricting the transferability of a letter of credit. A distinction is also made between sight letters of credit and time letters of credit: With sight letters of credit, payment is made immediately after presentation of the agreed documents; with time letters of credit, payment is made with a time delay.

Forfaiting
Forfaiting is an extension of the classic trade finance instruments. It involves the beneficiary (seller of the goods) selling his receivable, minus the fees, to a forfaiting company (e.g. a bank). Now the bank has become the new beneficiary and receives the payment from the debtor (buyer of the goods). For the seller, this has the benefit of being paid immediately by the bank.

Typically, companies have several of the abovementioned instruments in use. In addition, they will often find themselves on both sides of the equation – as beneficiary and debtor. This, coupled with a high number of guarantees and letters of credit, and in many cases manual and paper-based processes, leads to inefficiencies and tying up a lot of resources in companies. On top of this, companies may not always have a central overview of their current inventory, as the relevant instruments are often processed in a decentralized manner. To overcome these challenges, companies often turn to system-based support. This is achieved by means of a treasury management system or in the company's own trade finance systems, all depending on the requirements and scope of the functionalities.

If the focus is solely on mapping the inventory, both treasury management systems and trade finance systems can be suitable. However, companies tend implement their own trade finance system if they also want to achieve the following objectives:

• Mapping of workflows:
  This covers all steps from requesting an instrument, to approval, to closing the guarantee or letter of credit.
• Automation of processes:
  Where companies have mapped the entire workflow of a guarantee or letter of credit on the system side, the process can also be automated. For instance, it is possible for the system to communicate a guarantee application to the bank without the approval of another employee in the company, provided that the defined parameters are adhered to. In this respect, the system acts in accordance with the dual control principle. The parameters could be, for example:
  • The beneficiary is on a predefined list or is in one of the assigned countries or in none of the excluded countries.
  • A standard text is used
  • The guarantee amount is below a defined limit
  • A predefined minimum amount is available on the selected guarantee line, even after the guarantee has been issued
  • The application is completed according to the filed rules
  • In addition, individual checks can be performed before the guarantee claim is released

For these cases, the requested guarantee is automatically communicated to the bank by the applicant after the request has been made in the system. No second person is needed to approve the request, as this part is handled by the system. The system can also automatically process the response received from the bank, thus significantly reducing the burden on resources at the company.

• Communication with banks:
  This includes forwarding the guarantee application to the banks and processing the bank's response in the system. The Trade Finance System will need an appropriate communication channel for this (for example, EBICS, SWIFT, DVS, web interfaces with banks).
• Calculation of fees:
  Guarantees and letters of credit often come with a variety of different fees. A trade finance system can charge both classic guarantee fees and commitment fees or individual fees. In many cases, fees are also linked to a minimum amount, which the system takes into account. There are also different calculation methods for each bank. The following is an example of a quarterly fee charge:
  A guarantee was created on 12 August, quarterly guarantee fees are negotiated. The following possibilities emerge:
  • The quarterly fee is due on 30 September for the first time on a pro rata basis and thereafter always at the end of a quarter of the calendar year.
  • The quarterly fee is due on 12 November for the first time, i.e. exactly one quarter after the date of issue, and this rhythm will be maintained. 

To calculate these different fees properly, companies often use their own trade finance system. This allows companies to obtain an overview of the correct fees at all times, even with a large number of guarantees and letters of credit with different cost structures. Yet another advantage of the system-supported solution is that future fees can be calculated at any time. Using the stored fee parameters, the system can calculate or forecast the future payments at the relevant times.

The following overview lists the annual guarantee fees, applying the standard market fee rates listed as examples for the respective guarantee amount (in EUR).

Based on this, it becomes clear that companies have to pay fees of EUR 1 million to the contract banks for guarantees issued in the amount of EUR 100 million, with an annual fee of 1%.

One other aspect in this context is the guarantees that have already expired but have not yet been derecognized. Unless contractually agreed with the bank, the company must actively return expired guarantees. To this end, appropriate communication with the bank is necessary so that the bank derecognizes the guarantee and credits the guarantee amount back to the available guarantee line. Where this does not happen and expired guarantees are not derecognized, companies continue to pay the applicable fees to the bank. Trade finance systems assist in two ways: By providing a centrally managed overview of all transactions in the portfolio, expired guarantees can be displayed at any time. In addition, the system provides support through appropriate system messages or e-mail notifications.

Below you will find the amounts that are charged to the detriment of the companies after only a few days in the case of guarantees that have expired but have not been returned. The table below shows the guarantee fees (in EUR) incurred over a period of 18 days, taking into account the fee rates listed as examples, for the respective guarantee amount (in EUR).

This demonstrates that a company has to pay an additional expense of EUR 5000 for guarantees that have already expired in the amount of EUR 10 million and a fee rate of 1% per year for an 18-day delay in derecognition.

If the derecognition of guarantees that have already expired is triggered 18 days late each quarter, this would result in a company overpaying banks per year (four quarters) as follows.

If the preceding example is extended to four quarters, the company will incur avoidable additional expenses of EUR 20,000 per year.

These figures clearly demonstrate that hedging using guarantees and letters of credit is always associated with costs - bank charges but also personnel costs within the company. This makes it all the more important to ensure that the underlying processes are transparent. And if these processes, which are often still manual, are also mapped in a trade finance system, companies can make the best possible use of the available optimization potential. This is because digitally mapped processes are the only way for companies to use resources efficiently and thus reduce the workload of their employees. Through the use of digital solutions, employees can access all data at any time, regardless of where they are working - in the office, at home or on a business trip. This also makes the processing of guarantees and letters of credit location-independent. What's more, trade finance systems support the calculation and verification of fees. In doing so, they ensure that companies only pay the fees actually incurred and that expired guarantees are closed in good time, thus saving the company money.

Source: KPMG Corporate Treasury News, Edition 136, September 2023
Authors:
Nils Bothe, Partner, Finance and Treasury Management, Corporate Treasury Advisory, KPMG AG
Maximilian Gschoßmann, Manager, Finance and Treasury Management, Corporate Treasury Advisory, KPMG AG