Trade Finance

Companies trade - both nationally and internationally - with a wide variety of effects and risks. Risks in the context of trade are often connoted at an international level, for example currency fluctuations or political uncertainties. However, there are also corresponding challenges at a national level and, for example, the risk of service fulfilment or payment default does not stop at national or international trade relations.

To minimise these risks, companies often resort to guarantees and letters of credit - similar to a forward exchange transaction to hedge exchange rate fluctuations. We summarise these two concepts (guarantees and letters of credit) under the term trade finance.

By using trade finance instruments, trading transactions can not only be hedged, but also financed if necessary. In the following, we would therefore like to present trade finance instruments that are often found and also discuss the system-side mapping of the corresponding processes.

Guarantees and sureties are often summarised as common instruments under the generic term guarantees.

Guarantee
The surety, a unilateral obligation, obliges the guarantor (e.g. the guaranteeing bank) to fulfil an obligation to the beneficiary. However, this fulfilment only occurs if the debtor is unable to (fully) fulfil his obligations. Guarantees often occur in the course of rental guarantees or loan guarantees.

Gguarantee 
A guarantee is a written agreement between a guarantor (e.g. a bank) and the beneficiary (e.g. the buyer of goods). The debtor (seller of the goods) instructs the guarantor to issue a guarantee. This guarantee protects the beneficiary if the contractually agreed obligations are not fulfilled by the seller. This guarantee remains valid even if the debtor is no longer solvent. This is due to the legally independent nature of the guarantee, irrespective of the principal debt relationship between the debtor and the beneficiary.

Guarantees can take different forms. For example, fulfilment guarantees, warranty guarantees, advance payment guarantees, payment guarantees, customs guarantees and rental guarantees are just some of the many common types of guarantee. Guarantees can also be flexible in terms of duration.

Letter of credit
A letter of credit is a payment instrument with a security function. A bank is obliged to make payment as soon as the contractually agreed documents (e.g. delivery note) are presented. For this purpose, the debtor (buyer of the goods) applies to the issuing bank to open a letter of credit. The bank in turn gives the beneficiary (seller of the goods) an abstract promise of payment. At the same time, the documents to be submitted and their form (e.g. signed delivery note) are contractually stipulated in the letter of credit. The beneficiary submits these documents to the advising bank, which checks the documents. If the check is successful, payment is made to the beneficiary's account. In further steps, the documents are forwarded to the issuing bank and the debtor's account is debited.

Letters of credit can be organised in different ways. For example, it is possible to allow or restrict the transferability of a letter of credit. A distinction is also made between letters of credit at sight and letters of credit on demand: In the case of sight letters of credit, payment is made immediately after the agreed documents have been presented, whereas in the case of letters of credit on demand, payment is delayed.

Forfaiting
Forfaiting is an extension of the classic trade finance instruments. Here, the beneficiary (seller of the goods) sells its claim, minus the fees, to a forfaiting company (e.g. a bank). The bank is now the new beneficiary and receives payment from the debtor (buyer of the goods). The advantage for the seller lies in the immediate settlement of the debt by the bank.

Companies generally use several of the aforementioned instruments. In addition, companies are often on both sides - as beneficiary and debtor. In combination with a high number of guarantees and letters of credit as well as often manual and paper-based processes, this leads to inefficiencies and a high level of resource commitment in companies. In addition, companies do not always have a centralised overview of the current portfolio, as the corresponding instruments are often processed in a decentralised manner. To solve these challenges, companies often rely on system-based support. Depending on the requirements and scope of the functionalities, this is done using a treasury management system or in their own trade finance systems.

If it is purely a matter of mapping the portfolio, both a treasury management system and a trade finance system can be ideally suited. A separate trade finance system, on the other hand, is usually implemented if companies also want to realise the following points:

• Mapping of workflows:
  This includes all steps from the application for an instrument to the release and closing of the guarantee or letter of credit.
• Automation of processes:
  If companies have mapped the entire workflow of a guarantee or letter of credit in the system, the process can also be automated. For example, 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. The system operates according to the dual control principle. The parameters can be, for example
  
  • The beneficiary is in a predefined list or is located 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 fully completed in accordance with the stored rules
  • In addition, individual checks can be carried out before the guarantee application is released

In these cases, the guarantee applied for is automatically communicated to the bank by the applicant after the enquiry has been created in the system. A second person is not required to approve the application, as this part is taken over by the system. The response received from the bank can also be processed automatically by the system, thus significantly reducing the burden on the company's resources.

• Communication with banks:
  This includes forwarding the guarantee application to the banks and processing the bank response in the system. The Trade Finance System requires a corresponding communication channel for this (e.g. EBICS, SWIFT, DVS, web interfaces with banks).
• Calculation of fees:
  Guarantees and letters of credit often have a variety of different fees. A trade finance system can charge traditional guarantee fees as well as commitment fees or individual fees. Fees are often linked to a minimum amount, which the system takes into account. In addition, there are different calculation methods for each bank. The following is an example of a quarterly fee charge:
  A guarantee was issued on 12 August and quarterly guarantee fees are agreed. The following options now arise:
  
  
  • The quarterly fee is due for the first time on 30 September and then always at the end of a calendar quarter.
  • The quarterly fee is due for the first time on 12 November, i.e. exactly one quarter after the date of issue, and this rhythm will be maintained.

In order to be able to calculate these differently structured fees properly, a separate trade finance system is often used. This allows companies to maintain an overview of the correct fees at all times, even with a large number of guarantees and letters of credit with different cost structures. Another advantage of the system-supported solution is that future fees can be calculated at any time. Based on the stored fee parameters, the system can calculate or forecast future payments at the relevant times.

The following overview shows the annual guarantee fees incurred, taking into account the standard market fee rates for the respective guarantee amount (in EUR).

This shows that companies have to pay fees of EUR 1 million to the contracting banks for guarantees issued in the amount of EUR 100 million, with an annual fee of 1%.

Another aspect in this context relates to guarantees that have already expired but have not yet been derecognised. Unless contractually agreed with the bank, expired guarantees must be actively returned by the company. This requires appropriate communication with the bank so that it can derecognise the guarantee and credit the guarantee amount back to the available guarantee line. If this does not happen and expired guarantees are not derecognised, companies continue to pay the bank the fees incurred. Trade finance systems provide support in two ways: Through the centrally managed overview of all transactions in the portfolio, expired guarantees can be displayed at any time; In addition, the system provides support through corresponding system messages or e-mail notifications.

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

This shows that a company has to pay an additional expense of EUR 5 thousand 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 initiated 18 days late each quarter, this results in the following amounts that a company overpays to banks per year (four quarters).

If the previous example is extended to four quarters, this results in an avoidable additional expense of EUR 20 thousand per year for the company.

These figures clearly show that hedging by means of guarantees and letters of credit is always associated with costs - bank charges as well as personnel costs within the company. It is therefore all the more important that the underlying processes are transparent. 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 existing optimisation potential. Only digitally mapped processes allow companies to utilise resources efficiently and thus relieve the burden on employees. By using 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. Trade finance systems also support the calculation and verification of fees. This ensures that companies only pay the fees actually incurred and that expired guarantees are closed in good time, thus saving companies money.

Source: KPMG Corporate Treasury News, Ausgabe 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