Convergence of Physical and Financial Supply Chains: Part Two
By Bill McBeath
on Aug 31, 2010
With the maturing of global trade relationships, Open Accounts are replacing Letters of Credit as the dominant approach to enabling financial transactions between importers and exporters. We explore some of the implications.
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In Part One of this article, we discussed the forces driving the convergence of physical and financial supply chain; what it means for people in supply chain, finance, treasury, and banking functions; and various types of trade finance throughout the purchase-to-pay cycle, including Receivables financing, VMI financing, In-transit financing, and Pre-shipment financing. In this Part Two, we look at how the use of financial instruments is changing.
New Financial Models Evolving
International transactions between buyers and sellers usually entail more risk than domestic transactions, especially when the parties are not well known to each other. There are a range of options available to decrease the risk for one of the parties, but sometimes at the expense of increased risk for the other party, as shown in Figure 1 below.
Figure 1 – Risk Tradeoffs for International Trade Payment Options
As globalization of trade matures, the financial relationships are evolving. Some of the tried and true financial instruments of the past, such as Letter of Credit (LC), are giving way to more immediate straightforward processes, in particular, payment on Open Account (OA). LCs are useful during the initial push to overseas, when suppliers and buyers are not well known to each other and have yet to establish trust and a proven track record. But they are quite expensive and tie up lines of credit for importers. As importers and exporters do more business, relationships mature, trust increases, the risks of non-payment and nonperformance diminish, and importers are able to push trade payments off of LC and onto OA (with an open account, the exporter simply bills the importer, who is expected to pay under agreed terms at a future date). This shift away from Letters of Credit is requiring everyone to readjust because:
Banks made fees on LCs
Importers used LCs to mitigate performance risk, ensuring that the exporter/supplier performed to the contract
Suppliers relied on LCs to secure pre-shipment financing, get paid sooner, and most importantly to mitigate the risk of non-payment, especially with customers that were not well known to them.
Exporters lose a source of financing under Open Account, because they could borrow against the LC they had before. To fulfill this now unmet need, import banks are stepping in and playing an increasingly important role, broadening their offerings to provide export financing which helps to create liquidity in the supply chain. The financing provided by the bank can be either for pre-export financing (paying the supplier before goods are received) or post-export financing (payment after goods received). To manage their risk of providing this upfront liquidity, the import bank requires a detailed and reliable understanding of:
Importer’s credit-worthiness and payment track record—the bank often already has a good picture of this, since the importer is a client of the bank.
Exporter’s supply chain performance track record (on-time, quality, etc.)—in particular, this is important if the bank is providing pre-export financing.
With LCs, banks implicitly managed the import AP process for the importer. In effect, the importer outsourced this function to the bank, and in many cases no longer has the in-house operational capabilities required to track the events, validate the trade documents, and determine when to make a payment. Therefore, many importers want their bank to continue providing document examination and reconciliation services. In fact, some banks are broadening their capabilities to offer a wider set of services, managing the whole purchase order to payment cycle. These changes in financial models have major implications for the technology platforms used to manage the financial and physical supply chains.
In Part Three of this article, we explore some of these implications for technology, network-based platforms, and the opportunities created.
To view other articles from this issue of the brief, click here.