When you're selling products around the world, you need to maximize your payment options while protecting yourself from the risk of default. Three proven tools for helping to streamline international transactions are letters of credit, documentary collections and escrow services.
A letter of credit (LC) is a commitment by a bank that you will receive payment once the terms and conditions stated in the LC have been verified by your bank. LCs are considered one of the safest ways to ensure payment because financing is arranged by your buyer, through its bank, while your bank typically acts to confirm and guarantee your payments.
A less expensive alternative to letters of credit are documentary collections (DCs). A DC is a transaction in which you, the exporter, rely on your bank for the collection of global payments. Your bank, known as the remitting bank, sends documents to the collecting bank, along with instructions for payment. The collecting bank transmits funds from your buyer to your bank once the terms of the sale have been met. But unlike an LC, a DC doesn't give you the protection of a bank payment guarantee.
A third way for exporters to streamline international payments is through an escrow service, which accepts and holds payment from your buyer until the goods you exported have been delivered.
If you're interested in a primer on export financing, the U.S. government's Trade Finance Guide is a good starting point.
Risk Mitigation
Getting paid in the global marketplace is the final step in a global supply chain process in which your exports have to clear a number of hurdles, from transportation to customs.
The availability of quick, reliable and inexpensive credit reporting in many foreign markets will help you determine whether a sale can proceed on open account […] or under an LC or DC arrangement.
–John F. Dolan, trade finance expert
When you are doing business in other countries, you need international banking arrangements for transmitting payments and documents, and you have to be sure you are adhering to the legal requirements of the countries you are doing business in, says John F. Dolan, a trade finance expert, author and Distinguished Professor Emeritus at Wayne State University Law School in Detroit.
1. Letters of Credit
Dolan says letters of credit provide a quick and reliable way to protect yourself from buyer default. They are supported by a time-tested set of international rules governing both the buyer's bank and the seller's bank. While LCs are relatively inexpensive, there is a cost involved, and some expertise is needed to properly execute them.
But the beauty of LCs is that they can be used effectively for everything from transactions of a few thousand dollars to billion-dollar deals. With an LC, says Dolan, you must give your buyer credit terms, such as net 30, and understand that you will not receive payment unless the LC issued by your buyer's bank is confirmed by your bank.
2. Documentary Collections
DCs have the advantage of being less expensive while still being governed by international banking rules. They also can be put in place quickly. But, notes Dolan, the trade-off is “substantially less protection for sellers against buyer default."
Dolan says you should only consider DCs with buyers that have good credit. With a DC, he adds, you are shipping under a transport document, such as a bill of lading, and funds are released when your buyer receives the documents and knows that he will receive the shipment. The way it works is that you present the documents through your bank, which transmits them to your buyer's bank. Once the buyer accepts the documents, the foreign bank releases funds to your bank. While your bank facilitates the transaction, it does not guarantee it.
3. Escrow Services
Escrow services are worth considering when you are dealing with a buyer with a higher risk of non-payment. This is a cash-in-advance option in which you and your buyer rely on a third-party to collect, hold and ultimately disburse funds. It can reduce the risk of fraud and help to ensure that both the buyer and the seller meet the terms of the sales agreement.
With an escrow agreement, your buyer deposits the agreed-upon funds for a purchase into an escrow account. You don't ship your product until after the payment is verified. Once the shipment is received, your buyer has a pre-determined amount of time to inspect the goods. Once the buyer accepts the shipment, the funds are released to you by the escrow service.
Dolan warns that escrow services can be tricky. “Unless the underlying sales agreement issues are absolutely clear, this is an invitation to litigation," he says. “While there are reputable commercial banking and online escrow services, it can be difficult to find reliable sales agents, and the costs are usually higher than with LCs or DCs."
Technology and Relationships
Technology has transformed the once paper-based international trade finance process into a much faster and streamlined system. In particular, says Dolan, the ability for you or your bank to conduct due diligence on buyers is more efficient and less expensive than ever before. “The availability of quick, reliable and inexpensive credit reporting in many foreign markets will help you determine whether a sale can proceed on open account—always the first preference—or under an LC or DC arrangement," says Dolan.
Moreover, the use of electronic documents in the global marketplace—such as bills of lading, negotiable instruments, and confirmations of letters of credit—makes it easier to track shipments and to verify when your buyer has taken possession of your shipment. The more streamlined the supply chain process is, the faster you'll get paid.
While technology is improving the trade finance process, Dolan says there is no substitute for working with an experienced commercial banker. He advises that you work with a banker who has experience with international sales and collections, and who can offer a wide range of international finance services.
“It is always best to use a bank that is providing you with working capital, or to use that bank's larger correspondent's international department for the LC or DC transaction," says Dolan. “Nothing beats knowing your banker well, and working with a banker that knows you well."
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