Emerging markets treasurers say goodbye to letters of credit (LCs); BPOs are the future. At least that’s what Asia’s trade finance bankers argue.
For decades the favoured form of funding supporting trades from emerging markets, particularly in Asia, has been the LC. But over the past 20 years they have also begun producing more of the world’s manufactured products too. The money fostered in these countries has improved living standards and consumption across emerging Asia and other developing regions.
For foreign companies, the combination of low-cost manufacturing, an abundant labour force and vast potential consumer markets to be found in Asia is a tempting combination. But it is offset by the risks of doing business in countries that sometimes contain sizeable levels of corruption or unreliable infrastructure.
CEOs of international companies have had to carefully consider the risks of expanding businesses into emerging Asia against the potential rewards. Many have concluded that growing in Asia is too big an opportunity to miss, but mindful of potential risks, they have been very conservative over the financing behind their regional trade.
A lot of companies continue to use traditional document-based trade settlement instruments such as LCs. This mindset stands in stark contrast to the dramatic movement toward open account terms seen in more developed markets.
Open account trades and LCs sit of opposite sides of the financing spectrum, with the former offering ease of use and efficiency in exchange for increased risk, while the latter is highly secure but bureaucratic and unwieldy.
Today, corporates want a new form of trade financing that would let them avoid the inefficiencies of LCs and the risks associated with open account. Lenders have responded by introducing BPOs; a form of financing that they argue answers the concerns of the companies that they serve.
If they’re right, it could begin to take the mantle from LCs as the preferred trade finance tool of choice.
Best of both worlds
BPOs, not to be confused with business process outsourcing, are irrevocable commitments made by one bank to another that payment for a trade will occur on a specified date after a specified event has taken place.
While both BPOs and traditional LCs require matching key pieces of information from the purchase order and invoice underlying the transaction, the former uses electronic data rather than paper documents. This essentially allows banks to bridge the gap between an open account and LC arrangement.
A combination of growing corporate demand for automation in trade and supply chain finance and increased global trade has helped BPOs proliferate over the past few years. Swift, which developed a standard set of ISO 20022 messages back in 2002, helped provide the bedrock for formulating the International Chamber of Commerce (ICC) BPO rules several years after that.
The spread of BPOs dates back to the annual Sibos technology conference at Toronto in 2011. It was here that the banking commission of the ICC signed a cooperation agreement with Swift to recognise BPOs as a trade instrument, following years or torturous negotiation.
Then in April this year members of the ICC unanimously approved the rules governing BPOs. The vote marked the first time that the board had offered its full support to any product, including LCs.
How it works
The key to executing a BPO is that both a buyer and a seller and the banks representing them have both internet and email, and are willing to transact through them.
Matching between bank payment obligations typically takes place on the Trade Services Utility (TSU) platform, an electronic interbank messaging and matching utility by which lenders handle their customers’ transactions. Banks conducting trade payments through a TSU can monitor and finance trade transactions at various points throughout the supply chain, something that cannot be done with an LC.
“The electronic data matching component of BPO reduces transaction cost, document checking time and eliminates the risk of discrepancy,” says Kuresh Sarjan, head of trade and supply chain finance, Asia Pacific at Bank of America-Merrill Lynch (BoA-Merrill).
It is of course vital that all banks have access to a TSU and can process documents from it. “It essential that data matching criteria is agreed by all parties involved in a BPO transaction and that BPO testing is conducted with both clients and counterparty banks,” Sarjan adds.
International trade finance lenders are keen to extol BPOs, arguing that they will help support trades between buyers and suppliers that have not done much business together before, making it easier to enact a trade in risky markets and set up new supplier lines.
“Effectively you are able to get the best of both worlds. It gives the flexibility of an open account transaction because it’s fully automated, all electronic and you don’t need to do your documents through the banks as in the case of the LCs,” says Ashutosh Kumar, global head of corporate cash and trade for transaction banking at Standard Chartered. “It also ensures there’s a payment certainty because under the BPO, the buyer bank actually guarantees the payment or that it actually undertakes to pay if there is a match between the data.”
Even a smoothly executed LC can take 10 to 15 days to transact payment, as documents have to be physically delivered. A BPO for the same trade should take only two or three days, provided both banks are able to transact it, and it potentially offers major cost savings.
“A tanker carrying oil from Indonesia to Singapore [could travel the distance in only] 48 hours, but the documents take a week. The tanker would have to sit in Singapore for four to five days to wait for the documents to arrive. Can you imagine the cost to that tanker for parking in Singapore?” says Jiten Arora, global head of sales for transaction banking at Standard Chartered. “With the BPO, those documents will arrive in hours and not in weeks – that’s the biggest advantage.”
Experts say that using a BPO instead of an LC can cut buyers’ operational costs by 10%-30%, as fewer personnel are needed to be involved in the documentation preparation process. Likewise, banking fees can be reduced by up to 50% as handling fees are also removed from the equation.
If BPOs truly demonstrate such speed and flexibility they should quickly gain market share in trade finance, from a currently negligible market share. Swift predicts that 10%-15% of the world trade currently conducted in LCs figure will decline to 5%-7% by 2020 as more buyers and sellers turn to BPOs instead.
Corporate cheerleaders
Multinational companies also appear to be fans of the new trade finance process.
“Fifty percent of our business is currently on LCs. That means we have a lot of headcount, a lot of time and money spent in transacting our fees. Any kind of improvement we see in transacting and processing those LCs will certainly attract our attention and that’s certainly what the BPO did,” says David Vermylen, global credit manager of petrochemicals at British Petroleum (BP).
“If you look at how quick an establishment of purchase order happens in a BPO, how quick the matching occurs and knowing that you remove the documentation out of that critical path in order to get secure payment confirmation, this will mean for us a strong step forward and a strong reduction in costs,” he adds.
While BPOs sound like a godsend to Asia trade finance, there are still some caveats to the potential of the product. For a start all parties involved will need to be comfortable with conducting business through electronic channels. Secondly corporates and local banks will need to receive the training about how to use BPOs.
“For corporations examining the prospects of a BPO implementation, there are several considerations. Firstly, identify suitable clients for the new BPO services. For example, suppliers must ask themselves whether their clients are seeking efficiency via a reduction in paper or to use the data upload function of a BPO transaction integrated into their ERP [enterprise resource planning] system,” says Sarjan.
It’s also essential that data matching criteria are agreed by all parties involved in a BPO transaction and that the testing is conducted with both clients and counterparty banks. The most crucial step is the adoption of Swift’s ISO20022 messaging standard. A review process should follow shortly after.
“Following implementation of BPO structure, we suggest corporations also review processes against a set of pre-established objectives such as supply chain visibility, timeliness and cost savings to get a fuller picture of its benefits,” Sarjan adds.
The biggest risk over the longer term for individual transactions is human or electronic error. However even errors tend to be easier to fix than, say, having a postal service lose the documents backing an LC. If a company experiences a problem while conducting a BPO, errors can be easily amended. That same cannot be said for physically transported documents.
“Let’s assume something goes wrong with the shipment as it doesn’t always run perfectly, and some amendments need to be made. [With LCs] it takes considerable amount of time,” says BP’s Vermylen. “Through BPOs this could be done by making an electronic amendment of the baseline (also known as a payment order). This shows you that we can actually be compliant again within hours rather than days.”
Gaining credibility
The next step underpinning the advance of BPOs in trade finance is the adoption of universal rules covering the product.
Uniform Rules for Bank Payment Obligations (URBPO) are set to be launched in Paris on May 17, 2013, after which trade finance experts believe that the profile of BPOs and the legal framework that supports the instrument will be further enhanced.
“In case of legal disputes, if banks have disputes on some transactions they will be able to go to the ICC to get opinions and those opinions will help the litigation services,” said André Casterman, head of corporate advisory and supply chain markets at Swift at a media briefing in Hong Kong on April 24.
With definitive rules and commercialisation practices coming along soon, trade finance bankers anticipate that a wave of corporates and financial institutions will begin enquiring about how to use BPOs.
Many larger banks are already prepared, having put into place IT systems and trained trade finance teams about the execution of BPOs, along with establishing financing mechanisms. Ultimately, there should be little difference in how funding will work between LCs and BPOs.
According to Swift, six banks in Asia have already adopted the BPO: Standard Chartered, Bank of Tokyo-Mitsubishi UFJ, Bank of China, Siam Commercial Bank, Korea Exchange Bank and Hua Nan Bank. Another nine are in the process of doing so while 49 banking groups across the world are participating in the proliferation of the trade instrument.
“The recently issued rules governing BPO have obvious implications for global trade, the international supply chain and the banking sector. As such, we see BPO as a landmark regulatory development in all senses, providing banks not only with the opportunity to innovative on a product and service level, but to provide heightened risk mitigation solutions to trade clients,” says BoA-Merrill’s Sarjan.
Bankers predict that not only will BPOs replace LCs, they will also become widely used in open account transactions, replacing costlier risk mitigating instruments like trade insurance, highlight transaction bankers.
“LCs might be dirty and expensive from a time standpoint, but insurance is costly and also document-intensive,” said Sridhar Kanthadai, regional head, North Asia for transaction banking at Standard Chartered at the Swift event. “Some of the risk that people see in open account can be sorted in the elegant manner with the BPO without resorting to things like insurance.”
Chinese banks have also become keen to play an active role, following months of lobbying by Japanese corporates. “Some Japanese buyers have been requesting some kind of BPO transactions with the Chinese suppliers but some suppliers are located in Hong Kong and because of this, our head office cannot close such deals,” said Jackson Lo, product manager, trade product for corporate banking and financial institutions at Bank of China (Hong Kong) at the Swift press briefing. “This year, we have combined both the factoring and supply chain team into one team as we foresee many supply chain finance business opportunities coming from our head office in China.”
As the industry framework surrounding BPOs is more clearly established, the number of trades based upon these transactions should quickly flourish. Companies in Asia had best familiarise themselves with the acronym, because the use of the BPO is only set to expand.
