The usage of bank payment obligations (BPOs) has gained traction in recent months and is likely to replace letters of credits (LCs) in the long run as corporates continue to shift to using open account methods.
Currently 80% of trade is done on an open account basis, which is a non-guaranteed payment arrangement. In other words, future payment for delivered goods is dependent on good faith of the purchaser, according to the Royal Bank of Scotland (RBS) in an interview with Asiamoney PLUS on October 30.
The remaining 20% of trade is done on an LC basis, where a letter from a bank guaranteeing that a buyer’s payment to a seller will be received on time and for the correct amount. In the event the buyer is unable to make payment on the purchase, the bank will be required to cover the full amount of the purchase.
The LC is more cumbersome when compared to BPOs as it requires the physical movement of documents between parties and can take up to 10 to 15 days to process – and this is only things proceed smoothly – whereas the latter is all conducted electronically and can cut transaction flows to only three days.
“The buyer and seller will agree beforehand on what data needs to be provided and matched to enable the buyer's bank to honour it's obligation to effect payment,” said Anand Pande, global head of trade product management for Asia at RBS. “The BPO is a step in the right direction because it gives you certainty on payment dates in open account transactions. It also helps to grow trade as it facilitates bank to provide risk mitigation and financing options.”
Because of this, RBS expects the ratio between open account to LCs to gradually shift from 80:20 to 90:10 over the next few years as more corporates look to transacting on an open account basis given its many benefits.
Other financial institutions agree. Three out of four LCs are issued in emerging markets and Asia accounts for around 65%, highlights Standard Chartered. Given that Asia currently only accounts for 18% of global trade, there is evidently a large reliance of LCs in this region.
However, the growth of LCs is currently flat in emerging markets.
“What they want is something that offers the best of both worlds – they want something which is as safe as LC and as easy as open account but does away with the challenges – that is where BPOs come in.,” said Ashutosh Kumar, global head of trade product management, Standard Chartered to Asiamoney in an interview on October 31.
“With BPO you get the risk mitigation because the issuing bank is saying – if you ship the goods and provide the data instead of documents which comply with the underlying purchase order, as a bank I would pay you, so that mitigates the counterparty risk,” he added.
Corporates can also use the BPO as a form of guarantee to obtain additional financing and when compared to standby LCs, the former is more flexible as the corporate would be able to issue a partial BPO. Whereas LCs have to be used in full-form and for a longer duration, highlights Standard Chartered at a discussion session at Sibos entitled ‘Getting paid on time using the new bank payment obligation’ in Osaka on October 31.
“Because of this flexibility that you have, corporates will actually use their limits much lesser, using the limits for other activities,” said Vinod Madhavan, global head for local corporate products, receivables and supply chain at Standard Chartered.
“The way that the BPO is currently structured, there is an enhancement whereby you can actually try to meet the need of an LC issuance,” he added. “For example, you are trying to get across to the supplier that there is a genuine trade and hence, this opens the doors for financing through an issuance of the trade baseline, without having to add on the BPO.”
BP Chemicals’ global credit manager for Petrochemicals, David Vermylen, agrees: “If you need US$1 billion, we can easily put a couple of BPOs on those counterparties [like Exxon, Shell, etc.] over 10 to 15 transactions, and I think banks happily take that risk and help them discount it without having to go through a cumbersome process of either contacting credit issuer industry or factoring industry,” said Vermylen.
As a result, the BPO is anticipated to improve a corporate’s supply chain, as the effect of working capital improvements and release of extra liquidity is likely to be filter from top to bottom, note experts.
Moreover, the buyer is able to lower operational costs by 10% to 30% given that there are fewer personnel involved in documentation preparation. Banking fees are also reduced by up to 50% as handling fees are eliminated.
“This is something corporates can use to build strategic relationships with their sellers,” said Vermylen. “They not only like the improved working capital cycles and the simplicity but they also like the bonding that we have made between the buyer and seller.”
On the seller side, there will be three times faster turnaround of banking lines and can potentially lower the issuance of banking fees by up to 60% depending on the maturity of BPO issuance facility.
Despite the rising prevalence of the BPO, experts believe that it will not completely replace the LC.
“LCs are not going to disappear because it is all about trust. It depends on where you are on the trust equation,” said RBS’ Pande.