International trade has existed for centuries. As the volume of international business grew, so did the need for certain agreed-upon documentation to regulate transactions. One of these is payment methods in international trade.
There are five major types of payment used by businesses engaged in international trade:
- Documentary Collections
- Letters of Credit
- Cash against Documents
- Open Account Trade
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Payment Methods in International Trade
This is a method of payment used in international trade where the buyer’s bank, after receiving the seller’s invoice, sends to its correspondent bank an irrevocable documentary collection order for collection against the buyer.
It is also called a Documentary Letter of Credit. This is a letter from a bank, known as the issuing or confirming bank, i.e., the bank that issues the document to an exporter in a foreign country at his request, or confirms it when issued by another bank for presentation abroad.
The documentary collection order instructs the correspondent bank to obtain payment from their customer’s bank in the foreign country and forward payment to the exporter. The documentary collection order includes a discount fee and normally nothing else because it is an irrevocable credit when issued or confirmed by the confirming bank.
Confirming banks are paid when they present their customer’s collection orders. If there is no objection from the bank on which payment was drawn, funds will be released immediately. All costs associated with processing and handling these transactions are recovered through relatively small commissions at each end of the trade cycle v/s actual sales revenue generated per shipment.
Letters of Credit
A letter of credit (LC) or documentary credit is one of the most popular payment methods in international trade. It is an undertaking by a bank to pay the beneficiary (the seller), upon presentation of certain documents against acceptance by the bank of those documents. A Letter of Credit is used most often as the payment method for international trade.
Letter of Credits are irrevocable and must be confirmed. The exporter makes arrangements with their own bank who then contacts one or more banks in the country where they want to export.
The bank(s) abroad will appoint another correspondent, an advising bank to advise them on whether they should issue the Letter of Credit, and what its terms should be.
The advising bank will be appointed to give advice on whether any proposed documents are in order so that the exporters own bank can issue the Letter of Credit. The issuing bank provides the terms of the credit to their foreign correspondent who adds them to their draft document collection instructions known as a “collection order” which is sent back.
Other methods include cash against documents, open account trade (also called sometimes “balance of payment”).
Cash against Documents
This means that payment for goods sold is made after they are shipped according to shipping documents seen by both parties.
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Such transactions are usually very large because it is more convenient for importers to pay for goods when they actually arrive at their destination rather than wait until they have been sold in their country of destination.
Import duties are usually paid in cash against documents transactions. An open account transaction is when goods are shipped without the use of documentary letters of credit or other irrevocable payment arrangements.
Open account trade may be used where it is difficult to obtain Letter of Credit facilities, for instance in dealing with new customers; and also where the importing country imposes import prohibitions, quotas or exchange controls that inhibit the purchase of foreign currencies.
Cash In Advance
One party pays another party only after the goods have been shipped and all documents have been released from custody by an independent inspector. Payment is issued by check before the shipment arrives at its destination, making this method more expensive for importers because it requires that they pay for shipping costs upfront as well as import duties paid to foreign governments.
Open Account Trade
In open account trade, an exporter will send goods to a foreign customer, but the customer is not required to pay for them immediately when they arrive. Instead, the exporter will wait until the goods have been sold and the proceeds show up in his bank account before demanding payment from his or her foreign customer. The foreign customer can then make whatever arrangements he or she wants with its bank or financial institution to make payment for the goods.
Open Account transactions are usually used extensively by countries that depend heavily on exports like oil-rich nations. It is also common in certain other areas such as outfitting and service businesses (especially engineering and firms) that receive their payment directly in the form of a letter of credit or documentary collection.
At times, when an exporter is in urgent need of payment for goods already sent to a foreign customer, he can arrange with his bank to issue an “advance”. The bank will give the exporter the amount necessary to pay his supplier, but this transaction will be part of an agreement with the beneficiary’s bank that when they receive a claim from their beneficiary, they will forward it immediately for collection.
The advance must be repaid by debiting the account of the importer. A documentary Collection advised by the issuer bank is usually used for this purpose internationally. A variation on open account trade is that in which an importer receives goods free on board (F.O.B) and then arranges with his or her bank for payment as soon as they are sold.
This is where the goods are shipped to the buyer under an arrangement between exporter and importer, known as a consignment. The goods remain in the custody of the seller until they are sold.
At this point, payment for them by the buyer goes directly to the seller who delivers them to him or her at a later date, usually after deduction of a commission.
An alternative method of settlement is cash upon delivery (COD). This means that goods are paid for before delivery. But since only part of shipments may be found acceptable on arrival, there is always some risk involved in COD transactions unless insurance covers any loss from quality defects or what have you. In such cases though, values can change quickly because then it is likely that the seller will ask for a higher price.
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