One of the most important issues in international trade is the security of trade transactions. In this article, we are going to focus on how you can protect your interests while performing international transactions and which banking tools can be used by the parties to minimize risks in international trade.
Before entering into the international trade contract, the parties should figure out on the terms of the transaction, including with regards to the payment and delivery of goods. In one case, the seller delivers the goods, and the buyer pays for them upon receipt. Another option is to pay for the goods in advance, before delivering the goods.
In each of these options, one of partners carries significant commercial risks: in the case of delivery of goods without prepayment, the seller may not receive the payment. Whereas in the case of delivery in advance, the buyer may not receive the goods.
To minimize these risks, companies use various banking tools. In such transactions, banks act as intermediaries, ensuring control over the performance of the contract by the parties.
Insofar as obtaining full and timely payment is the final goal of each export sale, you must carefully select the appropriate payment method to minimize risks in international trade. You also need to take into account the buyer’s interests in the transactions. For the buyer, the final goal is the timely receipt of the goods, in proper quality and in the agreed volumes.
Before the negotiation process, you must decide which method of payment is most appropriate and safe for your company. There is no perfect recipe for how to protect yourself while performing international transactions. However, following simple instructions will help you minimize commercial risks in international trade
1. Check out your counterparty
Review relevant information on your counterparty before entering into the contract. Most databases as business registers, court records, property registers are available for searching. You also should have information on company’s reputation in trade, so on. Read about how to check a foreign company in our article.
2. Involve a legal specialist who is well versed in international trade
We recommend hiring an experienced international law attorney who will advise on various international trade issues. This expert can also represent your company in negotiation of the contract and draft the relevant contractual terms as well. If all things done correctly, the international transaction will be more balanced and less risky.
3. You should know the business customs of your partner’s country
Cultural specificities of your counterparty can bring unexpected “surprises” during the execution of the contract. You may face with some misunderstandings regarding contract performance. Taking into account these features, choose the most appropriate format of relationships.
4. Take into account currency risks
In international trade, one of the most important things you should think about is currency risks. The history has a lot of examples of currency crisis. So, if your partner offers a payment in local currency, think carefully whether you should accept this.
5. Consider local legislation of the country of import /export
If you are entering new markets, get advice from a local lawyer on customs clearance and certification.
6. Choose the least risky form of international payments
Review the Risk Scheme for the forms of international payments presented in this article in order to choose the most optimal one.
7. Consider political risks
Obviously, if your partner is a resident of a country with an unstable political system, you should take into account this factor by choosing the least risky forms of relationship. Look at the sanctions list that you can find at the official website of the Office of Foreign Assets Control (financial intelligence and enforcement agency of the U.S. Treasury Department). The sanctions database is available here.
International trade is the territory of risks, consisting of uncertainties regarding the payment terms between the seller and the buyer, time of delivery, product quality, etc.
For sellers, any sale is a gift until payment is received. Therefore, exporters want to receive payment as soon as possible, preferably immediately after entering into the contract or before sending the goods to the buyer.
For the buyer, any payment is a donation until the goods are received. Therefore, buyers want to receive the goods as soon as possible and postpone payment as long as possible, preferably until the goods are resold in the chain to another buyer in order to receive sufficient income to pay the exporter.
Cash-in-Advance is the most acceptable option for the seller, since payment is received before the goods are handed over to the buyer, thereby eliminating the risk of the debt. However, this method of payment is risky for the buyer, as the seller may not deliver the goods, or significantly violate the terms of delivery. Due to these circumstances, many companies refuse to use this method of payment.
One solution to this problem is to use escrow service. This service is widely used in the US and other countries, especially in the field of e-commerce. The essence of this service is that the payment transfers to the account of a third party (escrow agent), which holds the fund until the specified in agreement conditions are met. The escrow service is a financial security when a third-party controls and manages the amount paid under the contract.
One of the forms of escrow services is involving an attorney as an escrow agent. In this case, the attorney mediates the transaction. The amount of the transaction is transferred to the attorney’s account and is paid to the seller after the conditions of the contract are fulfilled. The guarantee is insurance coverage of the professional liability of an attorney, the authority of an attorney and the risks associated with the possibility of losing a lawyer’s license in case of serious violation.
Letters of credit (LC) are one of the safest tools available to international traders. A letter of credit is the obligation of the bank on behalf of the buyer that the payment will be made to the seller in the case that the conditions specified in the letter of credit were fulfilled, which is confirmed by the submission of all necessary documents. A letter of credit can be useful in cases where it is problematic to obtain detailed information about a buyer, including its reputation. However, the reputation of the buyer’s bank should be carefully checked by the seller. The letter of credit also protects the buyer, since it does not have any obligation to pay until the goods are delivered as specified in the contract.
Letter of credit scheme
Documentary collection is a banking instrument where the bank acts in accordance with the instructions of its client (seller). In this case, the bank sends to the buyer’s bank the foreign trade documents, received from the client, confirming operations regarding the goods (loading, dispatching, unloading), with instructions to issue documents to the buyer against payment.
The collection letter contains instructions that specify the documents necessary for the transfer of ownership of the goods. Despite the fact that banks are participants in this process, they perform only the functions of intermediaries and are not responsible in case of non-payment.
Documentary collection scheme
It is pretty risky payment method, suitable for counterparties who have a long experience of cooperation and trust each other.
This form of payment implies that the buyer pays the goods after a certain period of time after delivery of goods. At the same time, the parties keep mutual records of the amounts of current debt to each other.
By using an open account, the seller delivers the goods to the buyer without payment and at the same time sends the documents of title and invoice to him. The amount of debt is debited to the account in the name of the buyer. The buyer is obliged to pay off the open account debt within the agreed time.
Obviously, this is one of the most profitable options for the buyer in terms of the ability to defer payment. At the same time, this is one of the riskiest options for the seller. Due to intense competition in export markets, foreign buyers often require open account conditions from exporters. Exporters who do not want to provide deferred payment to the buyer may lose the customer. In this case, it is necessary to use combined methods to minimize commercial risks. For example, by offering open account terms, the seller may have an insurance policy that covers international trade risks associated with non-payment.
Consignment is a business arrangement in which a business, also referred to as a consignee, agrees to pay a seller, or consignor, for merchandise after the item sells. Consignment businesses are typically retail stores that specialize in a particular type of consumer product. The business accepts items for sale and agrees to pay the seller a percentage of the proceeds when the goods do sell.
Consignment in international trade is a type of open account, in which the payment is sent to the seller only after the goods have been sold by the original buyer to the final buyer.
The international consignment transaction is based on a contractual arrangement whereby the original purchaser manages and sells the goods to the subsequent purchaser. In this case, the seller retains ownership of the goods until they are sold.
Obviously, this type of payment is very risky, since the seller is not guaranteed any payment, and its goods are in another country in the possession of the distributor or agent. Consignment helps exporters become more competitive thanks to better availability and faster delivery of goods.
Using a consignment can help sellers reduce their direct storage and inventory management costs. The key to success in using consignment is partnership with reputable and trustworthy distributors. In this kind of relationship, we recommend purchasing an insurance policy covering possible risks.
Scheme: risks in international transactions
Trade Credit Insurance policy covers various risks you can face in international trade. Such policy protects from non-payment for delivered goods and ensures that your invoice will be paid. This tool allows you to be more flexible in negotiations with the buyers by choosing different types of payment methods.
Benefits of Trade Credit Insurance Coverage
Sales expansion – sellers can attract many buyers by offering various forms of international payments, including Open Account and Consignment.
Entering into new markets – In some countries, doing business is very risky. With a trade credit insurance policy, you can freely enter such risky markets.
Valuable information from insurance carrier – insurance companies calculate all risks which can affect to occurrence of insured event. You can obtain some important information on market you entering to.
Coverage against non-payment – in the event of non-payment, you will be compensated in the amount of your policy coverage. But you should carefully read your policy, including coverage limits.
What forms of international payments least risky?
There is no universal answer to this question. The form of payment that is less risky for the seller (exporter) at the same time may be riskier for the buyer (importer), and vice versa. As we see in the diagram, for the seller the most preferable form of payment is Cash-in-Advance. Whereas, for the buyer, consignment is the most profitable option.