Banks have identified supply chain financing as both a profitable service that can boost client base growth and a tool to help deal with cash-flow problems. The Banker looks at the main processes the banking industry will need to introduce to make supply chain financing work effectively.

Efficient use of working capital has emerged as a key business focus for corporates – both on the buy side and the sell side – in the aftermath of the global banking crisis. While delayed payments to suppliers have become common practice among corporate treasurers in the past six to eight years, the global liquidity crisis proved the domino effect that an inefficient, or non-existent, supply chain financing (SCF) programme can have on a buyer and its client base. Many suppliers faced bankruptcy due to late payments, which consequently disrupted product flow to buyers.

As a result, corporates have deployed SCF programmes – a strategy that banks have since identified as a profitable service that they can pitch to corporate clients. For most banks, SCF is the link between their traditional trade finance product suite, which typically features documentary credits, and corporate cash management solutions.

Blurred lines

New technologies, industry standards and initiatives within the banking industry are blurring the lines between what used to be two disparate business units and creating a centralised and standardised service.

Dr Eugenio Cavenaghi, head of global trade and supply chain finance, product development and facilitation at UniCredit, says the Italian bank has followed the trend in the corporate market, where almost all of its clients have an SCF strategy, over the past two years. This trend has led to a maturing of the European SCF market, he says.

“The big push came after the crisis in 2008 to 2009. That actually made SCF a success story for those companies that were already using an SCF programme. They registered a much lower insolvency rate in their supplier base compared to those who were not relying on an SCF programme,” says Mr Cavenaghi.

The big push came after the crisis in 2008 to 2009. That actually made SCF a success story for those companies that were already using an SCF
programme

Eugenio Cavenaghi

Working capital consists of the financial flows from accounts receivables, inventory and accounts payables. Put simply, optimising working capital means a reduction in accounts receivables and a reduction in inventory, as well as a delay in accounts payables. “This is easier said than done,” says Enrico Camerinelli, senior analyst at advisory firm Aite Group, referring to the domino effect delayed payments had on both buyers and suppliers.

Many new processes have to be introduced to make SCF work effectively. Here we look at the main ones.

E-invoicing

E-invoicing, typically associated with treasury services, is the prime link between cash and treasury services and trade finance. The switch to electronic invoices can improve a company’s working capital significantly and so meet one of the key requirements demanded by corporates.

For instance, a company that has 5000 employees with staff costs of E60 per hour, could expect to save 57% per 1.5 pages if it switches from issuing paper-based invoices to electronic ones, according to the ‘E-Invoicing/E-Billing: Opportunities in a Challenging Market Environment’ report published in April by e-billing specialist Billentis and business-to-business integration company GXS. The savings potential for invoice recipients is slightly higher at 62%.

This saving could be even higher. Depending on the size of the company and invoice volume. e-invoicing could be as little as one-fifth of the cost of paper transactions – and a return on investment, although not quantified in the report, is typically realised within six months, says the report.

Besides obvious cost savings, the improvement in internal processing efficiencies can help strengthen, streamline and optimise trade relationships between suppliers and buyers, making e-invoicing a perfect fit for SCF programmes as invoice discounting is a core service in such plans.

One of the most common discounting terms, 2/10 Net 30, could become more efficient if e-invoicing platforms were available. In a 2/10 Net 30 payment agreement, the supplier offers a 2% discount on the invoice if the buyer pays within 10 days instead of 30 days. But at least 80% of global trade and 64% of trade in the US is still paper-based, which means matching, approving and paying an invoice in 10 days is unachievable for the majority of corporates.

Electronic trade finance is maturing – and it is maturing as fast as business-to-business communications, such as e-invoicing. These are the drivers for banks’ trade finance solutions 

Nigel Taylor

E-invoicing is still far from achieving mass adoption, but implementation rates are growing steadily. In 2012, 15 billion e-invoices will be processed worldwide, of which 30% will take place in Europe, according to forecasts by Billentis. Another survey, published in April by research and advisory firm PayStream Advisors, found that 83% of US corporates already use automated payments, and that 42% were considering implementing e-invoicing technology. One-third of US corporates have either got an e-invoicing solution in place, or will go live with one in the next six months. While these figures may seem encouraging, the year-on-year comparison shows that e-invoicing adoption has grown by just 1% in the past 12 months.

“Electronic trade finance is maturing – and it is maturing as fast as business-to-business communications, such as e-invoicing. These are the drivers for banks’ trade finance solutions,” says Nigel Taylor, head of e-invoicing solutions at GXS. Although e-invoicing is a fundamental element in SCF, its use is required at the final stages of a trade transaction, which is the reason banks are looking to enter the supply chain at a much earlier stage. 

Dynamic discounting and reverse factoring

Dynamic discounting is similar to invoice discounting in that the invoice is paid earlier against a discount on its face value. The ‘dynamic’ factor is the differentiator: instead of a fixed value (for example, 2% as in the 2/10 Net 30 example) the discount is dynamically calculated depending on the payment term agreed. The earlier the invoice is paid, the higher the discount applied.

Reverse factoring (also known as approved payables financing) allows a supplier to receive early payment with a discount of an invoice due to be paid by a buyer. The buyer approves the invoice for payment and arranges for early payment by means of finance raised from a bank or other provider, who relies on the creditworthiness of the buyer without recourse to the supplier. This allows the buyer to pay at the normal invoice/draft due date and the supplier to receive early payment. The bank relies on the creditworthiness of the buyer and the cost of capital applied to the supplier is based on an arbitrage between the lower cost of capital of the buyer and the higher of the supplier.

Letters of credit and open accounts

Banks have traditionally specialised in issuing documentary credit, such as letters of credit and demand guarantees, which are costly to handle and process, as well as being time-consuming to issue and match against invoices.

Bruce Proctor, head of global trade and supply chain finance at Bank of America-Merrill Lynch (BAML), says there are many steps involved in issuing such a letter. “A local company from the US would request the issuance of a letter of credit, which we create on behalf of their supplier and forward it to the supplier’s bank, for instance, in China. The supplier’s bank then contacts the seller and requests documents required in the letter of credit.” Apart from issuing the letter of credit, the bank does not get involved in the supply chain until the time of the payment.

With the BPO, banks can mitigate the risks involved in open account transactions. It is a document that provides data for the bank to match the invoice to the purchase order and perform the payment 

Andre Casterman

In an open account trade, a buyer and seller agree the terms between themselves without a bank. About 85% of world trade is conducted on open account terms because “it is easier for buyers and sellers to just have an arrangement detailing terms of their trade”, according to Mr Proctor. He adds that open account is an attractive process with well established relationships, but companies also realise that there is administrative and financial work required.

“Someone has to create the invoices, someone has to verify the shipping of goods, someone has to validate the quality and quantity of the goods and someone needs to execute the payment. And when a corporate and supplier are trading for the first time, in a new market, counterparty risk becomes a problem, as do regulatory compliance requirements. In this case, it is better to have an intermediary – the bank – which can meet all those requirement,” says Mr Proctor.

Banks have indeed identified an active market to provide administrative and financial support for companies and Mr Proctor says that a number of BAML’s clients trade on an open account, while the bank is in charge of processing. “We match invoices, we purchase orders, we verify shipping documents – whatever the company wants us to do. The administrative side of SCF is growing and will become more complex,” he says.

Models converge

Now the two business models are set to converge into what the Society for Worldwide Interbank Financial Telecommunication (Swift) and the International Chamber of Commerce (ICC) call the bank payment obligation (BPO) – a virtual letter of credit that eliminates the need for paper documents and can be used in open account trades for both pre- and post-shipment transactions.

The BPO is based on the ISO 20022 messaging standard and is an irrevocable undertaking given by a bank to another bank that a payment will be made on a specified date after successful electronic matching of data, according to an industry-wide set of ICC rules. The BPO thus eliminates paper handling and manual data entry, the costly by-products of the safe documentary credits, and provides payment assurance and business efficiency through the matching that takes place between the purchase order and the invoice.

“The BPO is an irrevocable payment obligation that enables secure open account transactions – which by definition do not involve banks, because trade documents in open accounts do not reach banks, and banks don’t get involved in the transaction until the time of the payment,” says Andre Casterman, head of banking and trade solutions at Swift.

“With the BPO, banks can mitigate the risks involved in open account transactions. It is a document that provides data for the bank to match the invoice to the purchase order and perform the payment. This way banks separate the document flow from the information flow. Paper can still exist in the corporate-to-corporate space, as most trades are still made on paper. But with the BPO, banks extract the data from the paper document and use it electronically. So the bank knows about the transaction and can execute the same function as they do in the letter of credit,” he adds.

Consequently, the BPO creates a bank-to-bank open account channel, in which the buyer’s bank provides payment assurance to the seller’s bank and in which the seller’s bank can charge its client for this assurance. The seller receives its money from its own bank once it has presented the data that is required and has been agreed with the buyer. The seller receives its money even if the buyer does not pay its own bank.

Enter UCP600

This is a risky business for banks, but Mr Casterman points out that “the core business of trade finance is about risk and to charge customers for that risk”. To mitigate risks, especially in cross-border trades, the ICC is creating a supplement to its rules on global trade practices based on letters of credits, called UCP600, to accommodate the electronic nature of the BPO. UCP stands for ‘uniform customs and practice’ for documentary credits and the UCP600 code has been in practice since 2007.

Phillip Kerle, CEO of financial software company Demica, says that the ICC rules have been the backbone of international trade for many decades. “At Demica, we have an electronic system via which clients can send us data or request the issuance of a letter of credit. It is all done on a straight-through-processing basis. The messages are sent through the Swift network.”

UCP600 has been in practice since 2007 and its key directives include five banking days for acceptance or refusal of documents by a company, as well as a definition of provisions for discounting on deferred payment credits. UCP600 rules also state that letters of credit are binding. The eUCP600 directives were put in place not long after and contain the same rules as the UCP with reference to paperless transactions.

But just because the ICC supports an initiative such as the BPO, it does not necessarily mean it will take off, according to David Toubkin, executive director for trade finance at global trade solutions specialist Surecomp. “We asked our clients if they have ever used the electronic version of letters of credit – and not a single one had. So the BPO may take off, but I believe it will be a slow progress,” he says.

The success and deployment rate of
the BPO will depend on reliable data from de facto transactions. It will become effective in the second quarter of 2013 and already 31 banks have agreed to adopt the BPO, including Citi, JPMorgan, Barclays, BNP Paribas, Korea Exchange Bank and Bank of China.

Mr Proctor argues that the convergence between letters of credit and open accounts will continue and the emerging and evolving technological capabilities will also continue to create similarities between the payments world and the trade world. As open accounts become electronic, banks are realising that by catching up and by proving different financing options, they can re-intermediate themselves into trade finance by offering more than payments execution. 

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