Mind the gap

Managing the open account finance divide. By Jonathan Heuser, JPMorgan Chase, Global Trade Services, New York.

Mid-nineteenth century London was the capital of a far-flung empire and a hub for global commerce, and thus a fitting place for George Peabody, an American financier, to establish his trading house. When the childless Peabody chose a young Boston banker named Junius Spencer Morgan as partner and heir to his thriving business, Junius moved his family, including the young John Pierpont Morgan, to London, and laid the hereditary foundations of the venerable House of Morgan.

The House of Morgan rapidly became the premier international bank but by 1913 the centre of economic gravity had shifted to New York. Jack, the third of the Morgans to run the enterprise, opened a stately new headquarters at the corner of Broad and Wall Streets in Manhattan. Sealed within the building’s cornerstone was a copper box, the contents of which were meant to represent the basic elements of commerce that formed the House of Morgan’s roots. One of these totems was the form used for a letter of credit (LC).

For hundreds of years before Jack Morgan’s symbolic gesture, letters of credit had been a key building block of commerce – a part of trade’s foundation. Geographically separated trading partners sought to complete transactions with a minimum of risk, with the problematic result of increasing the risk of their counterparties. LCs helped to span this divide.

International trade was burgeoning in advance of the development of a systematised global economy, and banks in JP Morgan’s day were quasi-governmental institutions that filled the resulting vacuum. Since then, international trade has only grown in importance, though politics, regulations, and technology have changed the landscape across which goods and payments flow. Trade finance has changed along with the times.

Import volumes have surged and letters of credit are still in heavy use. At the same time, communications and technology have made the world seem smaller and enabled close cooperation between trading parties. Retailers in general and the apparel industry participants especially have long sourced goods offshore, but today there is more focus on buying overseas than ever and market leaders in almost every industry have globalised their supply chains. Expansion now comes from not only organic company growth but also from a drive to take more control of goods earlier in the sourcing process, and to disintermediate players – like agents and middlemen – who might no longer add value for importers of a certain size.

China continues to be the main beneficiary of this import growth, but sourcing locations have grown far more diverse: ‘country of origin’ is rarely a single place, and importing is truly ‘run-of-the-mill’ – no longer the exotic proposition it may have once seemed. Far-off factories have become trusted partners. Diversity in the supplier base – factories of different sizes, locations, and capabilities – has led to a diversity of payment instruments as well.

Until quite recently, the letter of credit reigned as the principle trade finance instrument. Interestingly, LCs in 2006 still account for a significant volume of imports, but trend lines indicate that open account payments are growing dramatically. The letter of credit has defied predictions of its demise because it is effective at what it does, and because it has become automated, faster, cheaper, and more user-friendly. All the same, despite its established benefits, the buyer, the seller, or sometimes both feel that they no longer need the structure the letter of credit provides.

As LCs lose preeminence, what will replace them? Open account payments, certainly, but in many forms: through bank platforms, through homegrown processes, through TradeCard, through straight software providers, or even through enterprise resource planning systems.

As a result, the rise of open account creates a new problem: lack of industry standards for processes, documents and regulations. Many trading partners see open account as a way to save money and simplify the payment process. Some of the unintended consequences of their approach may be confusion and increased risk – especially if market conditions become less certain.

Moving away from the letter of credit has ramifications far beyond a simple question of cost. Proper analysis of various payment methods should include several elements. The common payment methods, for comparison, can be arranged along a spectrum, beginning with letters of credit and running to private label letters of credit, bank-outsourced open account and in-house open account. The letter of credit end of this continuum represents lower risk and higher third-party transactional costs, while the open account end indicates higher risks and lower third-party transactional costs.

Cost is the most widely cited reason for changing from LCs to open account, and clearly open account bears lower ‘transactional’ costs than a letter of credit. This conventional analysis, however, overlooks important underlying aspects of the transaction. Generally, a letter of credit enables the supplier better access to lower cost financing, and a greater amount of pre-export financing from their local lender – working capital that may not be available through an open account transaction.

A letter of credit is typically marked against the applicant’s credit line with the issuing bank. The bank assigns a certain amount of credit or risk-related cost to usage of this credit line commensurate with the risk of providing an independent guarantee of the payment. The cost varies, depending upon the creditworthiness of the applicant, and may be borne by the importer or the exporter. With a letter of credit in place, the supplier’s local bank knows that as long as the supplier performs, that supplier will get paid – after all, the importer is a creditworthy buyer, guaranteed by a creditworthy bank.

For that local lender, payment risk is virtually eliminated, and only supplier performance risk remains. The local lender is thus willing to provide working capital to the supplier at a lower rate than would have been possible without the guarantee provided by a letter of credit. Without the LC, the local lender has only a purchase order (PO) to rely upon, and to that lender the PO might not be worth much more than the paper upon which it is written. Financing under the open account scenario would then be calculated based on the vendor’s stand-alone credit rating – typically not as solid as the importer’s.

Higher financing costs generally translate into a higher cost of goods. When goods are being purchased under a letter of credit, the supply chain flow begins when the buyer first orders the goods from the supplier, and continues as the goods are produced, shipped, cleared through customs, delivered into available inventory and finally purchased by a customer. The supplier receives a letter of credit about 90 days before the goods are shipped, enabling the supplier to get financing from that point until the buyer makes payment.

At the bottom of figure one are a number of different interest rates, which are not true market rates, but are instead representative of the ‘relative’ borrowing costs for different types of working capital financing. The buyer’s cost is the lowest, shown here as 1%. The seller’s rate is the highest, shown as 4%, and the LC-based financing rate and supply chain finance rates fall between. In this example, if we look at the 140 days between the start of the production process until the goods are eventually converted to cash, 110 days are financed at the 3% LC-based rate, and 30 days at the buyer’s 1% rate.

When the buyer moves from letters of credit to open account and has negotiated 60-day payment terms – a move commonly associated with the change to open account – his entire 150-day supply chain flow is financed at the seller’s 4% rate. In fact, the seller is still carrying this burden for 10 days after the buyer has converted the goods to cash.

In the first scenario, the goods are financed for 140 days at a mixture of 3% and 1%, and in the second are financed for 150 days at 4%. Costs have clearly been added to the overall supply chain, and logically the supplier will endeavour to recover these elsewhere – through the cost of goods, for example.

It is critical for importers to recognise that the supply chain is a linked system in which a change that benefits one party is likely to extract a price from another participant. The question, then, should be, which party is the best and most effective with which piece of the supply chain? The buyer? The seller? A bank? Some other partner? The analysis can be complex.

Starting at a high level, a company must connect its payment strategy to its overall financial strategy. The company needs to define the end goals of its supply chain: is the objective to extract maximum value for the company as an individual unit, or to lower costs throughout the entire supply chain? Does the company plan to take all benefits for itself, or share them with partners? Is the company focused on what it does best – sourcing, transporting, marketing and selling goods – or taking on challenges outside of its core business that may distract it from its primary goals?

These questions have yielded a myriad of answers across companies, but certain trends tend to characterise industry leaders:

• Building a trade payment programme with different payment methods gives a company flexibility to accommodate various financing scenarios, vendor types and market conditions, and will be especially beneficial if the different processes can be rationalised; for example, by establishing similar operating process for LCs, open account payments, or other instruments;
• The ability to integrate a variety of vendors into the process – from large, strategic suppliers capable of EDI (electronic data interchange) exchange, to smaller factories reliant on the web or even paper documents;
• Communicating options and strategy to internal buyers – or to those that own the supplier relationship – as well as to suppliers themselves;
• Understanding the importance of the buyer’s commitment to the financial supply chain;
• Integrating supply chain and financial analysis;
• Incorporating risk management, customs and regulatory compliance;
• Securing appropriate technology – whether by buying, borrowing or building;
• Connecting other partners, such as freight forwarders, carriers, banks, inspection companies, and customs authorities – to better leverage the flow of documents and information.

Perhaps the most important hallmark of a market leader, however, is a willingness to ask the questions posed above, to draw conclusions and to make informed decisions, rather than to be led down a particular road by circumstance or rote. Support for such decisions can only come from a trade finance provider that integrates a sophisticated suite of finance instruments and processes with global logistics and trade management resources – a global bank that can both anticipate and help bridge all the gaps that might otherwise compromise your trade flows. Such international trade banks can offer the unique ability to provide coordinate advisory and services for a client’s entire supply chain – both financial and physical. It is becoming increasingly apparent that nothing less will serve.