Corporates facing risks with open-account trading
Companies are increasingly using open-account transactions again to facilitate mutual global trade, but by almost cutting out trade-finance banks entirely, companies are opening themselves up to risks.
Open-account transactions – in which goods are shipped and delivered before payment is due – form part of a long-term shift among companies of all sizes seeking alternatives to traditional forms of trade financing provided by banks.
The financial crisis heightened that interest among companies as banks pulled back from financing trade, but escalated risk and poor global economic growth in the past few years meant that open-account transactions were put on hold.
However, with rising confidence on the direction of global growth, together with increased pressure on companies to optimize working capital and technological advances, companies are again engaging in open-account transactions.
Indeed, the implementation of standardized messaging methods, such as Swift’s ISO 20022 service as supported by the Single Euro Payments Area, has made it easier for the corporates to manage their flows and given them greater autonomy from the banks.
This change has led to a dramatic shift away from traditional trade instruments, such as letters of credit, to more direct ways of working with counterparties. The use of open account in trade finance has been a consistent trend in recent years, shifting to account for 90% of all trade transactions, according to Swift.
However, although it has its advantages for importers in terms of cash-flow and cost, open account leaves exporters exposed to higher risk, as buyers might default after the goods have been shipped. And in the difficult economic climate the risks have never been higher.
The benefits of open account arise out of working with parties that are trusted, with long-term relationships of on-time and complete payments. Jeremy Shaw, head of EMEA trade finance at JPMorgan, points out that it shows the transparency and trust in a counterparty.
Although the transactions can seem attractive because of the reduction of paperwork, a simplified supply chain and lowered cost, there are rising negative impacts, particularly in the face of the changing geopolitical climate.
Société Générale’s global head of trade services, Thierry Roehm, questions the merits of working on open account when weighed against the potential risks. Assessing the plus points of working on open account, Roehm states it is “simplicity and lower cost… as long as everything goes well”.
As corporates look to operate in increasingly competitive markets, they are potentially opening themselves up to increased risk by looking for the best returns, Roehm says. Operating through open account does not provide any protection from any form of risk. And in the current geopolitical climate, there is concern about how badly this could affect certain trade corridors.
Roehm says there is a concern that without banks to intermediate and secure trade activities, “heightened levels of risk could slow down international transactions”.
The level of risk, whether from the spoilage of the shipped commodities to counterparty default, can be mitigated through the use of private credit insurance, but this is regularly not taken out.
Shaw says the responsibility falls on the seller’s side: “The seller clearly has to have solid credit management controls in place and be comfortable with political and currency risks of the buyer’s market.”
But political risk is not the only factor that is coming into play; as Shaw notes, the familiar issues around increased anti-money-laundering measures and compliance are also affecting the way that corporates are completing their business.
Michael Spiegel, head of trade finance and cash management corporates at Deutsche Bank, adds: “The greater the political volatility, the more clients will look to mitigate the political risk exposure through structural means, including using letters of credit, or demanding payment on shipment instead of delivery, or using a commercial intermediary to take the delivery and payment risk.”
There has been debate around the move towards the use of bank payment obligations (BPO) in open-account transactions, but so far they still account for very few of the overall transactions. The BPO provides additional support in the event of a bad transaction, providing a safer alternative to prepayments to the exporter as they do not pay upfront. But in spite of its apparent advantages, the system is still slow to take off. Commerzbank became the latest bank to use the BPO for the first time last month, taking the number of banks that have actually used it up to just 15, four years after it was launched.
Without the back-up of support, there is the possibility some corporates will find themselves with potentially serious problems should a counterparty fail or the geopolitical climate change.
“It should be clear that in the event of a dispute, enforcing an open-account claim in a politically hostile jurisdiction opens one up to the possibility of unsympathetic courts, high costs, and low probability of success,” says Spiegel. “Prosecuting a claim for non-payment of an open account in certain jurisdictions can be quite complex, and made even more difficult if there is political tension between the seller’s jurisdiction and the buyer’s.”