At a basic level, trading internationally is not that dissimilar to trading domestically, except that when dealing with businesses based in overseas markets, receiving and making payments can be a more complex process.
In international trade, the payment method used has a significant effect on the financing required and the level of risk assumed.
International payment options include:
- Open account payment
- Documentary collection
- Letters of Credit or Documentary Credit
- Payment in advance.
The risk ladder
Open account payment is similar to offering credit to a domestic customer. Typically, the credit term (eg 30 days) starts once the goods are despatched and invoiced, in line with the terms of trade.
80% of global trade is on an open account basis  – it is the simplest and the least expensive method of payment, but it does assume a level of confidence in a trading partner's ability/willingness to pay.
Many businesses enter into international trade with a small transaction, shipping goods on open account, sending an invoice and getting paid in 30 days. With this option, the business bears the risk of offering a small amount of credit, while waiting for payment.
As more orders come in and a business relationship grows, opportunities increase, but so do the risks. Other trading instruments, such as letters of credit, import bills and trade credit insurance, offer greater risk mitigation while the relationship evolves and trust develops.
Types of transaction
For any individual transaction, the most appropriate method will depend upon the level of risk involved, each party’s commercial leverage, and the exporter and importer's relative cost of financing.
A documentary collection, where a bill of exchange is drawn up, allows the exporter to keep control of the goods and raise additional finance. Documentary collections are typically used by exporters selling to importers with whom they have an established relationship.
There are a number of nuances associated with documentary collections. One variant is that an overseas bank, acting on behalf of the exporter's bank, will only release the documents necessary for the importer to take possession of the goods once the importer formally accepts the terms of the bill. However, the exporter still carries the risk that the importer will not settle the bill when it comes due. On the other hand the costs associated with a documentary collection are lower than with a letter of credit (see below).
However, not all documentary collections include presentation of a bill of exchange for acceptance by the buyer. Some documentary collections are payable at sight, so there is no bill and low risk of the buyer getting the goods before it has paid for them. Others documentary collections require acceptance or avalisation of the bill by the buyer's bank, so the seller takes credit risk on the buyer's bank, not the buyer.
Letters of credit
Letters of credit (or documentary credits) are the most secure method of payment (other than payment in advance). The importer arranges a letter of credit (LC) with its bank (the ‘issuing bank’) which pays a correspondent bank (the ‘advising bank’), once all the necessary documentation is submitted. It is important to note that LCs are not an absolute and automatic guarantee of payment; the bank will only pay if the exporter presents all the right documents before the expiry date of the letter of credit.
Letters of Credit are typically used for exports to new customers. They offer reassurance to exporters that they will be paid (subject to them presenting the right documentation within the appropriate timeframe) and to importers that they will actually receive the goods they ordered. However, in its simplest form a LC does not protect an exporter against risks such as the default of the issuing bank or country risk (eg where the importer's government changes the law so that the settlement of LCs becomes impossible). Exporters may therefore find it worthwhile to discuss the various possible additional options relating to LCs (such as confirmation) with their banks in order to select the solution best suited to their needs.
Full or part pre-payment is typically used for low value sales to individuals or new customers. Although it is the least favourable option from the buyer's perspective, start-up businesses often use advance payment via credit card. Many websites use an online payment processor such as PayPal, Google Checkout or WorldPay to provide a measure of comfort to both buyer and seller. It is important to bear in mind that the degree of protection and the dispute process can vary significantly among payment processors.
- Striking a balance between exporters' and importers' risk appetites is an integral part of agreeing the payment type used for international trade transactions.
- There are a variety of payment options available, all with differing risk/cost profiles.
- For new participants, understanding which may be the most appropriate payment type for a particular transaction can be challenging.