Mitigating the risks of open account trade

More regional companies are turning to supply-chain financing as they take a broader approach to risk mitigation.

It’s not just banks that are raising their games when it comes to risk management. Economic uncertainty and more stringent regulatory requirements are prompting companies to take a much closer look at their risk exposures.

But this is happening just as open account trade is increasingly common practice. Open account transactions means that widgets are shipped and delivered before the payment is due. Typical credit terms are for 30 to 90 days. Obviously, this is exactly what the importer wants — an opportunity to get the products and maybe even sell them before having to pay the bill. But it is risky for an exporter. But bankers say that open account trade is more efficient, and can offer savings, particularly for companies with a one-to-many relationship between themselves and their suppliers. But what firms need to do is make sure they establish firm risk policies that apply to all clients.

“Theoretically open account is cheaper [than letters of credit], but firms are only getting one thing accomplished,” said Jonathan Heuser, managing director, trade advisory and solutions delivery treasury services, treasury services at J.P. Morgan. “They may get paid but they still need to find risk mitigation and discounting, which letters of credit provide.”

He added: “Documentary trade and letters of credit are a fairly tactical solution to risk. You know exactly what you are getting and what it will and will not solve, but it only addresses risk on a given transaction. Once you move towards open account we see a broader approach to risk mitigation, meaning firms are establishing policies and tolerance limits for risk. Clients are taking a more strategic view of risk rather than transaction by transaction.”

How much of this broader approach to risk is due to the global financial crisis and how much has been provoked by growth into offshore markets varies. But one product of the global financial crisis has been an increased awareness of counterparty, liquidity, credit and settlement risk. “These days Asian corporations are looking at the interaction between business risk and financial risk and determining the right level of risk tolerance for the company. This was not the case earlier; it is the credit crisis that has brought this into sharper focus,” said Aneish Kumar, head of trade finance, Asia-Pacific at BNY Mellon.

According to Kumar, during the past two years firms have started paying far greater attention to risk and counterparty management, and have a much clearer grasp of the options available. “Risk management has evolved, and corporations now understand supply– demand-coordination risk, disruption risk and process risks in supply-chain financing much better. But they are still grappling with how to deal with some of the accidental triggers that disrupt the supply chain, not just accidents, but also transport issues and regulatory impositions,” said Kumar. Of course, the biggest problem is often people, who are the weakest link in the supply chain.

Other tricks of the trade

Other traditional trade finance techniques, such as export-credit insurance and factoring, can help mitigate the risk of non-payment associated with open-account trade. The relative lack of insurance companies offering trade-risk products in the region may also mean instruments like business payment obligations (BPOs) could become more common. BPOs, which are designed to help bridge the gap between open account and traditional trade, can provide assurances to both buyers and sellers.

“This product also creates a compelling need for firms to process their cross-border open account through banks, and also helps unlock more effective mitigations due to improved visibility and control,” said Kumar. “My gut feeling is that in order to improve financial efficiency, companies will be seen pursuing a more embedded relationship with their transaction banking providers.”

Firms are also more frequently turning to supplier and buyer finance programmes to mitigate some of the risks. Large anchor buyers are leveraging their credit ratings with banks to secure cheaper working capital funding for their suppliers and in return securing themselves more favourable payment terms.

“A big advantage for suppliers using traditional documentary trade was that they could realise their sale proceeds prior to maturity date and control their cash flow through letter of credit discounting and similar mechanisms,” said Nicole Wong, Deutsche Bank’s regional head of financial supply chain, Asia. “Corporations who are anchor buyers understand how important this is to their suppliers and, in the move away from documentary trade towards open-account trade, are increasingly turning to supply-chain financing to aid suppliers in managing their cash flow.”

Corporate care

But for a supply-chain-financing programme to work most effectively, the anchor client not only needs to carefully select the suppliers — some firms look at suppliers’ operating cash flows and debt- to-equity ratio of their suppliers or ask for up-front payment or deposit before they sign off a contract — but must also stay actively involved in the management of the supply chain. Heads of supply chains in multinational corporations (MNCs) also tend to enjoy more seniority and access to CFOs and treasurers than do their counterparties in Asian firms, but this too is changing.

“The factors ensuring a successful supply chain finance programme would be the dynamics of the supply chain — corporate-supplier/buyer relationship, the strength on the product, the length and depth of the relationship. This relationship should be viewed as an ecosystem where it is a symbiotic relationship,” said Ashutosh Kumar, global head of corporate cash and trade at Standard Chartered. “The corporation will have to have a view that a successful supply chain programme involves their participation and not a programme solely conducted by a financial institution, as the financial institution relies on the cooperation and information flow from the corporation to mitigate the risks.”

Burgeoning trade flows and the predominance of open account trade means the significance of trade finance instruments such as supply-chain finance is only likely to grow, especially as awareness of risk among Asian firms continues to rise.


This story was first published in the August 2011 issue of FinanceAsia magazine.

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