In 2011, cross-border trade reached a value of around US$18.2 trillion. Most of this activity—80 to 90 percent—was settled on open account terms, meaning that the buyer received the shipment before paying the seller. Open account trade has clear benefits for buyers of goods, but it puts sellers at some risk that the buyer might not pay. This can be especially troublesome when a company first begins selling to a new buyer in an unfamiliar region of the world. The traditional method for mitigating counterparty risk in such a situation is the letter of credit (L/C), a paper document issued by a bank that assures payment once the bank receives documentation that the shipment has fully met the contract terms.
Now companies have access to a new instrument. The bank payment obligation (BPO) functions like a traditional letter of credit instrument that supports a commercial open account trade payment. It transfers buyer risk to an obligor bank in the same way that an L/C does, but it does so much more efficiently because fulfillment of a BPO involves the digital exchange and matching of data in ISO 20022 XML format.
So if Company B orders 100 cartons of blue T-shirts and requests a BPO for the transaction, its bank will upload the transaction’s purchase order information to the SWIFT TSU. Then the seller—say, Company S—will have its bank upload invoice data, which should describe the manufacture and shipping of 100 cartons of blue T-shirts. The TSU will match the purchase order data with the invoice data. If the quantity, price, shipping terms, port of departure, etc. all match, then the bank for Company B is obligated to pay the bank for Company S. This is similar to the transaction-data matching that happens regularly in enterprise resource planning (ERP) and treasury management systems, but it’s performed by an independent third party, and the BPO adds assurances of payment from the buyer’s bank.
BPOs in Context
How does the BPO compare with existing tools and techniques? In terms of their risk mitigation benefits, BPOs are most comparable to letters of credit. In both cases, the buyer’s bank guarantees payment as long as certain conditions are met and documented. However, the BPO is not simply an electronic L/C. For one thing, the BPO is a straightforward bank-to-bank arrangement in which the seller’s bank—and not the seller itself—is the beneficiary. As such, the two-party BPO is simpler and more insulated from the underlying transaction than a traditional L/C, in which the issuing bank, the advising bank, and the beneficiary are all parties.
Building a Business Case for 21st-Century Trade Settlement
It takes two to tango in any kind of trade transaction, and local banks in emerging markets may have never heard of a bank payment obligation. Nevertheless, for companies that engage in large transactions in far-flung regions of the world, now is a good time to look into this option.