Different Payment Methods & Their Risks in International Trade
Once a trade transaction is completed, the importer must pay the exporter reliably and on time, with a bank often acting as an intermediary between both parties. Broadly speaking, there are five commonly available methods for efficient international trade settlements.
Letters of Credit (LC)
One of the most secure payment methods for both buyers and sellers, an LC is a letter from a bank that guarantees it will make a payment on behalf of the buyer to the seller, on time and for the stipulated amount, without fail. Terms of an LC can vary depending on the needs of the parties and it is usually the least risky for both.
Here the buyer must pay the seller upfront before the goods are shipped and ownership transferred. Obviously, this has the least risk for the seller and the most for the buyer.
The exporter will ship and deliver goods to the importer before payment is due, giving the buyer up to 90 days or more to make the payment. Clearly, this requires a great amount of trust between the two and is the most favourable for the buyer but most risky for the seller.
The seller’s bank is instructed to send the relevant export documents to the buyer’s bank along with instructions to present the documents to the buyer for payment and the terms under which the documents can be released to the buyer. The buyer makes the payment using a draft upon being presented with the documents (at sight) or on a previously stipulated date. However, there is no guarantee involved in this method, unlike with an LC, making it riskier for the seller. Still, these arrangements are often much cheaper than LCs.
Here an exporter ships goods to a foreign distributor, however the distributor (importer) only needs to make payments on the goods once they are sold to the end user. Ownership of the goods remain with the exporter until they are sold. Again, trust is essential in such an arrangement and the seller is exposed to substantial risk but also benefits from reduced costs involved in the storage, marketing and distribution of the goods
The table below indicates the relative riskiness of each of these methods:
|Payment Method||Buyer Receives Goods Before Payment||Settlement Timeframe||Risk to Seller||Risk to Buyer|
|Letters of Credit||No||As Arranged||Low||Low|
|Cash-In-Advance||No||Prior to Shipment||Lowest||Highest|
|Open Account||Yes||As Arranged||Highest||Lowest|
|Documentary Collections||Yes||Upon presentation of documents or on the stipulated date||Moderate||Moderate|
|Consignment||Yes||After sale by consignee to end user||Moderately Low if with established distributor. Otherwise high.||Low|