Trade Finance: What the Heck Is a Bank Payment Obligation?

While Letters of Credit (LCs) have been around for centuries as a reliable mechanism for trade, corporates are now looking for ways to reduce paper and increase efficiency. Prior to the financial crisis in 2008, corporates were moving in increasing numbers towards open account, but as risk spiked, many in the industry reverted to the security of LCs.
Today, the macroeconomic environment is comparatively stable, and corporates are turning back to open account. However, they are concurrently seeking new platforms that allow them to shift away from the perceived inefficiencies of LCs and the risks associated with open account – once and for all.
Bank Payment Obligations (BPOs) are a viable and appealing option, particularly once new rules and standards governing trade involving BPOs are finalized and implemented.
Benefits of BPOs
One of the most significant benefits of BPOs is that they remove paper from trade and eliminate manual processes. While both a BPO and a traditional LC require matching key pieces of information from the purchase order and invoice underlying the transaction, a critical difference is that with a BPO, electronic data, rather than paper documents, are used for the matching.
The financial institution matches the purchase order with the data electronically rather than manually - a much quicker process - and can then make payment to the recipient bank. Essentially, any paper still used by the buyer and seller stays out of the banking channels.
Dealing with paper is a huge cost of trade and complicates the processes involved, both for the seller who has to prepare the documents and the financial institution that has to review and manage the paper. Financial institutions and corporates alike stand to save tremendous amounts of time and reduce costs by using BPOs.
While the efficiencies of using electronic data rather than paper are clear, having electronic data also means there is a wealth of reporting available that adds value for financial institutions and corporates alike. In addition to using electronic data to speed up processes in the supply chain, corporates may also use it to improve their cash management, better link internal processes, and improve management of their supply chain.
Reluctance to Change
However, while financial institutions have been able to process BPOs for several years now, the actual transactional flow has remained light. Though BPOs combine the benefits of electronic efficiency with the comfort of an LC-like structure and rules, corporates are still reluctant to change.
In many cases they are used to existing processes around paperwork, invoices, packing lists, bills of lading and other documentation that have been in place for many years. Consequently, corporate systems and processes have been designed for LCs, the logistics in the supply chain revolve around LCs, and LCs are familiar to both counterparties in the transaction - and so end up being the preferred way corporates do business - regardless of any inefficiencies or added costs.
Large importers also employ literally hundreds of people to process LCs in some cases. Changing to a more streamlined process could affect staff assignments and workload. Perhaps most importantly, using BPOs requires a change to the entire thought process around trade, which is at least as significant as the idea of getting rid of paper.
Catalysts for Change
While many corporates are sticking with LCs and taking a "wait and see" approach to the BPO solution, others see huge potential benefits from making a change and are analyzing how best to do it.
Financial institutions are working with corporates to design standardized systems and that make it easier to move data from corporate to bank, and from bank to corporate, so that clients can convert to BPOs seamlessly, without implementing new systems.
Two important catalysts are likely to push the industry to a tipping point that will drive the shift to BPOs:
  • An established framework. Standardized industry rules on how banks handle BPOs will ensure consistent, transparent handling of all transactions and resolution of issues. The International Chamber of Commerce (ICC) BPO Working Group in conjunction with SWIFT, the operator of the messaging platform used by more than 10,000 financial institutions and corporations in 212 countries, is focusing on setting up these rules.
  • First movers. A shift by several significant global trading counterparts from LCs to BPOs will provide momentum, set a precedent, and create a competitive imperative for market participants to match their 'rivals' gains in speed and efficiency, and reduction in costs.
ICC/SWIFT Solutions
One of the most important current initiatives for both the ICC and SWIFT is the development and implementation of new operating rules and processes around BPOs. A drafting group is working on a set of rules that will govern BPOs. The aim is to have these rules approved as early as 2013.
Along with drafting the rules, the ICC is leading two other initiatives to help pave the way for faster conversion to BPOs. One focuses on industry education, with a dedicated thought leadership group developing significant education resources that can be used as part of the broader BPO conversation.
A second initiative comprises a commercialization group, which is involved in smoothing out operational bumps around the BPO process, better communicating the relevant information to target stakeholder groups, and disseminating information around the scope of the new incoming rules and gaining industry endorsement.
Tipping Point
Many larger financial institutions are already prepared for BPOs. Systems are in place and trade finance teams have been trained. Financing mechanisms have been established, so that ultimately, there is little difference in how financing will work between LCs and BPOs.
Some financial institutions, on the other hand, have decided that the investment to put the infrastructure in place may be too costly or may represent a non-core business or product. To service clients who want to switch from LCs to BPOs, these institutions can partner with those financial institutions that already have the processes in place.
As the benefits of the BPO become apparent, and the industry framework is more clearly established, the stage is set for a significant increase in BPO transactions.
The key, of course, is for corporates to change their processes. Once corporates do reach a tipping point, financial institutions could well face a sudden rush for BPOs. With the rules and commercialization practices coming along soon, financial institutions need to make sure that they are ready for this shift.
About the Author
New York-based Dan Taylor is Managing Director and Industry Issues Executive, Americas, for J.P. Morgan's Treasury & Securities Services Global Markets Infrastructure group. This article was first published in 360o: Views from J.P. Morgan, October 2012, and was re-edited for clarity and conciseness.