• Transactional finance

    Chapter 3 - Cotton marketing - The role of banks in cotton export finance


    Principal credit standards

    The most common type of financing is based on the strength of the export transaction. This type of financing is referred to as transactional finance. As a rule, the credit line agreed between the bank and the cotton exporter, and each utilization by the latter, are directly linked to the underlying commercial transaction. The financing covers the period from the purchase of the cotton or its production process through to the final payment of the sales proceeds by the buyer of the cotton.

    Typical structures of transactional finance for cotton producers and traders involved in exports are borrowing base facilities, inventory finance, pre-sold, and back-to-back transactions where the quantity and quality of the cotton purchased and resold are the same.

    Major criteria used by banks assessing the strength of an export transaction are:

    • The buyer’s solvency and reliability;
    • The status and terms of the export sales contract;
    • The quality, storage, transportation and processing of the cotton;
    • Price and currency risks;
    • The exporter’s ability to deliver the cotton as agreed.

    As a rule, for all financing, export goods must comply with industry, government and contract specifications. Payment by the buyer must be in line with foreign exchange and other governmental regulations.

    Transactional financing is subject to proper loan documentation providing, among other things, for: the assignment of accounts, receivables, insurance policies and proceeds under the export contracts; the pledging of goods; and possibly also non-transaction-related collateral such as mortgages.

    Borrowing base and inventory financing are related to physical stocks: these stocks are generally stored in eligible warehouses, properly marked, stored separately and clearly identifiable. Goods in storage should preferably be represented by title documents (e.g. warrants). Suitable commercial all-risks insurance covering storage, transportation and loading onboard ship should be in place.

    Mitigation of the buyer’s payment risk

    A major risk facing the cotton exporter and the financing bank in transactional finance is that of non-payment by the buyer for the cotton that has been delivered. It is therefore of vital importance to carefully assess the buyer’s ability and willingness to make payment. In cases where financing is provided by the bank, the receivables are assigned to the bank and the buyer makes payment into the borrower’s account with the financing bank.

    Below are some of the tools that can be used to eliminate or at least mitigate the risk of non-payment by the buyer:

    Letters of credit (L/Cs)

    An L/C is a payment instrument in which a bank assumes the payment obligation of the buyer. An L/C is:

    • The written assurance of bank
    • On the instructions of the applicant (buyer)
    • To pay a specific amount
    • To the beneficiary (exporter)
    • In the agreed currency
    • Against submission of documents in conformity with the documentary credit

    The information on payment flow is shown in figure 3.1 below. 


    One of the major advantages of an L/C is that the bank will effect the payment regardless of the buyer’s willingness to pay (meaning that the buyer cannot withhold payment on any pretext), provided the documents submitted are in conformity with the documentary credit. It is therefore very important for the exporter to ensure that no discrepancies arise in the documents: if there are discrepancies, the bank is no longer obliged to pay.

    Another major advantage is that L/Cs are subject to the Uniform Customs and Practice for Documentary Credits (UCP), which are recognized and accepted worldwide.

    By choosing an L/C, the cotton exporter transfers its payment risk from the buyer to the bank. This risk can also be mitigated by asking another bank (one with a better rating, for example) to confirm the relevant L/C. In this case, the confirming bank promises to pay as stipulated in the letter of credit against presentation of documents that conform with the L/C. Confirmation by a bank located in a country other than the one where the issuing bank is located removes the transfer, political and credit risks in respect of the issuing bank.

    Standby letters of credit

    A special form of documentary credit is the standby letter of credit. The standby L/C basically fulfils the same purpose as a guarantee: it is payable upon first demand and without objections or defences on the basis of the underlying transaction. The standby L/C is used to secure any claims the beneficiary might have against the applicant due to a breach of contract. It may cover performance obligations by the exporter or payment obligations by the buyer. The documents presented in the claim under the standby L/C must be submitted within the period specified therein and in the required format. These documents should show that the party that applied for the standby L/C has not or has insufficiently fulfilled its obligations.

    Documentary collections

    Documentary collection offers the exporter far greater security than selling on open account, but not as much as an L/C. Credit, political and transfer risks, for instance, are not covered. Documentary collections can be either

    • Documents against payment (DP) – instructions under a collection order to hand over the documents to the buyer against payment; or
    • Documents against acceptance (D/A) – instructions under a collection order to hand over the documents to the buyer against acceptance of the bill of exchange drawn on it.

    The advantage of documentary collections is that the documents, and thus the cotton, can be released to the importer simultaneously upon payment of the amount owed or acceptance of a draft. Furthermore, documentary collections are subject to the Uniform Rules for Collections (URC). However, if the importer refuses to accept the documents, losses can be incurred by the exporter. The exporter may be obliged to find an alternative buyer, which may prove to be extremely costly or even impossible.

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