Updated July 13, 2023
Introduction to Forfaiting
Forfaiting is a trade financing dealing with foreign receivables of exporters. Any exporter who forfaits the receivables can receive the payment immediately from the forfaiter (Bank/ Financial Institution) at a discounted value (i.e.) Selling of receivables which is due from the importer on a “without recourse” basis.
A Forfaiter can be any entity/individual who is a specialized firm that deals with buying foreign receivables from exporters. They take the responsibility of collecting the money from importers.
The exporter can sell their Medium to long-term receivables to the forfaiter at a discounted value through any intermediary. So selling the receivables helps the exporter to remove the risk of not receiving their receivables or receiving at a period longer than credit days. Moreover, post forfaiting, the exporter has no liability towards the forfaiter for the money to be received from the importer; all risks and rewards with respect to the receivables completely get transferred to the forfaiter.
Features of Forfaiting
- Forfaiting is a financial transaction that supports the exporters to receive their payment immediately from the forfaiter at a discount. Therefore, they ideally sell the receivables to them and take a cash settlement for it immediately.
- The transaction of forfaiting happens through an intermediate such as banks/financial institutions that deal with forfaiting.
- Forfaiting protects the exporters from the credit risk of the importer, money transfer risk, and other risks associated with the forex fluctuation and interest rate movement. The exporter’s fee for this transaction is the differential value between the receivables amount and the discounted amount received from the forfaiter.
- The receivables can be also be traded in the secondary market by way of any debt instrument like bills of exchange, promissory notes, letters of credit, etc. The time frame of the instruments can be from one month to even like ten years. But, predominantly, it comes under the time frame of one to three years.
How Does it Work?
A forfaiter purchases the receivables from the exporter and immediately pays the exporter at a discounted price. The amount to be received from the importer is guaranteed by the importer’s bank in the form of aval, letter of guarantee, or letter of credit. Thus, the exporter enjoys the money immediately and need not wait till the credit period to get the money from the importer, and it saves them from credit risk, transaction risk, and forex risks. All risks and rewards get transferred to the forfaiter, and the exporter doesn’t have any liability towards the money to be received from the importer.
The gain for the forfaiter through this transaction is the differential value of receivables and discounted value paid to an exporter. This is more like a commission/interest earned by the forfaiter for the services rendered and for providing money to the exporter. The forfaiting transaction brings in an additional cost to the exporter, and it is fixed by the discount rate based on the LIBOR (London inter bank offered rate) rates basis the time period of receivables and a margin on the transaction after evaluating the risk in the transaction. This transaction also helps the importers who cannot pay for the goods in full at the time of the transaction. The importer’s receivables can be converted into secondary market debt instruments.
Examples of Forfaiting
ABC Corp is an institution dealing with forfaiting. X Corp and exporter from India to the US approaches the ABC Corp to set up a deal for forfaiting as they have cash flow needs and cannot wait till the importer pays them. Once X Corp approaches ABC Corp, they will ask for all required documents, understand the transaction, and then accept the seller’s foreign receivables and provide the discount rate. X Corp will add the discount price charged by the forfeiter to their client and increase the selling price. Once the sale is completed, ABC corp offers them the discount price. The banker of the importer provides a guarantee to ABC Corp, and on the due period, the importer pays ABC Corp.
Types of Forfaiting
- Promissory notes are provided by importers, and it acts as a written promise to pay the exporter.
- Bills of exchange are like promissory notes and are written orders that secure an importer to pay an exporter the agreed money.
- Account receivables are the amount owed by the exporter to the exporter, and they are listed as yet to be received on the books.
- The importer’s banks issue letters of credit, and it provides a guarantee that the due amount will be paid even if the importer defaults.
Documents Required by Forfaiting
The Copy of the following documents are needed from the exporter to execute the forfaiting transaction.
- Supply contract and the payment terms with the importer.
- Signed Commercial invoice.
- Shipping documents.
- Letter of assignment and notification to the guarantor.
- Letter of guarantee or aval.
Advantages
- Forfaiting protects the interest of the exporter by removing the risk of default of payment from the importer. It also protects them from forex transaction risks.
- Though the sale made by the exporter is a credit sale, forfaiting transaction converts that into a cash sale and improves the cash flow position and working capital position of the exporter. It also removes the cost associated with credit transactions.
- Forfaiting offers a lot of ease and flexibility to the exporter as the transactions can be tailored basis the requirement of the exporter and provide complete support in all international transactions.
- Forfaiting can be used in the case of the insurance coverage for the credit sale to protect the receivables.
- Forfaiting helps exporters transact even with customers in countries with higher risk as the receivables are protected.
Disadvantages
- Forfaiting comes with a cost that is higher than the normal lending process. Therefore, it adds more cost to the exporter, who in turn try to cover the cost from the importer by increasing the price of the goods.
- Forfaiting transaction has some criteria to be fulfilled like $100,000 is the minimum transaction size at present to enter forfaiting. Although the exporters can approach the forfaiter for the transaction and the time frame also matters to execute the transaction, it is not available for deferred payments.
- Not all countries and currencies have complete liquidity; only certain currencies are considered for forfaiting basis their liquidity position in the international market. So, this can be sometimes unfavorable to the developing countries as their currencies are not operational internationally.
- There is no complete guarantee provided for the forfaiting institutions by any international agencies, which can add up risk while dealing with long-term forfaiting.
Conclusion
Forfaiting is a trade finance service provided by any firm or institution by providing medium to long-term finance to the exporters. It mitigates the risk of exporters dealing with foreign clients where the forfeiter covers credit and transaction risks. The exporter can approach the forfaiter before finalizing the transaction with the buyer, sets the deal and discount rate, and charge the cost of forfaiting back to the buyer by adding the value into selling price and executes the transaction in a risk freeway. This supports and encourages exports/ imports and enhances international trading.
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