Financing of international trade is a complex and sophisticated affair. It requires a mechanism that addresses the concerns of both the exporter (seller) and importer (buyer). Obviously, there are several issues, some of them ticklish, in any cross border trade transaction.
Some of the major issues involved in international trade are, the solvency and standing of the buyer and seller, the local laws, the different currencies and their values, the local customs and practices, and last but not the least, different languages. All of these factors impact cross-border trade in different ways.
Such a tall order of demands placed on the exporter and importer, calls for a system that is comprehensive in its scope and application. Some of the popular systems under which international trade transactions are undertaken are Documentary Credits, and Letters of Guarantee. Yet another system or mechanism, to conduct foreign trade transactions that is increasingly used is called "Forfaiting".
What is Forfaiting? Forfaiting is a mechanism to finance international trade under which the exporter (seller) gets his Drafts or Bills of Exchange pre-accepted by the importer (buyer)' and further avalized by the importer's Bank, and gets the same purchased by the Forfaiter. The term "Aval" means a sort of guarantee or commitment on part of the importer's Bank to honor the exporter's pre-accepted Draft, irrespective of the importer's conduct in this regard.
After parting with money to the exporter against the pre-accepted Draft, the Forfaiter, in turn, collects the proceeds of the same from the importer. Further, this transaction is without recourse to the seller. That is, the forfaiter cannot revert to the exporter in the event of the importer's default to pay.
The forfaiter may, in the normal course, wait for his payment to come through the importer's Bank. Or, he has also the option to sell the Draft or Bill of Exchange that he has purchased, to another forfaiter, for consideration, also without recourse. Thereafter the second forfaiter will claim the proceeds of the Draft from the importer.
The forfaiter is the financier who advances money to the exporter against pre-accepted Drafts and claims his dues from the importer. And he undertakes this risk without recourse. That is, if the importer does not pay, the forfaiter accepts the loss. The most popular instrument against which the forfaiter extends financing is the Draft or Bill of Exchange. A Bill of Exchange is a financial document that is drawn by the seller on the buyer demanding payment for the goods or services supplied. It mentions the amount, date, buyer's name, etc., on the face of it.
There are three major features of a forfaiting transaction:
- One, the forfaiter purchases the exporter's Draft for the full value of it (100%). Unlike in a factoring transaction, where a part of the bill amount is retained by the factor as a reserve.
- The second major feature is that the forfaiter undertakes this transaction without recourse to the seller. The forfaiter cannot revert to the seller to recover the money he had advanced to the seller, in the event of default in payment by the buyer.
- The third major feature of the forfaiting transaction is that the forfaiter is practically assured of payment, because the Draft is pre-accepted by the buyer, and also avalized by the buyer's Banker.
On account of the flexible terms of financing available under this system, it is gaining in popularity among businesses, especially, where it is not practicable for firms to avail of the conventional financing options.
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