Global business traditionally evolved from successful domestic ventures. Today, global strategies just might be the start of a business. Either way, risk management is a core issue. Since traders encountered one another on border paths, establishing trust and minimizing risk have been central to commerce. Domestic infrastructure for minimizing risk evolved much faster since challenges presented by differing laws, standards, customs and languages were minimal. International trade adds interpretations, time delays and uncontrollable events. Yet, becoming "good" or "great" at managing international risk is a valid business strategy and competitive advantage.
Getting paid, in timely fashion, for goods and services provided is an ever-present risk. Low risk cash-in-advance (CIA) payment methods include credit cards, checks, SWIFT bank transfers and e-commerce digital currency.[i] CIA obviously gives all advantages to the seller, so what happens in a "buyers-market" where multiple supply choices are available? CIA is not an effective strategy, at least for long, and particularly if significant growth is planned. Articulate your business goals and define the role international trade will play in reaching them. Be clear on where you are heading, and why.
A crucial question to answer - "how will deferred or lack of payment affect my/our financial situation?" If one errant transaction jeopardizes survival, then terms-of-sale choices are limited. In practice, this is often why fledgling firms start in low risk mode and move into shared risk strategies as trade experience is gained. Define acceptable levels of risk and how trade decisions will be made. One management team observed never agreed upon acceptable risk and therefore never developed an effective export plan, despite having a corporate goal to expand internationally.
Risk reduction tools generally fall into the areas of: Binding Agreements, Factoring, Guarantees, Hedging, and Insurance. Correct and accurate document preparation, emphasized before, underlies each of these. Errors and omissions are deal stoppers, causing stale documents[ii] and other bad things. Trusted intermediaries have been employed to reduce risk for centuries. With additional parties however, comes an even greater emphasis on details. By necessity, intermediaries must confirm that everyone shares an exact, matched understanding of the "deal". This will be apparent in how Letters of Credit work. Please note that I consider Letters of Credit to be a form of Guarantee.
Primary Risk Reduction Tools
Binging Agreements: An offer made by one party and agreed to by another that states consideration (payment) expected in return for specified goods/services, including; all terms, conditions and expectations of both parties. It is signed by authorized representatives and tries to summarize legal consequences of non-compliance. Despite downstream challenges of collection and enforcement, everyone in the transactional chain will seek to understand the intentions of parties involved. The more clearly this is laid out, the better for all concerned. Make appropriate time and effort to capture everything in writing before goods and services leave your control.
Factoring and Forfaiting: Based upon sales, not assets as loans generally are[iv]. Hence there is no increase to debt or reduction to credit limit. The focus shifts to credit worthiness of the invoiced party, along with the quality of the agreement + guarantees. For the seller of goods/services, factoring and forfaiting speed the return of working capital through the sale of receivables to an intermediary at discounted prices. Factoring generally pertains to short (90 day) receivables and covers most any type of goods. Forfaiting generally involves capital goods and medium – long term receivables, plus these deals can be traded on a secondary market.
Guarantees: Reputable, additional parties (to all involved) become part of the binding agreement by promising to make payment if necessary. Generally buyer and seller risks drop as a result. Governments are often involved (see Endnote #iv below) plus large public and private organizations experienced with foreign trade. One example may be found at www.smbcgroup.com – Sumitomo Mitsui Banking Corp. This firm provides an excellent example of turning international risk into a business strategy.
Hedging: An investment made with the goal of reducing significant risk. A common trade example is offsetting potential loss from currency fluctuation. As a US-based seller, quoting in $US dollars is sound strategy- BUT what is the foreign buyer to do? They must worry about risk from currency exchange rates. "Technically to hedge you would invest in two securities with negative correlations."[v] Take the example of purchasing both smoke detectors and homeowner insurance since INSURANCE is the most common form of hedging. You are not insuring against a fire starting- you are limiting out-of-pocket expense IF it occurs. The smoke detectors help prevent fires but do not reimburse for losses suffered.
Insurance: Risk reduction drives the demand for insurance, and it is a key part of world trade. The international industry is highly specialized by mode of transit, type of event and much more. Range of coverage runs from "errors and omissions" to physical damage/loss, non-payment, performance claims and geo-political upheaval. Incoterms(R)[vi] help to spell out who in the commerce chain needs protection, and from what. The industry is an excellent example of where document preparation is accurate and complete!
Letter of Credit: An obligation to pay once precisely defined criteria are met. Reputable parties decide when criteria is completely met and also become liable for payments. The meeting of criteria is proven by specified documents presented at stated places and times. Letters of credit are governed by the International Chamber of Commerce through rules published as Uniform Customs and Practice for Documentary Credits (UCP 600, effective 7/1/2007). This is a perfect example of a binding agreement, where errors, omissions and inconsistencies will have zero tolerance.
Foreign trade has ancient roots, as does risk. Minimizing risk has evolved, but the purpose remains- getting paid for each transaction while searching for new business opportunities.
[i] SWIFT is the accepted abbreviation for Society for Worldwide Interbank Financial Telecommunications. The e-commerce definition used is "the buying and selling of goods and services, or the transmitting of funds or data, over an electronic network, primarily the internet" from www.searchcio.techtarget.com/definition/e-commerce dated June 1, 2016. Digital currency refers to things like Bitcoin that is not backed by any country or central bank.
[ii] Stale documents refers to paperwork taking longer than times stipulated in agreements- it expires. An example of this would be documents calling for payment 30 days after delivery, with paperwork discrepancies taking 90 days to resolve. It is wise to have knowledgeable people preparing documents!
[iv] Note that www.sba.gov, www.exim.gov and www.opic.gov (Overseas Private Investment Corp) offer loan, guarantee and insurance programs specific to foreign trade and operate with the full backing of the US Government- specifically with risk reduction in mind. As always, www.export.gov is an excellent portal. Federal agencies do not participate in Factoring or Forfaiting. For further information on these two practices, go to www.keydifferences.com.
[vi] Incoterms® is a registered trademark of the International Chamber of Commerce