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Forfaiting - Meaning, Process, Example & Difference from Factoring

03/12/2021 9 Min Read

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Who is a forfaiter?

By definition, a forfaiter is a party that facilitates a forfaiting transaction. A forfaiter can either be an individual or a company that connects with an exporter and then holds, sells, or guarantees the payment obligations of the importer.

In short, a forfaiter serves as a third party to an import-export transaction. A forfaiter is compensated with a margin for hedging the risks of international trade. To simplify further, a forfaiter can be assumed to perform the functions of a central clearing counterparty on the OTC markets. Even several banks and financial institutions act as forfaiters to facilitate international trade transactions.

What is forfaiting?

what is forfaiting

Forfaiting is a method of trade financing. In this process, exporters sell their foreign receivables, either for a long-term or a medium-term, to a forfaiter at a discount. The forfaiter then gets the sum due from the importer on the contracted payment date. A forfaiting transaction occurs on a non-recourse basis. The term ‘non-recourse’ here means that the forfaiter has no right to recover payment from the exporter in case of default by the importer.

Forfaiting helps exporters improve their cash flow, as they can cash in their receivables immediately without waiting until the payment date. This allows the exporters to enter into long financing terms on their sales to foreign buyers. Exporters often pay higher fees with forfaiting since it eliminates virtually all risks of nonpayment.

Forfaiting is primarily used by large and medium-sized institutions and government agencies to export capital commodities and goods worth US$ 100,000 or more in the US.

Forfaiting can also be attractive in high-risk markets. The payment period for foreign buyers of US exports can range between 180 days and seven years, which is the period for most forfaiting transactions.

Eligibility/Characteristics

A forfaiter needs to know the following to engage in a forfaiting transaction.

  • The nationality and identity of the buyer.
  • Description of the products for sale.
  • A description of the value and currency of the contract.
  • The date and duration of the contract, including the credit period and number and timing of payments (including any interest rate agreed upon).
  • An evidence of debt issued {promissory notes, bills of exchange, letters of credit (LCS)}
  • Identity of the guarantor of payment (or avalor).

Characteristics of forfaiting

  • A typical forfaiting transaction requires a minimum amount payable of either US$ 250,000 or US$ 500,000.
  • The credit terms range from six months to seven years for the importer. Generally, it can be received in any major convertible currency such as USD, CAD, EUR, etc.
  • An agreement for the supply of goods and services.
  • To facilitate the transaction, banks issue LCs or guarantees to importers, usually in the country where they are based.

Why can forfaiting occur?

Forfaiting may occur when an exporter doesn’t have adequate working capital or needs immediate funds. It can also take place when the exporter aims to eliminate the risk of default by the importer.

Features of forfaiting

Typical features of a forfaiting transaction include:

  • A forfaiting transaction is always done at a discount and on a non-recourse basis.
  • A guarantee from his local bank always backs the importer's payment obligation. The receipt of payment is usually evidenced by an exchange bill, a promissory note, or an LC.
  • There are two types of financing: fixed rate and floating rate.
  • In general, forfaiting is suited to exports with high value, including capital goods for manufacturing, consumer durables for consumers, vehicles for transport, and even construction contracts for export.
  • The exporter usually receives the cash immediately after the goods are shipped and only upon submitting the required documents.

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How does forfaiting work?

Process

The forfaiting process is explained in the steps below:- Step 1: The exporter must zero in on the forfaiter with whom he wants to finance the transaction. A forfaiting agreement is entered into once the export is selected. Step 2: An agreement is made between the two parties--importer and exporter. Step 3: The importer secures a guarantee from his local bank to facilitate the trade. Step 4: The exporter ships the package of goods. Step 5: The exporter submits the required documents to the forfaiter. Step 6: The forfaiter pays the exporter a sum as decided in the agreement. By doing so, he obtains complete control over the shipment documents. Step 7: At maturity, the forfaiter presents the documents to the importer's bank. Step 8: The importer’s bank collects the payment from the importer. Step 9: Payments received by the importer's bank are routed to the forfaiter.

Documents

The documents required for forfaiting are as under:-

  • A letter of guarantee, or aval.
  • A copy of the commercial invoice with signature.
  • A copy of the sales agreement or the payment schedule.
  • A letter of assignment and notification to the guarantor.
  • A copy of the shipping documents, such as the receipts, railway bills, airway bills, and bills of lading, documents of title.

Usually, the aval appears on the front of the note. In countries that don’t recognize the validity of the aval, an importer may issue a guarantee in its place. It is included in a separate letter. As an alternative, a guarantor may agree to endorse a blank endorsement. There is also the possibility of using a standby LC.

Example

Let us assume that importer ‘X’ wants to purchase goods from exporter ‘Y’. The payment terms are 90 days. However, exporter ‘Y’ is facing a liquidity crunch. To facilitate this trade, exporter ‘Y’ approaches his bank ‘A’ for forfaiting. Importer ‘X’ has to then approach his bank ‘B’ in his home country to provide a guarantee for this transaction.

Once the goods are shipped and documents are submitted by exporter ‘Y’ to his bank ‘A’, he will receive the payment for the sales contract at a discount. This will improve the exporter’s liquidity position.

At maturity, i.e., after 90 days, the forfaiter that is bank ‘A’ will approach the importer’s bank ‘B’ for payment. Then, bank ‘B’ will transfer the payment received from importer ‘Y’ to bank ‘A’.

Cost Elements

Forfaiting involves different types of charges. The forfaiter charges a fee based on the relationship with the exporter, the trade volume, and the cost of funds. During a forfaiting transaction, there are primarily three types of fees to consider.

Commitment fees

Commitment fees are paid by the exporter to the forfaiter in consideration of the agreements to execute specific transactions of forfaiting at certain discount rates and within the determined time frame. These fees are in the range of 0.5-1.5 % per annum, and must be paid regardless of whether the export contract is executed.

Discount fees

It refers to the cost incurred on credit provided through the forfaiting agreement. A discount rate is determined using the London Interbank Offered Rate (LIBOR) for the period under consideration. Exporters are paid almost immediately, but forfaiters have to wait until maturity to recover the amount from importers. Forfaiters may see their profits wiped out by adverse movements in the foreign currency market. Thus, the discount fee accounts for any possible losses/gains resulting from changes in exchange rates during the intervening period.

Documentation fees

Document fees are generally not charged when the legal formalities and documentation required are minor. Usually, they are charged to cover the cost of legal procedures and paperwork in complex transactions.

Types of Forfaiting

There are several types of financial agreements that a forfaiter can purchase and convert into debt instruments:-

Promissory notes

Promissory notes are payments issued by importers to exporters as an assurance that payments will be made.

Bills of exchange

In essence, a bill of exchange is like a promissory note and is a written order binding an importer to pay an exporter a certain amount.

Account receivables

Account receivables on the balance sheet indicate the amount owed, although they have not yet been paid.

Letters of credit

A bank and guarantees issue an LC that the debt will be paid regardless of the default of the importer.

Advantages of forfaiting

  • Forfaiting protects the exporter from the non-payment risk and eliminates the cost of the collection while providing immediate cash to the exporter.
  • Commercial banks can earn a substantial amount when the currency appreciates by purchasing instruments yielding a high return.
  • Here, the risk is minimum due to the involvement of both the exporter and importer banks.
  • The forfaiting process converts a credit sale to a cash sale, simplifying the transaction.
  • Forfaiters have the flexibility to customize the offer according to the needs of sellers of capital goods. It can also be used for a variety of international transactions.

Disadvantages of forfaiting

  • Only the major selected currencies are taken into account to facilitate forfaiting, since they possess international liquidity.
  • In contrast to primary financing provided by banks or financial institutions, forfaiting significantly reduces the risk for exporters. However, it also results in a higher export cost.
  • Typically, the importer is responsible for the higher export cost factored into the standard pricing.
  • A forfaiting facility cannot be applied to all transactions. Forfaiting is permissible on transactions more significant than a definite sum.

Difference between Forfaiting, Factoring, Discounting, and Letter of Credit

Difference between Forfaiting, Factoring, Discounting, and Letter of Credit

FAQs on Forfaiting

Does forfaiting require an LC?

Yes, it does. Since forfaiting is done on a non-recourse basis, bills of exchange, promissory notes, or a standby LC act as a collateralized asset for the debt.

Is forfaiting always done without recourse?

Yes. With a forfaiting transaction, the forfaiter accepts the risk of nonpayment. Therefore it is done without recourse.

Can forfaiting be done with recourse?

No. Forfaiting is a type of trade finance in which exporters retain their receivables from overseas while selling them at a discount on a ‘without recourse’ basis.

Who bears the cost of forfaiting?

The exporter bears the cost of forfaiting, and forfaiters deduct such costs from the amount paid to the exporter.

Which parties are involved in forfaiting?

There are three parties involved in the forfaiting process-- the exporter, the importer ,and the forfaiter.

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Avani Ghangurde

Senior Associate Communications at Drip Capital

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