Forfaiting

From Open Risk Manual

Definition

Forfaiting is a form of Receivables Purchase in which sellers of goods and services that are part of a Physical Supply Chain sell future payment obligations represented by financial instruments or payment obligations (normally in negotiable or transferable form), at a discount or at face value in return for a financing charge.[1]

Also denoted as Without recourse financing or discounting of promissory notes/bills of exchange. In the primary market there will be either a Master Agreement with a Transaction Confirmation for each individual transaction or a one-off agreement limited to a single transaction.

Business Model Description

Forfaiting requires the existence of an underlying Payment Obligation usually embodied in some form of legal instrument distinct from the commercial transaction that gave rise to it. Such commercial transactions could be exports, imports or domestic trade. Typical payment instruments include negotiable instruments such as bills of exchange and promissory notes but obligations arising from letters of credit are also widely forfaited.

There is a primary and secondary forfaiting market. In the primary market, transactions are originated and obligations can be purchased from sellers of goods and services or their buyers, often in the latter case involving a bank in the buyer’s country. Pure working capital can also be raised through forfaiting by purchasing a promissory note or an unconditional payment undertaking from the finance provider. The secondary market is conducted between finance providers such as banks, forfaiting houses or other investors.

Tenors can vary from one month to several years. Transaction sizes are generally at the higher end of the supply chain spectrum and large volumes of low value instruments are more commonly confined to domestic forfaiting.

The advance ratio is normally 100% of the face value of the payment obligation less finance charges. There may be one or more such instruments in any given transaction although the number is usually small.

Forfaiting is undertaken without Recourse to the seller of goods and services or, in the secondary market, the seller of the forfaited asset. Generally, Forfaiting results in a “true sale” whereby the buyer owns all the rights in the forfaited payment obligation. Security in respect of the forfaited asset can be given in the form of an aval or Guarantee from a third party.

Value Proposition

Clients (the sellers into the supply chain) receive the following benefits:

  • Working Capital optimisation (better utilization of financial resources)
  • Potential finance raised against a strong Credit Rating (either of buyer or financial institution providing security for the payment obligation) with lower implied cost of funding for the seller
  • Assists sellers in selling to buyers or countries where they have little local knowledge and open-account sales would not otherwise be possible
  • Potentially improved payment and commercial terms for the seller and buyer
  • Finance and liquidity availability for sellers with limited credit availability from traditional banking sources
  • Supply chain stability
  • Relieves sellers of goods and services of administration and collection costs


Customer Segments

In the primary market there is normally a seller of goods and services (e.g. exporter) or buyer (e.g. importer) as seller of the instrument or payment obligation to the initial finance provider (commonly known as the primary forfaiter). In the secondary market, there will be sellers and buyers (forfaiting), usually composed of finance providers and investors.

Distribution Channels

Distribution Channels are the means by which a company communicates with and reaches its Customer Segments to deliver its Value Proposition.

Customer Relationships

The parties to the financing are the seller and the finance provider.

Revenue Streams

  • Fees
  • Security Margin

Key Resources

  • Personnel
  • IT Systems

Key Activities

Generally, forfaiting is a manual or semi-manual process. Sale and purchase documentation is negotiated and signed between parties in both primary and secondary markets in hard copy. Individual transaction confirmations can be sent by email or SWIFT.

Due diligence and credit analysis will need to be carried out on the obligors and on the legal nature of the instruments being used with a view to ensuring that, so far as possible, these are valid and enforceable even where problems may arise in the related sale of goods. The need for any local registrations and permissions will also be investigated.

Ownership to the payment instrument being used must pass to the purchaser and the appropriate legal method of doing this must therefore be ascertained. These can include assignment, novation or endorsement. There may be a need to hold and/or present originals of the payment instruments for payment to the obligor. The precise situation will depend on the nature of the instrument.

Confirmations from obligors to pay the new holder of the payment instrument are often sought especially in relation to letters of credit where the forfaiter is not a nominated bank under the letter of credit and is thus not a party to that transaction.

KYC/AML must be carried out on all relevant parties including the seller and the obligors in accordance with applicable local requirements.

Documentation relating to the export or import of goods must be examined manually with a view to satisfying not only KYC/AML requirements but ensuring the transaction is capable of being financed and that all documentation is authentic and legally valid and enforceable. URF 800 sets out rules for examination of such documents.

Risk Management

The risk management section focuses on the risks that must be managed by the business model. The risks to the business model itself can be identified with the Business Model Risk identification framework

  • Default Event or Insolvency of the buyer, mitigated by Credit Risk Analysis, Security, Credit Risk Monitoring and potentially Credit Insurance
  • The existence of valid and eligible receivables being discounted, mitigated by a regime of sampling or individual verification
  • Country Risk or Political Risk, mitigated by Due Diligence and Political Risk Insurance. Special circumstances relating to Sovereign Risk may apply to receivables due from governments or government agencies
  • Loss Given Default The risk arising from removing recourse to the seller of goods and services or, in the secondary market, a seller of the forfaited asset, mitigated by the credit rating of the buyer and limited recourse in certain circumstances (see Article 13 URF)
  • (Dilution Risk) disputes arising out of the underlying commercial transaction, mitigated by use of unconditional payment instruments and limited recourse to the seller
  • Legal Risk from KYC/AML issues (to be handled during the on-boarding procedures and subsequently in periodic reviews)
  • Risks arising in the event of insolvency of the seller of goods and services, such as ‘claw-back’, especially where a finance provider is aware of distress at the time of financing mitigated by due diligence
  • Fraud Risk by the seller, for example by inflating the value of invoices or offering invoices without an underlying commercial transaction, mitigated by verification of the transaction and deploying adequate credit controls
  • Fraud by collusion between the seller and one or more of its buyers leading to diversion of funds from meeting maturing obligations, mitigated by monitoring the financial health and management integrity of the seller through maintaining contact and receiving regular management information to look for signs of a deterioration of the business and suspicious circumstances, and also mitigated where necessary, by direct collections on the part of the finance provider
  • Double Financing, mitigated by obtaining ownership of the forfaited receivable, applying appropriate KYC procedures and perfecting the assignment of rights to the forfaited receivable
  • Internal Fraud Risk by collusion between the seller and an employee of the finance provider, mitigated by Internal Controls and Segregation of Duties
  • General Operational Risk resulting from multiple operational requirements to perfect title to the receivables and undertake ongoing administration, mitigated by sound procedures, appropriate levels of automation and process controls
  • Business Execution risk in case of
    • Lack of legal authority, mitigated by legal due diligence on the respective jurisdiction and the involved contractual parties
    • Payment instruments being in unenforceable form, and failure to perfect an assignment of rights
    • Prohibited and restrictive categories of goods
  • Foreign Exchange Risk and Interest Rate Risk, mitigated by hedging

Key Partnerships

Partnerships is the network of suppliers and partners that help make the business model work:

  • Platform providers (B2B networks, e-invoicing solutions, software vendors)
  • Bank or Non-Bank Funders providing funding for SCF programmes
  • Credit Insurers
  • Other risk management partners (FX/IR hedging)

Cost Structure

  • Personnel Salaries
  • Infrastructure Costs

Competitors

  • Alternative Supply Chain Providers
  • Alternative Forms of Financing

References

  1. Standard Definitions for Techniques of Supply Chain Finance, Global Supply Chain Finance Forum