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What is forfaiting in international trade?

Forfaiting is the purchase of an exporter’s receivables, representing what importers owe in trade transactions. Learn more about its meaning and characteristics.

Navigating the complex landscape of international trade can be challenging, especially when it comes to managing credit risks and ensuring prompt payments. Here, forfaiting emerges as an important tool for exporters seeking to put in place a secure financial mechanism. In essence, forfaiting is a form of trade finance that allows exporters to successfully mitigate risks, maintain cash flow, and facilitate international trade with confidence. It not only ensures that sellers receive immediate cash by selling their receivables at a discount but also shifts the credit risk to the forfaiting agency.

Forfaiting is an essential tool for exporters navigating international trade — it ensures timely payments and minimizes credit risks. In this blog, let’s understand what forfaiting is, the various types of forfaiting, its characteristics, and the advantages of forfaiting.

What is forfaiting in international trade?

Forfaiting in international trade refers to the purchase of an exporter’s receivables — the amount importers owe under trade transactions — at a discount from a specialized financial institution or agency, known as a forfaiter. This transaction involves an irrevocable, non-recourse basis, meaning the exporter relinquishes future claims on the receivables to the forfaiter. Thus, the exporter gets immediate cash and transfers the risk of non-payment by the importer to the forfaiter¹.

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Characteristics of forfaiting

Before we identify the types of forfaiting, it’s crucial to understand its fundamental characteristics:

Non-recourse:

Once the forfaiter buys the receivables, the exporter is no longer liable if the importer defaults. Forfaiting is typically used for high-value capital goods transactions, such as the sale of machinery, equipment, and aircraft. It is also used for financing infrastructure projects and other long-term contracts.

Flexibility:

These contracts are usually tailor-made according to the needs of the transaction. It is a medium- to long-term financing solution, with terms typically ranging from six months to 10 years.

Simplicity and agility:

Unlike complex traditional financing methods, forfaiting is straightforward and provides quick cash flow.

Risk mitigation:

It covers risks related to non-payment, political changes, exchange rate, and transfer.

Different types of forfaiting

Below are some of the common types of forfaiting:

Recourse vs non-recourse forfaiting:

Recourse forfaiting:
In recourse forfaiting, the exporter is not completely absolved of credit risk. If the importer fails to pay the amount due, the forfaiter has the right to recover the money from the exporter. This type of forfaiting is less common because one of the primary appeals of forfaiting is the ability to eliminate credit risk.

Non-recourse forfaiting:
This is the more common form of forfaiting. Here, the forfaiter can’t seek compensation from the exporter if the importer defaults on payment. Once the forfaiter purchases the receivable, all credit risks associated with the importer’s payment are transferred to the forfaiter. This is highly beneficial for exporters as it provides them with a risk-free way to offer competitive credit terms to importers.

Full vs. limited forfaiting:

Full forfaiting:
This involves the sale of the entire receivable balance to the forfaiter. The exporter receives an immediate cash payment for the full invoice amount, minus a discount. This type of forfaiting eliminates the exporter’s credit risk exposure and is usually non-recourse.

Limited forfaiting:
In this arrangement, only a portion of the receivable is sold to the forfaiter. The exporter may still be responsible for some portion of the credit risk, depending on the specifics of the agreement. This is less common and may be used in situations where the exporter only needs partial financing or is willing to retain some credit risk.

Fixed-rate vs floating-rate forfaiting:

Fixed-rate forfaiting:
Here, the discount rate at which the receivables are purchased is fixed for the entire period of receivable. This means the exporter knows in advance the exact amount of money they will receive. It provides certainty and protects against interest rate fluctuations.

Floating-rate forfaiting:
With this type, the discount rate is tied to a benchmark interest rate and fluctuates over the life of the receivable. While this can potentially provide better rates to the exporter if interest rates decrease, it also introduces uncertainty and the risk of rates increasing in the future.

How does forfaiting work?

Forfaiting is a relatively straightforward process, typically involving the following steps:
1. The exporter and importer agree on the terms of the sale, including the payment terms.
2. The exporter applies to a forfaiter for financing.
3. The forfaiter evaluates the creditworthiness of the importer and the transaction.
4. If the forfaiter approves the financing, the exporter and forfaiter enter into a forfaiting agreement.
5. The exporter transports the merchandise to the importer.
6. The importer signs and delivers to the forfaiter a series of bills of exchange or promissory notes, representing the amount of the receivables.
7. The forfaiter disburses the cash proceeds of the forfaiting transaction to the exporter.
8. The importer pays the forfaiter at maturity of the bills of exchange or promissory notes.

What documents are required in forfaiting?

The following documents are typically required in a forfaiting transaction:
• A commercial contract between the exporter and importer.
• Bills of exchange or promissory notes signed by the importer.
• Shipping paperwork, for example, a sea consignment note or air freight receipt.
• Insurance certificate.
• Guarantee from the importer’s bank (if required).

What are the cost elements in forfaiting?

Costs in forfaiting primarily comprise:
• Discount rate: Interest cost for the exporter, which the forfeiter determines based on the creditworthiness of the importer and the transaction’s tenure.
• Commitment fee: Sometimes charged by the forfaiter for agreeing to undertake the transaction.
• Administrative fees: Fees charged for handling documentation and due diligence.

Difference between forfaiting and discounting

Forfaiting and discounting are two different types of trade finance techniques. Forfaiting is a non-recourse financing arrangement, in which the exporter is no longer liable for the receivables if the importer defaults. Discounting is a recourse financing arrangement, in which the exporter remains liable for the receivables if the importer defaults.

Forfaiting is typically used for medium- to long-term financing solutions, while discounting is typically used for short-term financing solutions. Forfaiting is also typically used for high-value, capital goods transactions, while discounting can be used for a wider range of transactions.

Advantages and disadvantages of forfaiting

Advantages of forfaiting

• Immediate cash flow: Exporters can receive immediate cash payment for their exports without having to wait for the importer to pay.
• Reduced risk: Exporters are no longer liable for the receivables if the importer defaults.
• Improved competitiveness: Exporters can offer their buyers longer payment terms, which can make them more competitive in the international market.

Disadvantages of forfaiting

• Cost: The discount rate and other fees may affect the overall profitability of the trade transaction.
• Dependency: Reliance on forfaiters’ willingness to accept the bills or promissory notes.
• Eligibility: Not all trade receivables are eligible for forfaiting, often depending on the importer’s credit rating.

Criteria considered by forfaiting companies

Forfaiting companies have specific requirements and criteria when considering whether to engage in a forfaiting transaction. These criteria might include:
• Creditworthiness: The importer’s credit history and financial health.
• Political and economic stability: The stability of the importer’s country, considering factors like currency convertibility, transfer risk, and the political environment.
• Transaction size: Many forfaiters have minimum transaction sizes due to the fixed costs involved in arranging these transactions.
• Repayment period: The duration of the receivables. Forfaiting is generally used for medium to long-term receivables (typically between 180 days and up to seven years, sometimes more).
• Export type: As noted above, forfaiting is generally more suited to physical goods, particularly those with high value, rather than services or perishable goods.

Amazon Global Selling: Easy e-commerce exports from India

When examining forfaiting in international trade, it’s worth noting how innovations in e-commerce have provided smaller businesses with avenues to enter global markets. Amazon Global Selling is an e-commerce exports program that assists sellers in expanding beyond their local confines. By offering a structured platform for product listing, documents and licenses, customer service, training through webinars, and fulfillment across different countries, Amazon Global Selling makes international selling more accessible for emerging exports businesses in India. However, it is important for exporters to understand how to navigate various financial and credit challenges in global transactions, and tools like forfaiting, which could complement their efforts to manage these risks effectively.

Frequently Asked Questions

What is a forfaiter?

A forfaiter is a financial institution or entity that purchases exporters’ receivables at a discount, providing immediate cash and assuming all credit risk for the transactions.

Does forfeiting require an LC?

Why can forfaiting occur?

Forfaiting occurs to mitigate credit risk, enhance cash flow, and facilitate immediate capital for exporters, allowing them to conduct international trade safely and efficiently.

Which parties are involved in forfaiting?

Three main parties are involved in forfaiting: the exporter (seller), the importer (buyer), and the forfeiter (the entity purchasing the receivables).

Why is there a need for forfaiting?

Forfaiting is needed to ensure exporters receive immediate payment, avoid credit risks related to international trade, and improve their cash flow and balance sheets.

Who bears the cost of forfaiting?

The exporter indirectly bears the cost of forfaiting, as the receivables are purchased at a discount by the forfeiter, reflecting fees and the cost of assuming credit risk.

Published on November 8, 2023.

Sources:
1. https://www.trade.gov/forfaiting
2. https://www.dripcapital.com/en-in/resources/finance-guides/forfaiting
3. https://www.investopedia.com/terms/f/forfaiting.asp

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