Think of a bill of exchange as an invoice presented in exchange for goods or services. In international trade, the exporter, or seller, presents a bill of exchange to the buyer, or importer, who must sign the bill for it to be valid. The bill of exchange unconditionally requires the buyer to pay a certain amount either on receipt of the bill or at some specified date in the future. The buyer usually isn't required to pay interest on the debt, but if they are, the requirement must be stated on the bill.
Banks typically become third parties to bills of exchange to help guarantee payment or receipt of funds. This helps reduce any counterparty risk inherent to the transaction.
Bill of Exchange in International Trade
International trade presents unique risks that are not often present in domestic transactions, making bills of exchange useful and more common. There are several reasons for this, such as separate legal jurisdictions and lengthy transportation routes. Most of these trades require currency exchanges, making long-term trade arrangements sensitive to exchange-rate fluctuations.
Traditionally, the exporter or the exporter's bank draws up the bill of exchange and submits the document through the importer's bank; the importer's bank offers a contingent guarantee on the transaction. If the importer dishonors the bill of exchange and fails to make the payment, the importer's bank makes the payment and then pursues its customer for reimbursement.
Bill of Exchange vs. Promissory Note
Though both are used in trade to establish an obligation for a buyer to pay a seller, bills of exchange differ in a fundamental way from promissory notes. Unlike the bill of exchange, which is written by the creditor, a promissory note is issued by the debtor, promising to pay a certain amount of money.
Trading Bills of Exchange
Bills of exchange can be bought and sold in secondary markets, though this is primarily done by banks and other financial institutions. Normally, the bill is discounted or sold for an amount that is less than the face value, as the holder is looking to raise cash immediately rather than wait for the bill to mature. The difference between the discounted price and the face value is the buyer's profit for assuming the risk.
Like a bond, the discount tends to be greatest when the maturity date of the contract is furthest away. In the U.S., banks' buying and selling of bills of exchange is regulated by the Federal Reserve.
Bills of exchange do not trade on an exchange like stocks or bonds, and there is no electronic settlement system. In fact, a trade involves physically sending a bill of exchange from one party to the other, and the party selling the bill must endorse it on the back, much like a common check.