What Is Forfaiting?
Forfaiting is a means of financing that enables exporters to receive immediate cash by selling their medium and long-term receivables—the amount an importer owes the exporter—at a discount through an intermediary. The exporter eliminates risk by making the sale without recourse. It has no liability regarding the importer's possible default on the receivables.
The forfaiter is the individual or entity that purchases the receivables, and the importer then pays the receivables amount to the forfaiter. A forfaiter is typically a bank or a financial firm that specializes in export financing.
A forfaiter's purchase of the receivables expedites payment and cash flow for the exporter. The importer's bank typically guarantees the amount.
The purchase also eliminates the credit risk involved in a credit sale to an importer. Forfaiting facilitates the transaction for an importer that cannot afford to pay in full for goods upon delivery. It is most commonly used in cases of large, international sales of commodities or capital goods where the price exceeds $100,000.
The importer's receivables convert into a debt instrument that it can freely trade on a secondary market. The receivables are typically in the form of unconditional bills of exchange or promissory notes that are legally enforceable providing security for the forfaiter or a subsequent purchaser of the debt.
These debt instruments have a range of maturities from as short as one month to as long as 10 years. Most maturities fall between one and three years from the time of sale.
- Forfaiting helps exporters to receive payment for a shipment without any risk.
- The payment amount is typically guaranteed by an intermediary such as a bank, which is the forfaiter.
- Forfaiting also protects against credit risk, transfer risk, and the risks posed by foreign exchange rate or interest rate changes.
Advantages of Forfaiting
Forfaiting eliminates the risk that the exporter will receive payment. The practice also protects against credit risk, transfer risk, and the risks posed by foreign exchange rate or interest rate changes. Forfaiting simplifies the transaction by transforming a credit-based sale into a cash transaction. This credit-to-cash process gives immediate cash flow for the seller and eliminates collection costs. Additionally, the exporter can remove the accounts receivable, a liability, from its balance sheet.
Forfaiting is flexible. A forfaiter can tailor its offering to suit an exporter's needs and adapt it to a variety of international transactions. Exporters can use forfaiting in place of credit or insurance coverage for a sale. Forfaiting is helpful in situations where a country or a specific bank within the country does not have access to an export credit agency (ECA). The practice allows an exporter to transact business with buyers in countries with high levels of political risk.
Disadvantages of Forfaiting
Forfaiting mitigates risks for exporters, but it is generally more expensive than commercial lender financing leading to higher export costs. These higher costs are generally pushed onto the importer as part of the standard pricing. Additionally, only transactions over $100,000 with longer terms are eligible for forfaiting, but forfaiting is not available for deferred payments.
Some discrimination exists where underdeveloped countries are concerned compared to Western countries. For example, only selected currencies are taken for forfaiting because they have international liquidity. Lastly, there is no International Credit Agency that can provide guarantees for forfaiting companies. This lack of guarantee affects long-term forfaiting.
Real World Example
The Black Sea Trade & Development Bank (BSTDB) lists forfaiting in its list of special products along with underwriting, hedging instruments, financial leasing, and discounting. BSTDB was established as a source of financing for development projects by 11 founding countries, Albania, Armenia, Azerbaijan, Bulgaria, Georgia, Greece, Moldova, Romania, Russia, Turkey, and Ukraine.
The bank explains that "the importer’s obligations are evidenced by accepted bills of exchange or promissory notes which a bank will aval, or guarantee." The minimum operation size that BSTDB will finance through forfaiting is EUR 5 million with a repayment period of one to five years. The bank may also apply option, commitment, termination, or discount rate fees.