Factoring 101

Introduction to Forfaiting

Introduction to Forfaiting

Forfaiting is a form of trade finance (usually international in nature) in which a series of trade credit instruments are purchased by an entity known as a forfaiter for immediate payment to the seller.  Similar to factoring in many ways, forfaiting enables sellers of goods to offer attractive credit terms to their customers.  Where factors purchase short-term trade invoices at a discount however, forfaiters purchase discounted debt instruments.  Such instruments include drafts drawn under letters of credit, promissory notes, bills of exchange or many other freely negotiable evidences of indebtedness. 

Introduction to Forfaiting

Forfaiting is a form of trade finance (usually international in nature) in which a series of trade credit instruments are purchased by an entity known as a forfaiter for immediate payment to the seller.  Similar to factoring in many ways, forfaiting enables sellers of goods to offer attractive credit terms to their customers.  Where factors purchase short-term trade invoices at a discount however, forfaiters purchase discounted debt instruments.  Such instruments include drafts drawn under letters of credit, promissory notes, bills of exchange or many other freely negotiable evidences of indebtedness. 

In forfaiting transactions, unlike factoring, the discount taken by the forfaiter represents the total interest to be paid over the life of the debt instrument’s credit period plus a fee for risk.  Additionally, where factors seldom purchase trade debt maturing in over 90 days, most forfaiting transactions are negotiated for much longer terms such as 3-5 years. Forfaiting transactions are much larger than factoring transactions also, with purchases of less than $100,000 being very rare.  More typically, forfaiting transactions involve the sales of large amounts of goods or equipment with purchase prices of tens or even hundreds of millions of dollars being common.

An additional characteristic of the debt instruments purchased by a forfaiter is that they are usually accompanied by a letter of guarantee (although some large corporations may represent strong enough credits in their own right).  The letter of guarantee, known in the forfaiting industry as an aval, will usually be issued by the importer’s bank under a trade credit agreement or in some cases, will take the form of a standby letter of credit.  Because of the guarantee, forfaiting is always a non-recourse transaction to the exporter.

Forfaiting provides a very flexible method of trade finance that can be tailored to meet the needs of a wide range of transactional types.  The terms of the debt instruments which are to be purchased by the forfaiter are most often negotiated between the exporter and importer at the time of sale but in some cases, such terms are actually set forth by the forfaiter.  Normally, the debt instruments involved in forfaiting transactions are of the fixed-rate variety (although forfaiters have become flexible regarding terms they will accept)  and are denominated and structured in one of the world’s major currencies such as the U.S. dollar or Euro.

The History of Forfaiting

Forfaiting as a method of trade finance developed in Europe during the years following World War II.  With massive amounts of trade finance required to assist in the rebuilding of Europe, many suppliers simply did not have the necessary capital to provide supplier credit and could not hold an importer’s promissory note or bill of exchange to maturity.  Forfaiting developed as a financing option available to small and mid-size businesses which provided terms of payment beyond the traditional 90-180 days.

Initially, forfaiting was controlled by a handful of specialist banks and finance houses based in Switzerland and used primarily by Eastern European importers requiring financing for purchases of Western capital goods.  As international trade grew in the 1960s and 70s, other nations began to utilize forfaiting assisted by large money center banks and financial institutions.  Today, the international forfaiting market touches importers and exporters in approximately 100 countries.  Although annual volumes of forfaiting are not accounted for, it is estimated that approximately 2% to 3% of all international trade employs some form of forfaiting as a method of financing.   

Geographic Regions of Popularity

Developing markets continue to make the expansion of global trade challenging.  Demands for credit terms from many countries in South America, Eastern Europe,  and the Third World are extremely difficult to evaluate from a traditional finance standpoint but provide fertile ground for forfaiting-styled transactions.

While forfaiting as a source of international commercial finance is much less common than factoring or asset-based lending, it is extremely importing in certain areas of the world where the development of credit is in its infancy.  Europe provides the bulk of forfaiting volume with Italy, Germany and Great Britain accounting for the majority of annual volume. 

Just as with factoring, the U.S and Canadian market has developed slowly compared to other areas of the globe but transactions are now becoming much more common in South and Central America as well as Asia.  Even Africa is now benefitting from forfaiting transactions.  It is important to note, however, that regardless of country, the avalizing bank must always be internationally recognized as creditworthy. 

 

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