Prior to the commencement of the Sibos 2013 trade show organised by SWIFT in Dubai, UAE, on 16-19 September, David Hennah, head of product management at Misys examines what he thinks will be one of the ‘hot topics’ at this year’s event - the Bank Payment Obligation (BPO).
In the past I have characterised the Letter of Credit (L/C) trade finance instrument as a creation of commerce, whereas the Bank Payment Obligation (BPO) is the brainchild of bankers. This article will look at the development of the BPO which I expect to be much discussed at the Sibos 2013 trade show organised by SWIFT on 16-19 September in Dubai, United Arab Emriates (UAE).
Industry estimates suggest that some 82% of total world trade is now subject to open account terms, and that this number is projected to rise to a staggering 89% by 2020 (see Figure 1 below) with the overall market share of L/Cs continuing to decline around the world.
Figure 1: Projected growth of world trade by value - SWIFT predictions.
The BPO was conceived as an instrument that would effectively enable banks to re-intermediate themselves into the open account world by providing tangible bank assistance to these transactions where required.
BPO is defined by financial messaging service provider SWIFT - the organisers of the impending Sibos 2013 trade show in Dubai, UAE, who are making space at their event to advance its cause - and by the contributing International Chamber of Commerce (ICC) as: “an irrevocable undertaking given by one bank to another bank that payment will be made on a specified date after successful electronic matching of data, generated by SWIFT’s Trade Services Utility (TSU) or any equivalent Transaction Matching Application, based on Uniform Rules for BPO issued by ICC”.
Educational Challenge: The Background and the Future
The genesis of the BPO as a trade finance market instrument represents an educational challenge. Historically, L/Cs came into the world as a result of sellers of goods identifying a need to mitigate the commercial risks of trading with unknown buyers from other parts of the world. The obvious providers of such risk mitigation services came in the form of financial institutions acting as trusted third parties. Over the course of several centuries the undisputed versatility and value of the letter of credit has been extended not only to provide payment assurance but also to support alternative forms of short term working capital financing.
The birth of the BPO came about because bankers had become increasingly concerned that the recent growth in the volume and value of world trade had not been accompanied by a parallel growth in the volume and value of L/C traffic. Indeed, the amount of business conducted on L/C has at best remained stagnant for the best part of the past two decades or more, thus signalling to the industry that more and more trade is now being conducted on open account and that in relative terms traditional trade finance is diminishing in importance.
As many bankers would no doubt agree a majority of trade conducted on open account is done without the need for any form of bank assistance other than the payment at the end of the transaction. What the BPO seeks to address therefore is an unknown percentage of the open account market where there is a residual need for risk mitigation, payment assurance and/or financing services. This is the space that is currently occupied by services such as factoring and so-called reverse factoring on the financing side, and standbys/guarantees and credit insurance on the risk mitigation/payment assurance side. In recent years, there has not only been significant growth in international factoring but the business of reverse factoring, or approved payables finance, has come from almost nowhere to occupy centre stage.
In the meantime, the limited numbers of corporates that have adopted BPO in support of live commercial transactions have tended to do so not as a means of soliciting bank assistance for open account but rather as a means of reducing the processing and confirmation costs of their residual L/C business.
This leads us to question the extent to which the corporate world will eventually acknowledge and embrace the BPO as an open account financing tool and how long this adoption process will take. It also begs the question as to how strong an appetite the banks may have to promote a new instrument such as BPO, as they face up to the prospect of losing further ground in traditional trade.
Recent estimates suggest that the BPO has the potential to obtain a market share similar to that of L/Cs (say around 10%) by the year 2020 (see Figure 1). This would be a remarkable achievement for a new financial instrument still in its infancy compared to the centuries-old letter of credit.
Figure 2: An estimated distribution of trade/supply chain finance business by instrument.
Models to Follow: Traingle or Square?
The banks that have so far made significant inroads in the supply chain finance business (e.g. Citibank, JP Morgan) are at variance with the names that have traditionally led the way in trade finance, such as Wells Fargo and Standard Chartered.
The popular ‘three-corner’ model for supply chain finance (SCF) undoubtedly favours big banks with a significant global footprint, a strong financial standing and extensive market coverage. In this model, one bank (the bank of the buyer) services the needs of both buyer and suppliers, most commonly placing reliance on the buyer’s credit lines and credit standing to offer finance to the supplier. Of course, this approach does not come without its issues, the most well-known of which is supplier on-boarding and the related difficulties around know your customer (KYC) regulations.
It is perhaps worth bearing in mind that traditionally, the world of trade finance follows an 80/20, or it might even be argued 90/10 rule, in which 90% of the business is managed by 10% of the banks. Given this established hierarchy, it becomes somewhat questionable as to how many banks in the world, regardless of ambition, will realistically have the financial strength, capacity and appetite to compete in the closed world of three-corner supply chain finance.
It seems more likely, therefore, that as time goes by, the only way that the next tier of international banks can take advantage of potential SCF opportunities, is to do so in a more open ‘four-corner’ model in which a buyer’s bank collaborates with the supplier’s bank, perhaps agreeing upon a joint share of both risk and reward/revenue. Indeed, it is fair to say that a certain amount of supply chain finance business is already evolving along this four-corner path.
How the BPO Can Thrive
It is in the area of four-corner supply chain finance business that the Bank Payment Obligation has the potential to come into its own. Used as it is, in an automated processing environment, the delayed issuance of a BPO is relatively easy to agree and execute. This delayed issuance of a BPO is entirely consistent with the common business scenario in which a supplier may experience a very late and very limited requirement for financing to plug a short-term working capital deficit.
A BPO can be put in place very quickly and easily, at limited cost, providing an assurance to the seller’s bank that the buyer’s bank will pay on the due date and enable the seller’s bank to proceed with the financing, relying on the strength of the BPO as collateral. Alternatively, the due date of the BPO can be amended by agreement so that the buyer’s bank is obliged to pay in advance.
There are so many options attached to the issuance and application of the BPO that bank services can be tailored flexibly to match individual needs and circumstances. Missing still are adequate levels of awareness amongst corporates and, with a few notable exceptions, a strong appetite among banks to foster that awareness.
Until corporates come knocking at the door demanding BPO from their banks, market uptake will continue to be slow and steady rather than revolutionary in nature. Some of the supporting technology, connectivity and processes are there if people choose to adopt them but not enough and uptake hasn’t, so far, been as fast as hoped.
A key missing component is the technology enablers within banks, which are needed to support not only the automated processing of BPO-based transactions within the banks’ own back offices but also the ease of communication. This is needed to support the automated and standardised exchange of data between corporate treasuries, finance departments and other players in the financial supply chain with the banks.
While there are clear advantages in restricting the use of mandatory channels, rules and standards to the exchange of data between banks and the central transaction matching application only, the absence of similar mandatory conditions in relation to the exchange of corporate data creates a potential gap in the end-to-end automation of information flows.
Conclusion: Opportunities for Technology Providers
Leaders in the financial software industry have an opportunity to provide solutions to this BPO problem and facilitate market adoption of it by bringing to market the channels that will simplify the required exchange of data between corporates and banks.
This kind of development is not so far removed from the work that has already been done in recent years to support the exchange of L/C and guarantee-related data in the form of the MT798 message. It is a natural extension of channels already used today to support complementary services such as payments, cash reporting and foreign exchange (FX) within the broader context of working capital management. Hopefully greater discussion at Sibos 2013 will aid the co-operative forces required to drive BPO adoption upwards and technology providers will be able to demonstrate the systems they can contribute to help drive uptake.