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Managing the cash conversion cycle: where can SWIFT add value?

SWIFT can help the banking industry restore trust and deliver value-added solutions for risk and financing in trade services

The credit crisis has created a risk-averse culture in today’s financial markets. The shortage of liquidity is expected to result in a contraction of global trade volumes for the first time since 1982.  Despite uncertain market conditions, wholesale reversion to traditional trade finance is unlikely to take hold on a permanent basis. Instead, the banking industry must identify ways of collaborating in order to restore trust and enable the delivery of value-added solutions for risk and financing. SWIFT’s Trade Services Utility has been designed to help the banks fill the gaps.

Is the world really that flat?
Charlie Chaplin once famously entered a Charlie Chaplin look-alike competition in Monte Carlo. He came third, which just goes to show that things are not always what they seem and that appearances can be misleading. Today, we live in what Charles Handy has aptly described as the Age of Unreason, when we can no longer assume that what once worked well will work well again, when most of our working assumptions, or mindsets, can and should be legitimately challenged.

The current credit crisis has been described as the worst since the Great Depression. For many, the scale of financial distress spreading across the financial centres of the world goes beyond living memory.  For decades, global economic activity has been dominated by boom and bust cycles, leading to the popular conclusion that markets tend naturally towards equilibrium and that deviations are random. But the difference this time is that the crisis is not confined to any one segment of the market. It has enveloped the entire financial system. The central banks have pumped liquidity into the banking system yet the flow of credit from the banks into the world economy has continued to experience severe disruption. So does it remain valid to assume that this is a cycle just like any other and that Reagan’s “magic of the marketplace” will simply restore order and trust over time?

The problem for the banks is at least twofold. Since the turmoil of 2000/2001 money has been cheap.  Financial innovation has run amok, leading to the creation of new markets and new financial instruments, giving licence to unprecedented levels of lending. Many of these loan structures have been created with a lack of due diligence and have subsequently resulted in widespread foreclosure and loss.

Secondly, the capital base of the banks has been severely impaired so that they are unable to get a decent grip on their overall risk exposures. So the natural instinct is to reduce exposure. The liquidity libretto has finally stopped and the banks are dancing to a different tune.  Since 2005, Friedman would have us believe that the world is flat and in a flat world, companies must take advantage of the best producers at the lowest price.

Global supply chains, drawing on parts and products from every corner of the world, have seemingly become an essential part of the fabric of international trade. But now, between the Lexus and the olive tree, greed has been overtaken by fear and the world has perhaps become a little less flat than we may otherwise have thought it to be.

The financing of trade
In international trade, it has been a long held view among sellers that a promise to pay given by a bank is of greater value than a promise to pay given by a buyer, witness the addition of a bank’s “pour aval” on an accepted bill of exchange, for example. The ultimate form of bank guarantee that has been used in international trade since the Middle Ages has been the Letter of Credit (LC).

For almost a century, the LC has flourished under the Uniform Customs and Practices set down by the International Chambers of Commerce. Where an LC is irrevocable, it cannot be changed without the full consent of all parties involved. So the only real risk of an irrevocable LC being invalidated would be if the issuing bank were to go out of business.

Some exporters favour the increased security of a Confirmed LC where the confirmation of a local bank is added to the promise to pay of the issuing bank.

Over the years, statistical evidence has suggested that more than 80% of documents presented under an LC are discrepant. In short, they go wrong more than they go right. Discrepancies lead to disputes; disputes lead to delay; delay leads to increased cost.  With the growth of globalisation coupled with widespread deregulation, traditional trading patterns have changed.

The Internet has enabled importers to seek out and more easily identify potential trading partners from low cost country sources, sometimes employing reverse auctions to negotiate lowest price. Whereas in the past, the exporter may have enjoyed a much stronger position to dictate the terms of trade and insist on the use of an LC, now it is often the case that the importer is empowered to dictate terms.

Over time, supply chains have tended to narrow as trading relationships have matured and stabilised. In these circumstances, the importer will by and large seek to avoid the encumbrance of an LC and give preference to trading on open account, the more so once a reliable supply chain has become established. In an open account environment, the seller quite simply is required to ship the goods and await payment, placing trust entirely on the promise of the buyer.  Not only has the seller’s risk been significantly increased but access to affordable finance, using the LC as a reliable form of collateral, is no longer an option. 

Over the past decade or more, usage of LCs has been in terminal decline. Current estimates suggest that some 85% of world trade is now being conducted on open account. In a world in which the risk metrics have been deemed manageable and alternative forms of commercial financing made widely available at reasonable cost, international trade has continued to blossom in accordance with what may be regarded as the unfolding customs and practices of open account.  Factoring business, whereby the exporter can sell invoices to a third party factor for an agreed percentage of their value, has been on the increase and there has also been a burgeoning demand for so-called reverse factoring, or supply chain finance, by which the seller is able to obtain access to finance based upon the credit rating of the buyer. Lack of liquidity has been neither a barrier nor a constraint.

The sudden loss of confidence brought about by recent events has created a more risk-averse culture that has affected both financial institutions and trading companies alike.

Bank perception of risk is leading to a loss of appetite and a consequent tightening of liquidity. This trend is thought to be accelerating and spreading across all continents of the world.  Notwithstanding the planned increase in capacity and concurrent fall in the oil price, the impact on trade is also reflected in the recent fall in shipping rates as demonstrated by the eleven-fold drop in the Baltic Exchange’s Dry Index since May 2008. The World Bank predicts that, for the first time since 1982, global trade volumes are likely to contract in 2009.

It may perhaps be regarded as something of an irony that in recent years banks have continued to promote the sale of Letters of Credit to a shrinking market in which corporate demand has been stagnant. Now that corporates are in some cases seeking to revert back from open account to LC, banks are in some cases reportedly less willing to issue or confirm.  This is particularly true in relation to small and medium sized enterprises which fall short of the more stringent conditions now being applied.  However, where business is being done, the tight credit conditions, coupled with more rigorous risk assessment processes and volatile markets, have enabled banks to drive up their rates to levels two or even three times higher than a year ago.

Either way, it’s bad news for the exporter. The shortage of credit has become a threat to world trade and to emerging markets in particular. The weaker emerging economies are the first to suffer and will inevitably be the ones to suffer most. 

Various strategies are being undertaken by governments, export credit agencies, regional development banks, international banks and others to provide ongoing support to world trade. However, the economic environment remains challenging and many of the world’s leading trade banks recognise the need to remain focused on working together to facilitate the provision of effective financing, risk mitigation and other value-added services in support of world trade.

Supply chain solutions and the cash conversion cycle
The tightening of credit globally represents both a challenge and an opportunity to the banks. Although there has been some anecdotal evidence of an increase in demand for LCs, this is not borne out by SWIFT messaging traffic, the volume of which has continued to stagnate.  The world of trade has largely moved on and there would appear to be no turning back. Strong importers will continue to push for open account. Suppliers with a satisfactory track record of trading on open account will hardly be in a position suddenly to insist upon the issuance of an LC instead. It will take more than uncertainty in financial markets to undo these trends.

There is and will continue to be, however, a growing demand for banks to provide greater innovation in the developing world of supply chain solutions. 

Supply chain is where the money is. Indeed, the Supply Chain Council tells us that it accounts for between 60% and 90% of all company costs.  This is where the corporate market is looking now for the banking industry as a whole to bring value in terms of both liquidity management and processing efficiency. 

With regard to liquidity, supply chain finance involves the provision of financing solutions at corresponding points in the physical supply chain e.g. pre-shipment, post-shipment or post-acceptance. As with traditional trade finance, suppliers receive a percentage of the transaction value up front.  With regard to processing, banks can complement standard risk mitigation and cash forecasting tools with services to support the outsourcing of document preparation, managed account payables, account reconciliation etc.

Information services can also be applied intelligently to the management of the cash conversion cycle, a powerful operational performance metric used to assess how well a company is managing its working capital.  It is calculated by adding together the number of days taken to convert inventory to sales (days inventory outstanding = DIO) to the number of days taken to collect payment for goods sold (days sales outstanding = DSO) and subtracting the number of days taken to pay suppliers (Days Payables Outstanding). 

The lower the cash conversion cycle, the more efficient the company is because by turning over working capital more times per year, the company can not only generate increased sales but also reduce the cost of borrowing. Many large retailers are able to work on a negative cash conversion by selling stock before paying suppliers.

Managing the cash conversion cycle relies upon the efficient management of information, tracking events in the physical supply chain and matching them to trigger points in the financial supply chain.

In many respects, the solution to these business requirements may be found in the dissection of the trusty age-old LC so that a more selective use may be made of some or all of its constituent parts e.g. the delivery of transaction information (purchase order management, electronic invoicing etc), event information (discrepancy management, dispute handling etc) and risk mitigation (regulatory compliance, money movement etc), as well as providing access to finance.  What is also required is an ability to leverage the benefits of an LC whilst avoiding at least some of the drawbacks. It’s a tall order perhaps. Or is it?

SWIFT’s Trade Services Utility (TSU)
SWIFT is in a somewhat privileged position insofar as it is able to monitor and analyse underlying trends in the usage of its various message types for payments, trade, treasury and securities related transactions. In recent years, the usage of traditional trade messages (LCs, collections and guarantees) has remained relatively flat whilst payment volumes have continued to grow.

All of this has been going on at a time when the volume and value of world trade itself has continued to grow exponentially. Thus, SWIFT traffic analysis confirms the widely held view that the vast majority of international trade today is conducted on open account, resulting to some extent in the risk to the banks of disintermediation through lack of visibility.

In response to these changing market needs, in April 2007, SWIFT launched the Trade Services Utility (TSU), a data matching and workflow engine which enables banks to establish a common view of supply chain transaction data and to monitor events all the way from inception to completion. Based upon this evidence, trigger points may be identified for the provision of financial services, typically financing, by the bank to its corporate customer.

The banks participating in a TSU transaction may submit data sets containing the key data elements which have been extracted from the underlying documentation. The transaction will typically begin with data extracted from the purchase order. Where no purchase order exists, data taken from the commercial invoice may be used instead. The matching of these elements, the detail of which may be taken all the way down to line item level, establishes a baseline in the TSU, against which all future data set submissions must also match.

Hence, commercial invoice data, transport data (e.g. forwarders cargo receipt or advance shipment notice), insurance and certificate data must all be found to be consistent with the original purchase order. This provides a highly efficient and effective means of tracking and validating events along the physical supply chain whilst at the same time affording the banks the opportunity to make available services at corresponding points along the financial supply chain.

A simple example might be that of a preliminary data set match used to highlight exceptions. This enables the bank to accelerate its internal decision making processes and thereby enhance service levels to the customer before documents are presented. 
More advanced examples would be the provision of pre-shipment finance based upon the matching of the purchase order data or post-shipment finance based upon the matching of the invoice to the original baseline.

Most importantly, the TSU is designed to offer a common standard for the exchange of trade-related data between banks, hence providing the key to interoperability.

In the next release of the Trade Services Utility which is currently being tested and will be made commercially available at the beginning of March 2009, some important enhancements have been made.  These include the ability to accommodate more than two banks to a single transaction. In addition to the Buyers Bank and Sellers Bank, the TSU will also support the inclusion of a Submitting Bank (a bank which may submit data on behalf of another bank) and, more significantly still, the inclusion of a Bank Payment Obligation (BPO) Obligor Bank. To understand the role of this Obligor Bank, we must clearly understand the definition of the Bank Payment Obligation (BPO) itself.

The TSU Bank Payment Obligation represents an irrevocable undertaking given on the part of one bank (the Obligor Bank) to pay another bank (the Sellers Bank) provided a number of predetermined conditions have been fully satisfied. These conditions must be met by the electronic matching of data within the TSU.

There are a number of parallels to be drawn between usage of a traditional letter of credit and the TSU Bank Payment Obligation. The issuance of a BPO equates to the issuance of an LC. Notification of a BPO equates to the advising of an LC. The BPO payment guarantee equates to the confirmation of an LC. Whether the transaction is supported by an LC or by a TSU Bank Payment Obligation, there is a responsibility on both importer and exporter to produce compliant data in consideration of which the Obligor Bank will provide a conditional guarantee of payment.

Usage of the TSU itself, and by definition the TSU Bank Payment Obligation, is governed by a Service Description and Rulebook, setting out the roles and responsibilities of all who take part.  By subscribing to the TSU, each financial institution agrees to abide by and be bound by the associated rules. The Bank Payment Obligation will constitute a legally binding, valid and enforceable obligation to pay, in accordance with the agreed terms, and subject to the appropriate standard of law. Discussions related to additional aspects of risk participation and balance sheet treatment are in progress with a view to establishing a common framework for all those who take part.

As at mid-November 2008, more than 80 banks in almost 100 locations across 30 countries and covering every region of the world, have subscribed to the TSU. Six software vendors have been officially accredited with having developed applications that will support the TSU from both a functional and technical perspective. In addition, some of the participating banks are also willing to make their own software applications available to partner banks on a white label basis. 

Conclusion
From March 2009, banks using the TSU will be able to make use of the Bank Payment Obligation to support live transactions. This may prove to be a significant step forward in addressing the needs of the market, given the prevailing credit conditions.

If all those years ago, there were two people in the world who looked more like Charlie Chaplin than Charlie Chaplin himself, it leaves me wondering whether the world might finally be ready to recognise a financial instrument that arguably today looks rather more like a Letter of Credit than a Letter of Credit.