Promissory notes and bills of exchange are both negotiable instruments. Both instruments are used as a means of payment. They are used in trade deals for transferring payments according to the specified terms and conditions.
Bills of exchange and promissory notes are both formal written agreements. Bills of exchange are primarily used in international trade and promissory notes are often used in domestic trade agreements.
Both financial instruments have several features in common. However, they differ in usage and functioning as well in several ways.
Bill of Exchange
A bill of exchange is a written commitment to make a payment by one party to another party with specified details. It is issued by a third-party, usually a bank, at the request of the applicant (importers). It is an agreement that confirms that one party owes a specific sum of money to a second party.
A bill of exchange needs acceptance when payment is due. It must accompany other important documents such as trade contract, bill of lading, shipment documents, and invoices at the time of presentation.
Itis also a written commitment by one party to make payment to a second party with certain conditions. It specifies the payment amount, interest rate, maturity date, and repayment terms.
Unlike bills of exchange, a promissory note can be issued by an individual, a company, a bank, or a financial institute. It is a negotiable financial instrument, which means it can be used as a tradable instrument.
A bill of exchange and a promissory note work as payment instruments. Both are written and formal commitments made by one party in favor of a second party, usually the counterparty of the trade deal.
Bill of Exchange
It involves three parties; a drawee, a drawer, and a payee. A drawee is the one who makes the payment. A payee is the one who eventually receives the payment. A drawer is an entity that obliges the payment instrument. A payee and the drawer can be the same party as well, often when a bank receives the bill of exchange first.
It is issued by a third-party institute such as a bank. It is a transferable instrument. The first beneficiary of the bill of exchange can endorse it and transfer the benefits to another party.
Although a bill of exchange can have a deferred maturity date, it does not pay interest. The receiver eventually will receive only the specified amount only. Bills of exchange are non-tradable instruments; however, the beneficiary can transfer it to another party at discount.
Promissory notes primarily involve only two parties; the issuer and the beneficiary. It must specify the details such as amount, maturity date, interest date, and repayment terms if any.
The promissory note is a negotiable financial instrument. The primary beneficiary can trade the instruments at a discounted face value in the secondary market. However, unlike a bill of exchange, it makes an interest payment. The fact that it offers higher returns than a bill of exchange makes them a preferred instrument for many.
It can be issued by individuals, companies, or financial institutes. Promissory notes can be secured or non-secured arrangements. Even without collateral, these instruments are issued on the back of good credibility of the issuer.
It also comes with legal security and requires certain approvals from regulatory authorities for issuance. A default of promissory notes can also result in a litigation process for the issuer.
When to use a Bill of Exchange?
A bill of exchange comes with the backing of financial security as it is issued by a bank usually. It remains a popular choice for parties involved in a trade deal. It is used to reduce the financial risks involved in a trade deal.
A bill of exchange is a preferable choice in international trade agreements. It reduces the currency exchange and interest rate risks for both parties. It can be used in domestic trade contracts as well.
When to use Promissory Notes?
Promissory notes are also used as written commitments to make a payment on a specified future date. As these instruments can be issued by individuals and companies, they work well in domestic markets.
It is also negotiable instruments that come with returns on investment. These instruments can be used as investments and payment tools as well. Promissory notes are often issued on the back of the high credibility of the issuer, hence are well-suited for the domestic markets.
Bills of exchange and promissory notes can be used in domestic and international trades. However, the working mechanism and the utility demand contrasting utilization of these instruments.
Pros and Cons of using a Bill of Exchange
A bill of exchange comes with certain advantages over promissory notes.
Pros of using a bill of exchange are:
- It is a negotiable instrument issued by a financial institute.
- Provides better financial security in international dealings as compared to a promissory note.
- It can be transferred to another party through endorsements.
- It can embed several features aligning with the trade contract terms and conditions.
Cons of using a bill of exchange:
- The transferability clause means the liability on the debtor is secondary.
- It does not provide a legal cover to the buyer against the non-performance of the seller.
- It cannot fully mitigate the default risk of the buyer.
Pros and Cons of using Promissory Notes
Promissory notes offer some advantages as compared to a bill of exchange.
Pros of using promissory notes:
- The promissory note can be used as a mode of payment and can be issued by an individual, a company, or a bank.
- It can be used as a negotiable trading instrument.
- It offers returns on investments with a specified interest rate.
- Promissory notes provide a useful resource to short-term financing problems such as working capital needs.
Cons of using promissory notes:
- Promissory notes can be used frequently in domestic trade only as the issuers’ credibility matters the most.
- It does not offer the right to recourse making it a less secured instrument for international trade.
- Promissory notes are held by the beneficiary party and can be traded without the consent of the issuer.
Bills of exchange and promissory notes are both written commitments to make payments with specified terms. Both offer good financial security and features. A bill of exchange is a preferred instrument for international trade while promissory notes are often used in domestic markets.