A bill of exchange is a financial instrument that binds one party to make payment to a second party. It includes the date and amount to be paid. It works similarly to a bank cheque or promissory note. It is often used in international trade by banks or companies, though its popularity has declined in the past few years.
What is a Bill of Exchange?
A bill of exchange is a written contract between two parties in a trade contract. It is used to formally bind the buyer to make payment to the seller on a predetermined date and amount.
Individuals and financial institutes such as banks can issue a bill of exchange. Its commonly referred to as a trade draft if issued directly by a buyer company. It is called a bank draft if issued by a bank on behalf of the applicant.
It is a negotiable and transferable instrument. The beneficiary can transfer the payment rights to another party. The Beneficiary of a bill of exchange can also negotiate credit against its credit value. Although it does not act as a financial guarantee or a confirmed payment instrument. The issuer of the bill of exchange (buyer) may end up paying to an unknown third-party.
How Does a Bill of Exchange Work?
Two parties can directly arrange the issuance and payment of a bill of exchange. International trade is risky and both parties may not know each other well. Hence a bank may act as a third-party facilitator.
Usually, there are three parties involved in a bill of exchange.
Drawee: it is the party that makes payment to another party upon presentation of the instrument.
Payee: It is the party receiving the payment. It can be the second party in the trade contract or a third-party presenting the bill.
Drawer: It is the party that obliges the first party to make the payment. It can be a bank or the payee if issued directly between the two parties.
Once both parties in a trade contract agree upon the terms and conditions, they can select a bill of exchange as the payment mode. Both parties can negotiate the issuance of a bill of exchange through a bank too. Unlike a bank cheque, it includes the terms of the contract and specifies the date and amount to be paid.
Both parties in trade contracts often include a credit period when issuing a bill of exchange. Usually, a delayed payment does not incur interest charges to the drawee. However, in the case of large amount or terms of contract, it may incur interest charges as agreed by both parties. It usually includes a probatory period after an estimated time of goods shipment such as 60 or 90 days after the shipment.
The beneficiary of the bill of exchange can directly receive the payment once the trade terms are completed. Sellers often use it to avail advance payments from lenders (banks). For increased security, the sellers can involve their bank to receive the payments from the drawee’s bank.
Important Points to Note
A bill of exchange is a negotiable and transferable instrument. It works similarly to a bank cheque. It can work as a mode of payment in international trade with the involvement of a bank.
Here are a few key points to note with this arrangement.
- It is a written order to make payment to the beneficiary that does not involve any bank guarantee.
- Both parties can directly arrange the bill of exchange order without involving a bank.
- It is a transferable and negotiable instrument.
- A bill of exchange can be traded on secondary markets. However, it requires high creditworthiness of the issuer, usually large corporations or banks.
- If a bank is involved, the bank may offer some financial guarantee of payment to the seller in case of the default of the buyer.
Types and Uses of Bill of Exchange
A bank cheque or promissory note is usually used in domestic trade contracts. It is often used in international trade. Banks offer the facilitator’s services in proceeding with the bills of exchange.
Exporters in international trade are the prime users of the bills of exchange. It is a negotiable instrument, hence can be traded on secondary markets. Corporations and banks trade the bills of exchange at discounted prices.
It can take a few simple variations by the issuer or by the maturity of the issued order.
Trade Draft: if the bill of exchange is issued by the buyer directly it is referred to as a trade draft.
Bank Draft: if a bill of exchange is issued through a bank, it is termed as a bank draft.
Sight Draft: in this type, the payment becomes due immediately upon presentation of the order.
Time Draft: It includes a probatory period usually 60 or 90 days after an estimated time for the shipment of goods. It clearly indicates a future date of payment.
Suppose a buyer company Green Star in Germany approaches Blue Tech in China for the import of electronics. The order is worth $500,000. Both parties can agree on the goods manufacturing and shipment terms. The mode of payment is chosen as a bill of exchange. For further security, both parties agree to involve their banks.
Once Green Star issues a bill of exchange, it becomes an obligation. Blue tech can deposit it to its bank or trade on a secondary market. Under normal circumstances, Blue tech will present the bill of exchange worth $ 500,000 upon shipment of goods.
Advantages of a Bill of Exchange
It primarily works as a payment order. It provides several benefits to both parties in the trade contract.
- It is a simple documented payment instrument that becomes an obligation once issued.
- The Beneficiary party can trade the bill of exchange on secondary markets.
- It mitigates the exchange rate risk for both parties in international trade without using complex instruments such as Futures.
- It does not incur interest charges usually.
- Both parties can save on bank costs, interest costs, and other fees if issued on mutual terms.
- Both parties have the option of involving their banks for further financial security.
Disadvantages of a Bill of Exchange
It is a simple payment instrument, often used in international trade. However, despite its simplicity, it offers several limitations.
- It is an unsecured form of financial payment without the involvement of banks.
- This instrument does not fully cover the default risk of the issuer.
- It does not legally cover the buyer against the non-performance of the seller.
- It lacks the financial guarantee or legal binding to both parties in international trade.
A bill of exchange is a simple financial instrument issued for the payment obligation in international trade. It is a negotiable and transferable instrument. It does not incur interest and issuing charges. Both parties can arrange it directly or with the help of their banks.