International Payments Using Drafts

Commonly used in international trade, a draft is an unconditional order in writing – usually signed by the exporter (seller) and addressed to the importer (buyer) or the importer’s agent – ordering the importer to pay on demand, or at a fixed or determinable future date, the amount specified on its face. Such an instrument, also known as a bill of exchange, serves three important functions:

  1. To provide written evidence, in clear and simple terms, of financial obligation.
  2. To enable both parties to potentially reduce their costs of financing.
  3. To provide a negotiable and unconditional instrument (that is, payment must be made to any holder in due course despite any disputes over the underlying commercial transaction.)

Using a draft also enables an exporter to employ its bank as a collection agent. The bank forwards the draft or bill of exchange to the foreign buyer (either directly or through a branch or correspondent bank), collects on the drafts, and then remits the proceeds to the exporters. The bank has all the necessary documents for control of the merchandise and turns them over to the importer only when the draft has been paid or accepted in accordance with the exporter’s instructions. The conditions for a draft to be negotiable are that it must be:

  •  In writing
  •  Signed by the issuer (drawer)
  •  An unconditional order to pay
  •  A certain sum of money
  •  Payable on demand or at a definite future time
  •  Payable to order of bearer

There are usually three parties to draft. The party who signs and sends the draft to the second party is called the drawer; payment is made to the third party, the payee. Normally, the drawer and payee are the same person. The party to whom the draft is addressed is the drawee, who may be either the buyer or if a letter of credit was used, the buyer’s bank. In case of confirmed L/C, the drawee would be the confirming bank.

Drafts may be either sight or time drafts. Sights drafts must be paid on presentation or else dishonored. Time drafts are payable at some specified future date and as such become a useful financing device. The maturity of a time draft is known as its usance or tenor. As mentioned earlier to qualify as a negotiable instrument, the date of payment must be determinable.  A time draft becomes an acceptance after being accepted by the drawee. Accepting a draft means writing accepted across its face, followed by an authorized person’s signature and the date. The party accepting a draft incurs the obligation to pay it at maturity. A draft accepted by a bank become a banker’s acceptance; one drawn on and accepted by a commercial enterprise is termed a trade acceptance. The exporter can hold the acceptance or sell it at discount from face value to its bank, to some other bank, or to an acceptance dealer.

Draft can be clean or documentary. A clean draft, one unaccompanied by any other papers, is normally used only for non-trade remittances .Its primary purpose is to put pressure on a recalcitrant debtor that must pay or accept the draft or else face damage to its credit reputation. Most drafts used in international trade are documentary. A documentary draft, which can be either sight or time, is accompanied by documents that are to be delivered to the drawee on payment or acceptance of the draft. Typically these documents include the bill of lading in negotiable form, the commercial invoice, the consular invoice where required, and an insurance certificate. There are two significant aspects to shipment goods under documentary time drafts for acceptance. First, the exporter is extending credit to the importer for the usance of the draft. Second, the exporter is relinquishing control of the goods in returns for a signature on the acceptance to assure it of payment.

It is important to bear in mind that sight drafts are not always paid at presentation, nor are time drafts always paid at maturity. Firms can get bank statistics on the promptness of sight and time draft payments, by country, from different bank publications. Unless a bank has accepted a draft, the exporter must ultimately look to the importer for payment. Thus, use of a sight or accepted time draft is warranted only when the exporter has faith in the importer’s financial strength and integrity.