Forfaiting can be described as the private placement of medium and long-term trade receivables. Generally it is non-recourse to the seller. A typical example is where an exporter, say a US company, has made a large sell to a foreign entity or country and the US Exim Bank has not insured 100% of the receivable. In this scenario, the Exporter finds a Forfaiter who purchases without recourse the uninsured portion of the receivable. Prior to this, the Forfaiter has sold the receivable to another entity often a foreign bank that is comfortable with the end buyer’s corporate and sovereign risk. Generally the receivable will be represented by a draft which will have the ‘Aval’ or guaranty of the end buyer or a bank.
Forfaiting unlike Factoring is more involved with longer tenor cross border transactions. The documentation is different from a factoring transaction as Forfaiting has elements of private placement, often a guaranty, with different types of notifications, and different settlement methodology.
Some of the larger players, several years back, almost folded with the financial crisis in the late ‘90s mainly due to the fact that they were holding on to the papers rather than placing them immediately.
Shorter term transactions are now increasingly being done by Forfaiters generally for cross border transactions.
Examples of financial obligations that are Forfaited include:
- Promissory Note that is issued by the Importer and is an obligation to the pay the Exporter.
- Bills of Exchange which are drawn by the Exporter and accepted by the Importer.
- Book Receivables which are an amount due to an Exporter that is not evidenced by a negotiable instrument but are backed by a separate letter of guaranty or letter of credit.
The Forfaiter purchases one of the above financial instruments from the Primary Holder and will then place or sell this in the Secondary Market making a spread between what the Forfaiter paid the Primary holder and what he can get from the Secondary buyer. This spread or income to the Forfaiter is obtained by using different methods of discounting designed to yield the Forfaiter a certain desired return.
Some of the main risks involved in Forfaiting:
- Transaction Risks: Since Forfaiting is non recourse financing it is important that the negotiable instrument that is being forfeited is abstracted from the underlying sales contract so that there are no lingering non-performing risks such as quality or quantity of goods, delay or non-delivery, time or place of delivery, etc.
- Risk that the Guarantor will remain viable. That the guarantee is irrevocable, unconditional, transferable, and completely abstract from the underlying commercial transaction in every way.
- Sovereign Risks that the importers country will have enough foreign exchange to pay the obligation and that there is clear evidence that the payment will be made in a freely convertible currency free from any deduction or taxes
- Documentation Risks: whether the signatures are confirmed by an acceptable entity such as a bank; whether there are any cross border, political, economic, legal, foreign exchange and local regulatory risks.
- Safe Custody: Risk of the loss, theft or misappropriation of the negotiable instrument.
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