Article

by David Hennah

It is a quirk of fate that I share my birthday with Charlie Chaplin, whose iconic image still commands instant recognition the world over. Legend has it that Chaplin enjoyed telling a story of how he once entered himself in a Charlie Chaplin lookalike com petition, only to suffer the ignominy of coming in third. In other words, the judges had found two contestants to look more like Charlie than Chaplin himself.

Much of the work surrounding the launch of the Bank Payment Obligation (BPO) has drawn direct comparisons to the letter of credit. Certainly, the BPO, discussed in some detail by SWIFT's Robert Marchal in the Winter 2010 issue of DCInsight, possesses many of the qualities that are widely valued in the L/C. However, it has never been the ambition of SWIFT that a BPO should look more like an L/C than an L/C. It is SWIFT's ambition, however, that over time a BPO should obtain the instant levels of recognition that an L/C has commanded for many hundreds of years.

Briefly put, if we consider that under an L/C the issuing bank is required to make payment subject to the presentation of compliant documents through the banking system, then it can equally be said that under a BPO an obligor bank is required to make payment subject to the presentation of compliant data through a central matching engine called the Trade Services Utility (TSU).

TSU

The TSU is a matching and workflow application that sits on the SWIFT network. It is accessible to the 106 financial institutions located in 31 countries globally that are currently subscribed to the service. The TSU was conceived by its own user community as a solution to address the changing needs of the market in the face of an ongoing migration of trade to open account.

This is not to say that traditional trade is ever going away. Indeed, there has been some anecdotal evidence of a renaissance in the use of traditional instruments in the wake of the recent deterioration in market conditions. Nevertheless, it remains a reality that a significant majority of trade business today - close to 90 per cent - is on open account.

In an open account environment, the ability of the banks to continue to provide cost-effective, reliable and resilient risk mitigation and financing solutions is restricted by an absence of visibility into the underlying transaction. The TSU is designed to re-create the visibility that goes hand in glove with traditional trade.

The first step in establishing an open account transaction in the TSU is for the participating banks - a buyer's bank, a seller's bank and potentially some additional banks as well - to agree the baseline. The baseline is essentially an exact matching of key data elements extracted from the relevant purchase order. Once the baseline has been established, then additional structured data sets - including commercial invoices, transport, insurance and certificates - can be fed in and matched, thus providing a facility to track events in the physical supply chain as the transaction progresses from start to finish. The events-matching process enables banks to identify potential trigger points for the provision of financial services. These services will typically be finance-related, such as an offer of pre-shipment finance based on a matched/confirmed purchase order or post-shipment finance based on a matched/confirmed invoice. Additional services may be offered to enhance process efficiency, including risk mitigation, cash forecasting, dispute resolution or in-sourcing of the business process.

At the same time, the establishment of the baseline by common agreement at the beginning of the transaction does significantly reduce the subsequent risks of discrepancy, dispute and delay.

One of the components that can optionally be included in a baseline is the Bank Payment Obligation. The BPO is not necessarily included in the initial baseline submission; it can also be introduced later by way of a baseline amendment, provided all parties to the transaction agree.

A BPO is an irrevocable (conditional) obligation of an obligor bank to pay a specified amount to a recipient bank according to an established baseline of a single TSU transaction. A BPO will constitute a legally binding, valid and enforce able obligation of the Obligor Bank to the Recipient Bank under the appropriate standard of law, enforceable in accordance with its terms.

BPO and L/C compared

Figure 1 illustrates a high-level comparison of the process flows associated with the L/C and the BPO. The key difference here is that whereas the L/C relies upon the physical checking of complete sets of documents, the BPO can be enforced against the automated matching of selected data elements in accordance with the agreed baseline. The involved banks must agree as to what needs to be achieved in order for the BPO to come into force. Normally, this will be dependent upon the matching of data. However, even in the event of a mismatch the banks can, if they wish, jointly agree to accept such a mismatch in order for the transaction to proceed unencumbered.

It should be emphasized that in the case of the BPO, the obligation to pay is primary, again aligning the BPO more closely to the L/C than a standby or guarantee. However, the obligation is strictly between banks, since only banks can access the TSU today, acting on behalf of their corporate customers.

The BPO is initially recorded as a contingent liability, similar to an L/C. It becomes a direct liability when the datamatching conditions, as set out in the baseline, have been met or, alternatively, any mismatches have been waived by agreement. Since data is compared automatically, the results are clear cut. Either the data matches or it does not. Any element of subjectivity that may sometimes be associated with a manual comparison of paper documents is therefore removed.

The commercial usage of the BPO is governed by a Service Description and Rulebook to which every participant bank must subscribe. The Rulebook sets out the mandatory obligations of all participants, including SWIFT, and provides a legal framework for the BPO which is similar to the way in which commercial usage of letters of credit is governed by UCP 600.

Under the UCP, an irrevocable credit constitutes a definite undertaking of the issuing bank, provided the stipulated documents are presented to the nomi nated bank or to the issuing bank and that the terms and conditions of the credit are complied with. Similarly, a confirmation of an irrevocable credit by another bank constitutes a definite under taking of the confirming bank, provided that the stipulated documents are presented.

In a BPO context, the BPO similarly constitutes a definite undertaking of the issuing bank, provided that the stipulated data is presented in accordance with the agreed baseline in the TSU. In many cases, the BPO will be issued by the buyer's bank. In those cases where the BPO has instead been issued by a third party bank, that bank's role is similar to that of a confirming bank.

The content of the Rulebook has been negotiated with the user community itself, including bank lawyers as well as trade specialists and an industry consultant. It has been clearly acknowledged that the Rulebook covers all aspects of the terms and conditions between participating financial institutions and that no supplementary agreements are required over and above the Rulebook.

Also included in the Service Description are some optional guidelines relating to the BPO-related service agreements that a bank may enter into with its corporate customer.

BPO live!

The establishment of the legal framework and accounting policy have been essential steps along the road towards bringing the BPO to market. The next logical step is to develop commercial usage of the BPO in a live business environment. Such usage will, first of all, help to develop a better understanding of the behaviour and performance of a BPO, which is critical in terms of determining capital treatment based upon probability of default, etc.

It is also SWIFT's objective to obtain an official form of recognition of the Bank Payment Obligation as an accepted market practice. Initial talks have taken place with ICC with a view to obtaining their endorsement.

In order to take this forward, SWIFT is currently working closely with a group of users who are committed to making the BPO a success. On 2 April 2010, the Bank of China became the first bank to issue a live BPO. More banks are scheduled to go live soon.

This first live transaction substituted a BPO for a domestic letter of credit, which is an instrument in common use in China. Until now, domestic L/C business has been processed manually, partly because of the need to handle Chinese characters, which are not supported in SWIFT Category 7 FIN messages. The TSU, which uses XML-based messaging, provides full technical support for UTF-8 universal character sets, including Chinese. Hence, there is a specific advantage to be gained in automating and integrating the processing of these transaction types.

Domestic L/Cs are particularly prevalent across Asia, and it may be that there is a niche market for a BPO to be considered as an alternative means of mitigating risk, guaranteeing payment and providing collateral for finance where required.

Summary

The recent tightening of credit conditions has highlighted a gap in the market which can be filled by the launch of a new instrument. Whilst there are a number of proprietary solutions available in the market, these are generally applied in a three-corner model only, having been developed by global banks to service their own needs. The advantage of the TSU/BPO model is its inter operability, thus enabling banks to work together and to provide extended reach in a four-corner environment. In order to establish market acceptance, it is imperative to gain industry standard recognition through an ICC endorsement. SWIFT also continues to work in parallel with BAFTIFSA on the development of standard definitions for instrument processing and financing, designed to ensure a common recognition of such terms by regulators and other interested stakeholders.

Trade remains a very traditional world and the world does not change overnight. The launch of the BPO represents an opportunity for all of us to open our minds to the possibilities of change and the potential to deliver something of real value to those we serve, our customers.

David Hennah is Senior Manager, Supply Chain Solutions, Markets Division, SWIFT s.c. in the United Kingdom. His e-mail is david.hennah@swift.com