"Challenges of International Transactions Using Bank Guarantees in Commodity Trading"

Carlos Augusto Silva Ribbeiro Júnior

Sales Business Development Manager | Commodities Sales | ICUMSA 45, Chicken Protein Business Development Manager

28 de junho de 2024

Introduction:

International commodity trading is a complex and dynamic industry, involving the exchange of physical commodities such as oil, gas, metals, and agricultural products across borders. The movement of vast sums of money in international transactions necessitates the use of reliable and secure payment mechanisms to mitigate risks and facilitate smooth transactions. Among these mechanisms, bank guarantees have emerged as a valuable tool in bridging the trust gap between parties involved in commodity trading. However, despite their widespread use, international transactions using bank guarantees are not without challenges. The cross-border nature of these transactions introduces additional complexities and potential pitfalls. As such, understanding these challenges is crucial for parties engaged in international commodity trading to effectively leverage bank guarantees and mitigate risks associated with their use. This paper aims to provide an in-depth exploration of the challenges encountered in international transactions using bank guarantees in commodity trading. It will delve into the legal, regulatory, and operational complexities surrounding the use of these instruments, highlighting potential pitfalls and offering practical insights to address them. Through this analysis, we hope to contribute to the body of knowledge on international trade finance and assist practitioners in navigating the intricacies of using bank guarantees in commodity transactions.

Complexity of Bank Guarantees and Required Documentation

This section will address the detailed requirements and complexity involved in obtaining and using bank guarantees for international commodity transactions. It will cover the various documents needed, the procedural intricacies, and the common challenges faced during the process.

In order to create a solid bank guarantee, certain types of documents are necessary. This list of documents must be known to all parties involved in the transaction to prevent any issues during the entire process of buying and selling commodities internationally.

To obtain a bank guarantee, a specific order of documents must be followed, which is outlined below:

- LOI (Letter of Intent)

- ICPO (Irrevocable Corporate Purchase Order)

- FCO (Full Corporate Offer)

- SPA (Sales and Purchase Agreement)

- BG (Bank Guarantee)

The entire process of buying and selling commodities up to the moment of the sales contract is generally straightforward, as the contract governs the understanding between the buying and selling parties about the purchased asset, determining the entire structure to facilitate product delivery. However, the issuance of the bank guarantee becomes extremely delicate due to the legislation of the issuing and receiving countries and the internal differences of each financial institution.

In all operations, it is customary for banks considered in the top 50 and top 25 rankings to be the issuers and receivers of the guarantees. The main reason for this is the commercial balance that these banks maintain between them. Banks not considered in the top 50 or top 25 often undergo a process where the more credible banks must confirm the letter of credit.

The most commonly used guarantee instruments today are the SBLC (Standby Letter of Credit) and the DLC (Documentary Letter of Credit), both with specific purposes and peculiarities. In this article, we will not delve into their peculiarities nor determine which document is safer for both parties.

One significant challenge is the buyer's difficulty in providing the draft of the bank guarantee contract issued by the buyer's institution, as the buyer often lacks knowledge of the process. This lack of understanding delays or hinders international commodity transactions.

This ignorance causes disruptions throughout the supply chain, affecting quotations, prices, dispatch bottlenecks, ship booking, storage costs, and customs costs, ultimately hampering the business itself.

The bank guarantee must contain key information such as target price, product description, product quantity, issuing bank, receiving bank, breakage percentage, total shipment, partial shipment, and special notes describing unique characteristics of the product to be guaranteed.

The lack of knowledge about the bank document and its preparation, as well as its correction and explanation, causes significant issues in the transaction process.

Risks Associated with Brokers' Lack of Knowledge

This section will explore the risks and issues that arise when brokers with little experience or knowledge attempt to mediate international transactions using bank guarantees. It will highlight the potential pitfalls and the importance of choosing experienced brokers to ensure transaction security.

The possibility of partnering with brokers to carry out an international transaction of any type of commodity is indeed common, due to the necessity for both the buyer and the seller to have their own broker to facilitate the transaction.

However, the plethora of individuals acting as commodity brokers who often lack qualification, understanding, and knowledge of the product frequently causes a series of misfortunes for both the buyer and the seller.

This is a constant characteristic in negotiations. In most cases, besides not mastering the necessary languages to negotiate, there is a lack of knowledge about the export or import process of a particular product and its regulations, from the country of origin to the destination country. There is also a complete lack of understanding of the banking processes and the basic requirements for opening or advising the buyer and the seller.

This is the main factor for time loss and the possibility of fraud in the international market, causing distrust and a lack of transparency to be imminent in all transactions.

Strategies to Mitigate Risks and Ensure Transaction Success

This section will present a best practices that can be adopted to mitigate risks and ensure the success of international commodity transactions using bank guarantees. It will provide practical advice and solutions to navigate the complexities and enhance the likelihood of successful outcomes.

The best practice I adopt to complete an international transaction is to conduct a thorough review of the entire operation and maintain a close relationship between the buyer and their broker. This approach aims to understand the purpose, necessity, and importance of the international transaction for the buyer. Without transparency and trust between the intermediaries and a deep understanding of the buyer's needs, the operation will inevitably fail. Only with a comprehensive understanding of the entire operation and absolute certainty that the buyer has the necessary resources and financial process knowledge will the transaction be successfully completed.