Bankers' acceptance (BA)

In trade and investments, a banker's acceptance (BA) is the promise of a future payment, or time draft, issued by a business and guaranteed by a bank. The time draft is called a banker's acceptance because the bank accepts the obligation to pay a specific amount to the holder of the draft on a specific date. The drawer, or the business issuing the time draft, provides a deposit from which the bank will draw the funds for payment.

A BA is mainly used to facilitate commercial transactions in international trade, usually regarding the export and import of goods. The importing firm's bank issues the BA to ensure payment to the exporting firm.

The individual or company who holds the BA has two options. It can hold onto the acceptance and collect payment on the day it reaches maturity, or the holder can sell the acceptance at a discounted price from face value on the secondary market.

BAs are considered safe and low-risk investments. Both the bank and the drawer are held liable for the specified amount when the acceptance matures.

Background

BAs can also be called trade bills, commercial bills, bank bills, or bills of exchange. They are available in various amounts, depending on the size of the transaction.

A BA is a short-term debt instrument in which the drawer agrees to repay borrowed funds. The maturity of a BA ranges from 30 to 180 days.

The rate that a bank charges for a BA is based on the rate that the instrument sells for on the secondary market. Banks then add commission to the BA rate.

A BA is a form of a commercial letter of credit, a written promise from a bank that ensures payment to the holder upon the receipt of documents indicating the shipping of goods. When a BA is used to finance a commercial transaction, it is called acceptance financing.

BAs are one of the oldest instruments in banking. They have been used to finance international trade for hundreds of years and have been traced back to the twelfth century.

When the United States created the Federal Reserve System in 1913, it sought to create a BA market to compete with that of the Bank of England. Reserve banks were granted the authority to buy BAs, and the Fed had the power to purchase all eligible acceptances. However, BAs never gained the prominence to become the cornerstone of America's money market.

As investment instruments, BAs are negotiable and are often included in money market funds, which invest in short-term securities that have a maturity of less than a year. A BA is similar to a T-bill, or Treasury bill. Like a Treasury bill, an investor may purchase the acceptance at a price less than its face value, and the holder receives the full value when the instrument reaches maturity.

Overview

A BA is primarily used to finance the buying and selling of goods. Goods can be shipped internationally between two countries or domestically between two organizations within the same country. The instrument is a safe way for parties not familiar with one another to do business. The acceptance relies on the bank's creditworthiness, not that of the business issuing the time draft.

A BA involves three parties: the exporter of goods, the importer of goods, and the bank. The exporter is the business selling and shipping the goods, and the importer is the company buying and receiving the goods.

The exporter and importer want to do business together, but they have not established a previous working relationship. They may be separated by distance and differing laws in each country. The exporting firm may not be able to trust the importing firm's credit, or its ability to make payment.

The exporter may ask the importer to issue a BA through a bank. The importer may also seek out a BA if it is unable to qualify for other means of financing or if the acceptance is the cheapest method.

A BA works like a post-dated check. The bank promises to pay a specific amount to the exporting firm on a specific date. When the draft is accepted, the bank will stamp "accepted" on it, demonstrating its guarantee to honor it. When the date of maturity arrives, the bank will deduct the funds from the importer's, or drawer's, deposit to pay the exporter.

The exporter can choose to keep the BA. When the instrument matures, the holder will receive the payment at full face value.

The exporter also has the option of selling the BA at a discount to the bank or other investors. By doing this, the exporter receives less than the face value but doesn't have to wait for the instrument to mature to get paid. If the bank buys the acceptance, it can hold onto it, thereby extending the loan to the importer, or it can sell the acceptance to investors at a discounted rate.

A BA benefits exporters and importers. Exporters receive the assurance of a form of payment before shipping their goods. Importers can specify a BA to be paid on a date after which they expect to receive the goods.

BAs are generally safe and low in risk because the bank and the drawer shoulder responsibility for payment. The bank is primarily liable at the time of maturity, and it would not risk its reputation by defaulting, or failing to make the payment. The drawer must deposit the funds into the bank before the specified date of payment, which also lowers the chance of a default.

If acceptances are sold on the secondary market, then the investors who purchase them provide the funds for the original transaction. This further decreases the risk for the bank.

Investors can profit from a BA through the difference between the discount and the face value, known as the yield. They can also resell the instruments at any time, as BAs do not have to be kept through the date of maturity.

Banker's acceptances are a stable instrument of debt and investment. They have facilitated international trade for hundreds of years by benefiting both sides of a transaction.

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