How Does a Banker's Acceptance Work?
A banker's acceptance is a financial instrument that most commonly occurs in international trade transactions. It provides a bridge between an importer and an exporter when they do not have an established relationship. A banker's acceptance can be used by an importer to finance his purchases or can be created through a letter of credit transaction.
A banker's acceptance is a legally binding obligation by the accepting bank to pay the stated amount at the maturity date of the time draft. It can have maturity dates ranging from 30 to 180 days. A banker's acceptance is a short-term debt instrument that helps to facilitate trade transactions between two parties when they do not have an established credit relationship.
An importer can use a banker's acceptance to finance his purchase of goods from foreign suppliers. After negotiating prices with the foreign exporter, the U.S. importer creates a time draft and presents it to his bank. The bank accepts the draft, discounts it and gives the importer cash which he uses to pay his foreign supplier.
On or before the maturity date of the accepted draft, the importer must pay the bank the face amount of the acceptance.
Suppose an importer in the United States wants to buy tools from an exporter in Germany. However, the exporter does not have a relationship with the importer, and the importer wants payment for his merchandise before it leaves his country. The solution is for the U.S. company to ask his bank to issue a letter of credit in favor of the German exporter.
The letter of credit will state that the German company will receive their funds upon presentation of an invoice and shipping documents with a time draft demanding payment. The bank will examine the documents and if everything is in order, accept the time draft and agree to pay a specific amount to the exporter on the due date of the draft.
When the German exporter receives his accepted time draft from the bank, he can either hold the draft until maturity, or he can discount the draft and receive his funds immediately, less the bank fees.
Since bankers' acceptances are an unconditional obligation by a bank to pay at the maturity date, investors consider them very safe investments, and an active secondary market exists. Bankers' acceptances trade as bearer instruments at a discount from face value.
For example, if an accepted draft has a face value of $100,000, the holder would be able to sell the draft for a lesser amount, say $97,500, in the secondary market. The discount amount fluctuates with current interest rates. The interest rate for bankers' acceptances is usually at a small spread over the current rates for U.S. Treasury bills.
Bankers' acceptances have been financing foreign trade since the 12th century. They came into existence in the United States when the Federal Reserve Bank was created in 1913. Due to the binding obligation by a bank, bankers' acceptances are considered very safe financial instruments.