What is a Bill of Exchange?

A bill of exchange is a legally binding payment used in trade to agree on a future payment. Commonly used as a payment mechanism in both domestic transactions and international trade, this tool guarantees that the obliging party makes payment in a binding agreement.

Here, we’ll explore the definition of a bill of exchange, its lifecycle, and some of the advantages of using them over other instruments in international trade.

The Definition of a Bill of Exchange

Dating back as far as the Middle Ages, a bill of exchange is a promissory note typically issued by the buyer to the seller of goods in exchange for the goods in question.

Imagine that the seller would like to sell their goods for cash; however, in some instances, the interested buyer may not have immediate access to money.

If the buyer is confident in their ability to generate cash in the future, the seller may trust the buyer’s claims and still be interested in selling the goods to them, provided the buyer agrees to pay in the future.

In these situations, bills of exchange become the preferred financial instrument. This is because a bill of exchange is a legal promise made by the buyer to the seller.

It’s worth noting that there is usually no collateral backing this promise, but it is not just a verbal promise; it’s a contract that is enforceable in a court of law. In a case of non-payment, the buyer will face legal consequences.

The bill of exchange creates value out of nothing: a simple piece of paper becomes a promissory note when the buyer signs it. It’s then possible to trade the note in the market as a security.

Example: The Lifecycle of a Bill of Exchange

To better understand bills of exchange, we must first understand how they arise in the ordinary course of business. We can best explain this by studying the exchange process.

1. Drawing of the Bill:

   The first part of the journey is when one party, the buyer, makes a verbal promise to another, the seller, to pay a specified amount of money at a future date.

   The seller is then required to draw up a bill of exchange and detail the agreement between the buyer and the seller. This act of formally writing down the written agreement in line with trade laws is called “drawing of a bill”.

   It is essential to note that the seller, not the buyer, is responsible for drawing the bill of exchange.

2. Acceptance of the Bill:

   In the next stage, the seller presents the formal bill of exchange to the buyer, or a specified person representing them, for their consideration and approval.

   By this stage, the seller has already drawn the bill of exchange, and can be referred to as the “drawer”, while the buyer is the “drawee”.

   The drawee must then carefully inspect the bill of exchange to verify that it explicitly matches their original agreement. If the drawee finds the bill to be accurate, they sign it. This act of signing the bill of exchange is the “acceptance of the bill.”

   At this point, a verbal promise has evolved into a security that a drawer can trade on the market.

3. Endorsement of the Bill:

   The drawer now has an accepted bill of exchange.

   They may instruct their treasury department to either wait for the bill to mature or collect the proceeds, depending on the type of bill.

   Alternatively, they could instruct their treasury to pass the bill on to third parties if they are willing to accept the credit of the drawee. Such passing of the bill to a third party is called “endorsement of the bill of exchange”. The drawer does this by signing at the back of the bill and relinquishing their claim in favour of another party.

   Other parties can endorse this bill innumerable times as long as buyers have faith that the bill will be paid when due.

4. Discounting of the Bill:

   When a bill is endorsed, the drawer’s receivables are set off against the drawer’s payables. This means that the drawer transfers their right to receive payment to someone else. The drawer is allowed to use the amount they are owed (receivables) to settle what they owe to others (payables).

   In these scenarios, bills of exchange are discounted.

   A bill of exchange can be sold to a bank, which will then deduct a certain amount of interest, referred to as the discount amount. The post-discount amount is then paid to the drawer. The bank will subsequently own the bill and have the right to collect dues from the drawee.

   The discounting of bills may be with or without recourse. This means that, depending on the terms, the bank may or may not be able to hold the drawer liable if the drawee does not pay.

   Additionally, since the bill of exchange is a marketable security, if the bank does not wish to hold the bill, it can simply rediscount it with another bank and exit the transaction.

Types of Bills of Exchange

Within the broader context, there are various types of bills of exchange that are worth knowing. Here are some of the most common types:

• Sight bill: With these bills, the drawee must make an immediate payment as soon as they see the bill. It’s sometimes known as a sight draft or a demand bill.

• Time bill: Sometimes known as a time draft, term bill, or usance bill, payment for these bills of exchange is due after a specified period, from issue or first sight by the payee. The issuing party must receive payment on the due date stated within the bill.

• Foreign bills: These bills are for foreign exchange transactions between two countries. Foreign bills are used every day in international trade, particularly in scenarios where parties settle cross-border transactions.

• Inland bill: On the other hand, an inland bill is a bill of exchange that is drawn and payable within the same country.

• Documentary bills: These are bills that are accompanied by shipping documents, such as an invoice or insurance papers. These additional papers are required for the drawee to obtain the goods in question.

• Clean bill: Unlike a documentary bill of exchange, a clean bill has no additional documents.

Advantages of Bills of Exchange for Banks

Banks are more than willing to lend against bills of exchange if the drawer and drawee are credible parties. This is because bills of exchange offer certain advantages, which are as follows:

• Short Term: Financing bills of exchange is a highly short-term loan. Therefore, the amount of time for which the bank’s money is at risk is very short. Additionally, the bank can earn a processing fee each time a bill is created.

• Self-Liquidating: Bills of exchange are self-liquidating loans. The drawer does not have to repay it. When the bill is due, the drawee most likely pays their dues, and the accounts of all parties are settled.

• Less Risky: Since bills of exchange arise relatively late in the cash-to-cash conversion cycle, they are subject to lower risks compared to working capital loans issued by banks. The low risk and high returns make bills of exchange a preferred investment for banks.

Disadvantages of Bills of Exchange

Whilst bills of exchange are commonly used in trade and revered for their flexibility, they are not without their disadvantages. Individuals should consider these disadvantages before relying on them:

The Cost of Dishonour: If the drawee dishonours the bill, meaning that they fail to pay when it is due, it causes a strain on the drawer or payee.

Circumstances may force the drawer to take legal action for the drawee to fulfil their part of the bargain, which can be both time-consuming and costly.

Requires High Trust: These bills are often issued without any collateral. This means that the drawee provides no security if they are unable to fulfil their obligations under the agreement.

In this scenario, if the drawee defaults and has no financial assets, the drawer could end up out of pocket, regardless of their legal right to enforce payment.

Not Suitable for Long-Term Financing: Bills of exchange are most commonly used for short-term transactions, typically lasting between 30 and 180 days.

Businesses that rely on bills of exchange for long-term financing may encounter liquidity issues if the drawee delays or fails to honor their payment. For long-term lending, businesses more often use term loans, bonds, or equity financing.

The Bottom Line

Bills of exchange are a valuable tool for managing trade between parties, offering security and flexibility to both drawers and drawees.

Understanding the ins and outs of how these processes work can help individuals unlock better cash flow, minimise risk, and even initiate promising negotiations with banks.

Frequently Asked Questions

1. What is a promissory note?

   A promissory note is an agreement written by a buyer to a seller, agreeing to pay a certain sum of money on demand or by a set deadline. It’s a legally binding agreement that is common in loans, trade, or personal finance.

2. What is a determinable future time in trade?

   In a trade context, a determinable future time refers to the period during which a payment must be made, as specified in the contract. This is decided by the drawer, and can be grounds for legal prosecution if the determinable future time isn’t met by the drawee with payment.

3. What is an unconditional order?

   An unconditional order is an explicit instruction by one party to another to pay a specified amount of money to another party, without any conditions attached.

   This means that the payment must be made as stated, without any room for change due to external events or circumstances.

4. Are bills of exchange and negotiable instruments the same thing?

   A bill of exchange is a type of negotiable instrument. It is a written order from one party to another, instructing the recipient to pay a specific amount of money to a third party upon demand or at a future date.

   To put it into perspective, negotiable instruments are a broader category, encompassing items such as promissory notes and cheques.

5. Who are all of the parties involved in the drawing of a bill of exchange?

   A bill of exchange often involves three key parties:

   1. The drawer: this is the person who creates (draws) the bill of exchange. They are often the seller or creditor to whom the drawee owes money.

   2. The drawee: The person or entity who is ordered to make the payment. They’ll become the acceptor after signing the bill.

   3. The payee: The person to whom the payment must be made. This is often the same party as the drawer, assuming the drawer wants to be paid directly. It can sometimes be a third party if the bill is endorsed to someone else.