Commercial drafts are payment instruments that facilitate domestic trade in China. Comprising Bank Acceptance Drafts (BADs) and Commercial Acceptance Drafts, commercial drafts are not only used for business-to-business payments, but also can be a form of short-term trade financing. They are one of the most commonly used payment instruments for domestic trade in China. However, it is not compulsory to issue or accept commercial drafts.
While commercial drafts have certain similarities to checks, they have many unique features. In fact, there is not a directly equivalent payment instrument in the United States.
Whether your entities in China are asked to receive commercial drafts for payments from clients in China, or they want to pay local vendors using commercial drafts, this guide can help you understand commercial drafts, the Electronic Commercial Draft System, and when to utilize commercial drafts for your China operations.
About Acceptance Drafts Bank
Acceptance Drafts are issued by banks or China Banking and Insurance Regulatory Commission–approved finance companies, which are non-bank captive companies that perform “in-house bank” functions for corporate groups or conglomerates. Finance company–issued drafts are less common than bank-issued drafts. Commercial Acceptance Drafts are drafts issued by companies.
- The paying counterparty. When receiving a commercial draft for payment, the party obliged to make the payment (counterparty) is the issuing bank or the finance company for a Bank Acceptance Draft, or a company for a Commercial Acceptance Draft.
- Tenor of the instrument. The tenor may be up to 6 months for paper-based commercial drafts, and 12 months for electronic commercial drafts issued on the Electronic Commercial Draft System (ECDS), which is discussed further below.
- Transferability. Commercial drafts are legally transferable payment instruments from one party to the next. Instead of holding the commercial draft until the payment date, the draft holder may opt to “pass” the instrument on to its trading partner(s). The draft can then be transferred by that party to its own trading partner(s), and so on.
- Discounting. Commercial drafts may be discounted at the prevailing market discount rate with a bank to receive cash earlier than the maturity date.
- Business justification. According to regulations, in order to issue or discount commercial drafts, there must be actual business needs, and banks will verify documents that support the trade background.
- Non-payment and fraud risks. Much like other paper-based payment instruments, non-payment and fraud risks exist when accepting commercial drafts, though there are ways to mitigate these risks.
The Electronic Commercial Draft System
To promote the usage and safety of commercial drafts, and to facilitate companies’ payment and trade financing drafts, the People’s Bank of China (PBOC) created the Electronic Commercial Draft System (ECDS) in January 2008 and launched it officially in October 2009. ECDS helps to mitigate the fraud and operational risks of commercial drafts by allowing the transactions to be processed electronically, preventing forged paper-based drafts while providing visibility into the transaction trail.
A Typical Transaction
When both trading parties agree to use a commercial draft for their transaction, invoices or contracts are generally considered paid when commercial drafts are received by the payee from the payor, though the timing of cash expenditures/receipts can be quite different from the invoice payment date.
- Company A can pay via Bank Acceptance Draft as it has a credit line with its bank. Company A’s bank issues a Bank Acceptance Draft today, with draft payment date in 90 days, to Company Z for payment of an invoice, and Company A provides the draft to Company Z for payment the same day. The invoice is considered paid today, while the draft payment date is 90 days from today. Company A does not need to settle with its bank until the payment date, therefore freeing up its cash for 90 days.
- Company Z accepts the draft for payment from Company A today, and chooses to hold the draft until maturity without discounting or transferring the draft to another party. While the invoice is considered paid today, the 90-day tenor of the draft means Company Z would receive funds 90 days from today.
- The net result is that while the invoice is considered paid today, company A’s cash expenditure for the invoice is delayed by 90 days, while company Z’s cash receipt for the same invoice is also delayed by 90 days.
- Benefit to the payor. The payor does not need to settle with its bank until the commercial draft’s payment due date. This can free up cash for the payor until the payment due date, and is one of the reasons that the commercial draft is a popular payment option today in China.
- From the payee’s perspective, the funds do not settle on the payee’s account until the payment date of the draft, thus lengthening the time of cash receipt and cash conversion cycle. Discounting and transferring the drafts are viable options to free up cash sooner, though discounting has a cost, and the payee’s own suppliers may not be willing to accept draft transfers. The cash flow impact is therefore one of the considerations for payees when deciding whether to accept commercial drafts as a method of payment.
When Should You pay with a Commercial Draft?
- Issuing Commercial Drafts requires applying for the service and credit line from a bank, and there are qualifications that a company needs to meet in order to issue these drafts.
- The application and the availability of the credit line for issuing Bank Acceptance Drafts are subject to each bank’s credit underwriting policy and the payor’s financial condition. Therefore, it is possible that the bank would not extend credit to the payor, or the bank may approve credit for a part of the requested amount and require cash collateral for the remaining portion.
- Suppliers may decline to receive commercial drafts for trade payments.
- Fees may apply when issuing commercial drafts, offsetting some of the benefits associated with delaying cash expenditure. Fee structures depend on each bank’s policy:
- From a bank’s perspective, issuing a Bank Acceptance Draft issuance is similar to providing short-term financing. Banks generally will charge interest on the issuance amount. In many cases, the interest rate for issuance of a Bank Acceptance Draft is lower than that of a short-term bank loan with the same tenor.
- If the company is required to provide a cash deposit as collateral in order to secure a Bank Acceptance Draft, some banks may allow the use of depository products that enjoy a higher interest rate than a regular bank deposit, partially offsetting the associated issuance fee and the opportunity cost of funds for the cash deposit. Risks Associated with Accepting Commercial Drafts
- Counterparty Risk. The draft is issued by commercial entity/bank that cannot support the actual payment at the due date.
- Fraud Risk. Draft may be forged and therefore may not represent a valid payable draft. However, ECDS greatly reduced this risk. According to relevant regulations, any draft above 1 million renminbi must be issued through ECDS.
- Operational Risk. Management of paper-based drafts creates risk for companies as well as administrative costs. This risk can be managed through ECDS.
Options for Depositing Commercial Drafts
- Hold until maturity. In this case, there is no additional cost to the company, though counterparty risk remains. The company can’t access cash until the maturity date.
- Directly transfer to supplier that accepts drafts. Associated risks can be transferred to the next party, though there may be a payable and receivable amount mismatch based on the company’s accounts payable and the draft amount. Supplier may choose not to accept these draft transfers.
- Discount at a bank. There is no recourse for discounting except in the case of a forged draft fraud, or court order. Some companies adopt a policy to discount all commercial drafts when received. However, discounting can be costly, and banks may not be willing to provide the service. Factors that may influence the discount rate include: market rate environment, the discounting bank’s lending quota (including the quota for Bank Acceptance Draft discounting), the discounting bank’s credit policy; rating, and pricing of the issuing bank of the draft; the amount of liquidity in the banking system, amount of the draft, etc.
Best Practices for Receiving Commercial Drafts
- Maintain a clear policy on how to manage commercial drafts at the company level.
- Accept only electronic drafts if possible.
- Consider accepting only drafts issued by larger, reputable banks for the following reasons:
- Counterparty risk mitigation. A risk exists that the bank is unable to make the payment on the due date. This is especially true of lesser-known banks.
- Easier draft transfer. If transferring the draft to another trading partner(s) such as a supplier, the supplier may evaluate whether or not to accept it based on the counterparty risk, and may be more willing to accept drafts from a reputable bank.
- Easier draft discounting and potentially better rate. The discounting bank may provide a better rate for drafts issued by more reputable banks.
- For high-value transactions, instead of accepting one draft with a high amount that would be difficult to transfer, consider requesting the payor to provide multiple Bank Acceptance Drafts in smaller amounts so that the drafts can be more easily transferred if needed.
- Note that this depends on whether the payor is willing to do so and and whether the payor’s bank would permit this arrangement.
- If the payor/payor’s bank is not able to split the high-value draft transaction, some banks will split the high-value Bank Acceptance Drafts into several drafts in small amounts for the payee. This is also subject to the bank’s policy.
- Limit/avoid receiving Commercial Acceptance Drafts if possible.
- If it’s necessary to receive a Commercial Acceptance Draft from companies or a Bank Acceptance Draft from finance companies as payment, conduct due diligence on these companies’ ability to pay and determine internal exposure limit/threshold for these drafts.