A Primer on Bills of Exchange
What are Bills of Exchange ?
A bill of exchange is a promissory note that is usually issued by the buyer to the seller of goods in return for the goods. The seller would like to sell their goods for cash. However, in certain cases, the buyer may not have cash immediately at the moment. However, they may be confident in their ability to generate cash in the future. The seller may also believe the buyers claims and may be interested in selling the goods to them as long as they promise to pay in the future.
In such a situation, bills of exchange become the preferred financial instruments. This is because a bill of exchange is a legal promise made by the buyer to the seller. There is usually no collateral backing this promise. However, it is not merely a verbal promise. It is a contract which is enforceable in the court of law. In essence, a bill of exchange is a promissory note and the buyer is expected to make good on their word.
The bill of exchange creates value out of nothing. A piece of paper becomes a promissory note when the buyer signs it. Such a note can then be traded in the market as a security. In this article, we will look at the concept of bills of exchange in more detail.
The Lifecycle of a Bill of Exchange
In order to better understand bills of exchange, we must first understand how they arise in the ordinary course of business. This can be best explained by studying the lifecycle of a bill of exchange.
- Drawing of the Bill: The first step is when the buyer makes a verbal promise to the seller to pay a certain amount of money at a future date. The seller is then required to draw up a bill of exchange writing down the agreement that has been agreed upon by the buyer and the seller. This act of formally writing down the written agreement in a format that is required by law is called drawing of a bill. It is important to note that the seller and not the buyer is required to draw the bill of exchange.
- Acceptance of the Bill: In the next stage, the seller presents the formal bill of exchange to the buyer for their consideration. By this stage, the seller has already drawn the bill of exchange and hence they can be referred to as the drawer while the buyer can be referred to as the drawee. The drawee is expected to carefully inspect the bill of exchange to verify that it explicitly mentions the agreement. If the drawee finds the bill to be accurate, he signs it. This act of signing the bill of exchange is called the acceptance of the bill. This is the moment when a verbal promise has become a security that can be traded in the market.
- 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 and collect the proceeds. 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. This is done by the drawer by signing at the back of the bill and relinquishing their claim in the favor of another party. This bill can be further endorsed innumerable times as long as buyers have faith that the bill will be paid when due.
- Discounting of The Bill: When a bill is endorsed, the drawers receivables are set off against the drawers payables. However, on some occasions, drawers may want to convert the bill of exchange into cash that they can hold. In such scenarios discounting of bills of exchange is used. A bill of exchange can be sold to the bank. The bank will deduct a certain amount of interest. This is called the discount amount and the post-discount amount is then paid to the drawer. The bank will then have ownership of the bill and has the right to collect dues from the drawee. The discounting of bills may be with or without recourse. Therefore, depending on the terms, the bank may or may not be able to hold the drawer liable if the drawee does not pay up.
Also, since the bill of exchange is a marketable security, in case the bank does not want to hold the bill, it can simply rediscount it with another bank and move out of the transaction.
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. They are as follows:
- Short Term: Financing bills of exchange is an extremely short term loan. Therefore the amount of time for which the banks money is at risk is very short. Also, the bank can earn more by way of processing fee each time a bill is originated.
- Self-Liquidating: Bills of exchange are self-liquidating loans. The drawer does not have to pay it back. When the bill is due, most probably the drawee pays his/her dues, and the accounts of all the parties are settled.
- Less Risky: Since bills of exchange arise pretty late in cash to cash conversion cycle, they are subject to lesser risks as compared to the working capital loans that are given out by banks. The low risk and high returns make bills of exchange a preferred investment for banks.
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