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Securing the Transaction: The Advantages of Using Online Escrow Services versus Letters of Credit in International Trade


April 24, 2012

Overview

The old adage goes that “no matter how much things change, they seem to stay the same.” Perhaps nowhere is this more evident than in the area of international trade, where cross-border transactions still flow largely at the speed of paper. Buyers and sellers, whether they are separated by only a few miles and a national boundary line or they are divided by thousands of miles of ocean, still rely on a complex system of financing - and paperwork. Financing for transactions is still dependent on the facilitating role played by large commercial banks, which are involved in the vast majority of international trade transactions.

So, in the Age of the Internet, one must ask a simple question - Why? Today, on a smaller scale, international transactions are successfully carried-out tens of thousands of times a day by individuals and companies alike. Whether it is for purchases made on eBay or various other websites or transactions made by businesses and even governments, settlements are made securely via credit cards, online payment systems (such as PayPal), and wired transactions. However, when it comes to buying and selling materials, goods, and products abroad, companies seeking to expand their sales horizons and engage in international trade have to deal with a workable, yet cumbersome and costly system. It is an international trade system that provides settlement security, but at a relatively high intensity - in terms of price, paperwork, and time.

This article explores the alternative - namely online escrow services. It looks at how such services work versus the traditional, letter of credit-based payment/settlement system. Further, the article goes on to discuss the implications of the development and growth of using escrow services for international trade and development.

The Comparison: Letters of Credit vs. Online Escrow Services

In order to illustrate the difference between the traditional payment/settlement process for international trade versus online escrow services, let’s take a step-by-step look at how take a typical international transaction works today using a letter of credit.

  1. The agreement - A seller and a buyer reach agreement on a specific transaction. They agree to a contractual agreement which will specify - among other items - the quantity and type of good(s) to be purchased, the purchase price, and the date/place for delivery of the item(s).
  2. Buyer initiates letter of credit - To begin the actual purchase transaction, the buyer works with a commercial bank to have a letter of credit issued. This letter of credit - with the seller named as beneficiary - must be fully funded by the buyer before issuance. These funds can come from one of two sources – either a deposit made by the buyer or a debit from the buyer’s existing account balance with the issuing bank (if sufficient funds are available in the account). The issuing bank also commonly required Insurance to be taken-out to ensure the transaction against a variety of risks (such as damage, delays, insolvency, etc.). For these services, the issuing bank levies a fee on the buyer. Such fees typically range from 1 to 10% of the total value for the transaction. This fee varies both on the specific underwriting characteristics for the transaction and the relationship of the issuing bank to the buyer.
  3. The transmittal of the letter of credit - The buyer’s bank issues the letter of credit and it is sent to the seller (see Figure 1).
  4. The receipt of the letter of credit - The seller receives the letter of credit. The company then presents the letter of credit to its commercial bank. With the guarantee from the issuing bank, the seller then has - in effect - a line of credit that it can potentially draw upon for its operations available at its bank and final payment will be made once the delivery conditions of the contract are satisfied (See Figure 2).
  5. The shipment is made - With the letter of credit in its possession, the seller then provides the consignment of goods to the shipping company (regardless of the nature of transport - water, trucking, rail, air) (See Figure 3).
  6. The bill of lading is issued - In exchange for the consignment, the seller receives a bill of lading. This document serves a number of purposes, as it is, in effect - a document of title, and a receipt for the goods. It also is a contractual obligation - a contract of carriage - that the shipping firm will deliver the consigned goods to a specific destination on or before a specific date.
  7. The receipt of goods - After the shipment is made, the buyer actually takes ownership of the goods and confirms that the seller’s consignment to them meets the specifications in the contract (quantity, quality and condition, etc.) (See Figure 4).
  8. Payment is made - Once all necessary steps are completed and it is assured that the consignment meets the terms of the contract, the seller can claim final payment from its bank from the funds that were previously deposited.


Sound complicated? It is. Sound paper intensive (even with email and edocs today)? It certainly is. Sound costly? It is, as there are many man hours, legal fees, and courier costs involved. And depending on the size and scope of the transaction - and the countries where the buyer and seller reside, the parties may choose to - or be required to - bring-in neutral, third-party banks to act as either (or both) clearing entities and/or guarantors for the letter of credit. All this to process payments - yes, that’s the way roughly 90% of international trading volume works. And for small businesses - and even large ones - in both developed and developing nations, this cumbersome and costly process can work to limit - or completely inhibit - their ability (or want) to expand internationally. Such limits can be seen as inhibiting not just the growth of particular companies and even regions (and their economic development and ability to create jobs through the proven multiplier effects of international trade), but global growth in the aggregate.

Figure 1


Source: Wikipedia (http://en.wikipedia.org/wiki/File:Letter_of_credit_1.png)


Figure 2


Source: Wikipedia (http://en.wikipedia.org/wiki/File:Letter_of_credit_3.png)


Figure 3


Source: Wikipedia (http://en.wikipedia.org/wiki/File:Letter_of_credit_2.png)


Figure 4


Source: Wikipedia (http://en.wikipedia.org/wiki/File:Letter_of_credit_4.png)


The Escrow Solution

So is there a better way? Is there a payments solution that can meet the demands of a growing global economy and protect all actors in cross-border transactions? Fortunately today, the answer is yes - and it comes in the form of independent, third-party escrow services. This analyst sees rapid scaling in the growth and use of such escrow services - which have been utilized for over a decade in smaller-scale commercial transactions - due to the advantages they hold over the institutionalized letter of credit-based payments/settlement system that is predominant today.

How do escrow services work in international trading transactions? As an illustration, let’s take a look at how the leading firm in the escrow marketplace - Rancho Santa Margarita, California-based Escrow.com - handles such transactions. Andee Hill, Director of Business Development for Escrow.com states, “We have processed over a billion dollars through the Escrow.com system serving customers in over 100 countries during our decade-plus of experience.”

Escrow.com uses a five-step transaction process, as illustrated below:

  • Step 1 - The Contract is Established
  • Step 2 - The Buyer Makes Payment
  • Step 3 - The Shipment is Made
  • Step 4 - The Shipment is Accepted
  • Step 5 - The Seller is Paid and the Transaction is Complete

This process works to protect the buyer and the seller - all at far less cost than the traditional, letter of credit-based process for importing and exporting. In fact, for transactions greater than $25,000, the escrow fee is less than 1% (.89%) of the transaction - payable by the buyer or seller - or split between the parties, depending on the contract terms. However, since it is an international transaction, there may still be additional charges if funds are wired to/from the escrow provider and if a guarantor bank is needed. This will depend on the countries involved. Also, all funds paid to and paid from Escrow.com are delivered in U.S. dollars at present. Thus, there could be conversion charges and some currency risk (due to the time lags involved between the initial deposit of the payment by the buyer till the time the funds are dispersed to the seller and the fluctuation in exchange rates between the currencies involved vis-a-vis the U.S. dollar - although this could work to the actual benefit of the seller if a gain occurs). All in all however, because the Escrow.com process is available to anyone with an Internet connection and access to banking services - and not necessarily the larger commercial banks that have formerly dominated international trade services - those engaging in importing or exporting can conduct their international operations in a far faster, far less-costly and equally or more secure manner than ever before.

Here’s a final cautionary note on online escrow services. According to the Internet Crime Complaint Center (IC3), escrow services fraud is one of the most prevalent areas of online fraud and crime going on today (see Sidebar: The Internet Crime Complaint Center {IC3} on Escrow Fraud). So, it is vitally important to choose your escrow service provider carefully in all situations. However, when dealing with international trading - especially considering the cross-border nature and size of the transactions involved - going with an established player in the field is crucial today.


Sidebar: The Internet Crime Complaint Center (IC3) on Escrow Fraud

The Internet Crime Complaint Center (IC3) characterizes escrow fraud in the following manner:
In an effort to persuade a wary Internet auction participant, the perpetrator will propose the use of a third-party escrow service to facilitate the exchange of money and merchandise. The victim is unaware the perpetrator has actually compromised a true escrow site and, in actuality, created one that closely resembles a legitimate escrow service. The victim sends payment to the phony escrow and receives nothing in return. Or, the victim sends merchandise to the subject and waits for his/her payment through the escrow site which is never received because it is not a legitimate service.

It is worth mentioning that on the IC3’s website, which is supported by the U.S. government and the FBI (Federal Bureau of Investigation), the online crime-fighting organization directs its audience to go to Escrow.com’s site for alerts on escrow fraud and tips on how not to become a victim of it in any online transaction.
Source: Internet Crime Complaint Center (IC3) (http://www.ic3.gov/crimeschemes.aspx#item-8)


Analysis

From this analyst’s perspective, the use of escrow services presents a “win-win” for all involved in international trade - with the exception of the facilitation entities (commercial banking, shipping companies, expediting firms, etc.) that have benefitted from the established way things have been done. The author can predict that with the upsurge in the use of such services - by both small and large firms alike - we will see a growth in importing and exporting activities around the globe as international transactions between firms are made far easier than ever before, while retaining the assurance protections necessary for global commerce to work. In echoing this sentiment, Brandon Abbey, Escrow.com’s President and Managing Director, commented that: “The global economy is here and it desperately needs solutions that can accelerate commerce. We provide a payment solution that is expedient and secure providing our customers a huge competitive advantage.”

About the Author

David C. Wyld (dwyld@selu.edu) is the Robert Maurin Professor of Management at Southeastern Louisiana University in Hammond, Louisiana. He is a management consultant, researcher/writer, and executive educator. He also serves as the Director of the Reverse Auction Research Center (http://reverseauctionresearch.com), a hub of research and news in the expanding world of competitive bidding. His blog, Wyld About Business, can be viewed at http://wyld-business.blogspot.com.


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