Bankers' acceptance

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A bankers' acceptance starts as an order to a bank by a bank's customer to pay a sum of money at a future date, typically within six months. At this stage, it is like a postdated check. When the bank endorses the order for payment as "accepted", it assumes responsibility for ultimate payment to the holder of the acceptance. At this point, the acceptance may be traded in secondary markets much like any other claim on the bank.

Bankers' acceptances are considered very safe assets, as they allow traders to substitute the bank's credit standing for their own. They are used widely in foreign trade where the creditworthiness of one trader is unknown to the trading partner. Acceptances sell at a discount from face value of the payment order, just as US Treasury bills are issued and trade at a discount from par value.

A bankers acceptance, or BA, is a time draft drawn on and accepted by a bank. Before acceptance, the draft is not an obligation of the bank; it is merely an order by the drawer to the bank to pay a specified sum of money on a specified date to a named person or to the bearer of the draft. Upon acceptance, which occurs when an authorized bank accepts and signs it, the draft becomes a primary and unconditional liability of the bank. If the bank is well known and enjoys a good reputation, the accepted draft may be readily sold in an active market.

Acceptances arise most often in connection with international trade: U.S. imports and exports and trade between foreign countries. An American importer may request acceptance financing from its bank when, as is frequently the case in international trade, it does not have a close relationship with and cannot obtain financing from the exporter it is dealing with. Once the importer and bank have completed an acceptance agreement, in which the bank agrees to accept drafts for the importer and the importer agrees to repay any drafts the bank accepts, the importer draws a time draft on the bank. The bank accepts the draft and discounts it; that is, it gives the importer cash for the draft but gives it an amount less than the face value of the draft. The importer uses the proceeds to pay the exporter.

The bank may hold the acceptance in its portfolio or it may sell, or rediscount, it in the secondary market. In the former case, the bank is making a loan to the importer; in the latter case, it is in effect substituting its credit for that of the importer, enabling the importer to borrow in the money market. On or before the maturity date, the importer pays the bank the face value of the acceptance. If the bank rediscounted the acceptance in the market, the bank pays the holder of the acceptance the face value on the maturity date.

A bankers acceptance (BA) is a money market instrument—a short-term discount instrument that usually arises in the course of international trade. Before we explain BAs, let's introduce some more basic concepts

A draft is a legally binding order by one party (the drawer) to a second party (the drawee) to make payment to a third party (the payee). A simple example is a bank check—which is simply an order directing a bank to pay a third party. The three parties don't have to be distinct. For example, someone might write himself a check as a simple means of transferring funds from one bank account to another. In this case, the drawer and payee are the same person. When a draft guarantees payment for goods in international trade, it is called a bill of exchange.

A draft can require immediate payment by the second party to the third upon presentation of the draft. This is called a sight draft. Checks are sight drafts. In trade, drafts often are for deferred payment. An importer might write a draft promising payment to an exporter for delivery of goods with payment to occur 60 days after the goods are delivered. Such drafts are called time drafts. They are said to mature on the payment date. In this example, the importer is both the drawer and the drawee. In cases where the drawer and drawee of a time draft are distinct parties, the payee may submit the draft to the drawee for confirmation that the draft is a legitimate order and that the drawee will make payment on the specified date. Such confirmation is called acceptance—the drawee accepts the order to pay as legitimate. The drawee stamps ACCEPTED on the draft and is thereafter obligated to make the specified payment when it is due. If the drawee is a bank, the acceptance is called a bankers acceptance (BA).

A bankers acceptance is an obligation of the accepting bank. Depending on the bank's reputation, a payee may be able to sell the bankers acceptance—that is, sell the time draft accepted by the bank. It will sell for the discounted value of the future payment. In this manner, the bankers acceptance becomes a discount instrument traded in the money market. Paying discounted value for a time draft is called discounting the draft.

In international trade, bankers acceptances arise in various ways. Consider two examples:

An importer plans to purchase goods from an exporter. The exporter will not grant credit, so the importer turns to its bank. They execute an acceptance agreement, under which the bank will accept drafts from the importer. In this manner, the bank extends credit to the importer, who agrees to pay the bank the face value of all drafts prior to their maturity. The importer draws a time draft, listing itself as the payee. The bank accepts the draft and discounts it—paying the importer the discounted value of the draft. The importer uses the proceeds to pay the exporter. The bank can then hold the bankers acceptance in its own portfolio or it can sell it at discounted value in the money market.

In an alternative arrangement, the exporter may agree to accept a letter of credit from the importer's bank. This specifies that the bank will accept time drafts from the exporter if the exporter presents suitable documentation that the goods were delivered. Under this arrangement, the exporter is the drawer and payee of the draft. Typically, the bank will not work directly with the exporter but with the exporter's correspondent bank. The exporter may realize proceeds from the bankers acceptance in several ways. The bank may discount it for the exporter; the exporter may hold the acceptance to maturity; or it may sell the acceptance to another party.

Bankers acceptances date back to the 12th century when early forms of the instruments were used to finance trade. During the 18th and 19th centuries, there was an active market for sterling bankers acceptances in London. When the United States Federal Reserve (Fed) was formed in 1913, one of its purposes was to promote a domestic bankers acceptance market to rival London's. This would boost US trade and enhance the competitive position of US banks. National banks were authorized to accept time drafts, and the Fed was authorized to purchase certain eligible bankers acceptances. Rules for eligibility are complex. Generally, they require that a bankers acceptance finance a self-liquidating transaction with a maturity under six months. Today, the Fed no longer buys bankers acceptances. The practical significance of eligibility is that there are no reserve requirements if a bank sells an eligible acceptance. Banks sometimes create ineligible acceptances, but they incur reserve requirements if sold.

Bankers acceptances are quoted in discount form. Maturities are generally between one and six months, and they trade as bearer instruments. Their credit quality is excellent. Not only are they a primary obligation of the accepting bank, but they are usually also a contingent obligation of the drawer.

Bankers acceptances trade at a spread over T-bills. The rates at which they trade are called bankers acceptance rates (or BA rates). The Fed publishes BA rates in its weekly H.15 bulletin. Those rates are a standard index used as an underlier in various interest rate swaps and other derivatives.