Month: December 2021

A merchant bank is a company that deals mostly in international finance, business loans for companies and underwriting. These banks are experts in international trade, which makes them specialists in dealing with multinational corporations. A merchant bank may perform some of the same services as an investment bank, but it does not provide regular banking services to the general public. One role of a merchant bank is to provide financing to large corporations that do business overseas. Assume, for example, that ABC Company is based in the United States and decides to purchase a supplier that is based in Germany. Merchant banker is any person who is engaged in the business of issue management either by making arrangements regarding selling, buying or subscribing to securities as manager -consultant, advisor or rendering corporate advisory services in relation to such issue management in merchant banking.

Issue management refers to managing issues of corporate securities like equity shares, preference shares and debentures or bonds. It involves marketing of capital issues, of existing companies including rights issues and dilution of shares by letter of offer. Management of issue also involves other issues. The decisions concerning size and timing of the public issue in the light of the market conditions are advised by the merchant bankers. In addition to these, the merchant bankers also assist the corporate units on the designing of a sound capital structure acceptable to the financial institutions and determining the quantum and terms of the public issues of different forms of securities. Further, they also advise the issuing company whether to go for a fresh issue, additional issue, bonus issue, right issue or combination of these. In brief, managing public issue is a complicated and technical job. It involves various strategic decisions and coordination of various agencies.

The public issues are managed by the involvement of various agencies i.e., under writers, brokers, bankers, advertising agencies, printers, auditors, legal advisers, registrar to the issue and merchant bankers providing specialized services to make the issue a success. However, merchant bank is the agency at the apex level, who plans, coordinates and controls the entire issue activity and directs different agencies to contribute to the successful marketing of securities.

Issue Managers are required to be registered with SEBI to carry on their Issue Management activities, since setting up of SEBI. SEBI has formulated Rules and

Regulations for merchant bankers which bring out the requirements for Registration of issue managers apart from prescribing the conduct rules for them. In terms of these regulations, issue managers are required to mainly comply with the following requirements for registration:

• Issue manager should be a corporate body, not being a Non Banking Financial Company (as per RBI).
• He should have necessary infrastructure like adequate office space, equipment’s and manpower to effectively discharge his activities.
• He should have minimum two persons who have the experience to conduct the business of Merchant Banking.
• He should fulfil capital adequacy requirements i.e. should have a minimum net worth of Rs.5 crores.
• He should have professional qualification from an institute recognized by government in Law, Finance or Business Management.

Issue managers play vital role in fund raising through public issue of securities. Whether through book building (discussed later) or otherwise, their role is catalytic for the making of the issue a success. They are involved from cradle to grave in the issue. Hence companies coming with new issue of capital decide about Issue managers after due diligence and carefully analysing the competence and capabilities of the merchant banker to handle the issue. They provide valuable service in preparation and drafting the prospectus, pricing the issue, marketing and underwriting the issue, coordinating the activities or different agencies/institutions involved in this context to carry out legalities involved in the process, deciding the basis of allotment, making the allotment, despatch of share certificates/refund orders as the case may be, and finally, in listing of shares on stock exchanges and sometimes as market maker as well. SEBI has issued compendium of circulars to merchant bankers from time to time and broadly has divided these activities into two groups i.e., Pre-issue activities and Post-issue activities.

Pre activities:

1) Issue of shares

2) Marketing, Coordination and underwriting of the issue.

3) Pricing of issues

Post activities:

1) Collection of application forms and amount received

2) Scrutinising application

3) Deciding allotment procedure

4) Mailing of share certificates/refund or allotment orders.

Securitization is a carefully structured process by which a pool of loans and other receivables are packaged and sold in the form of asset-backed securities to the investors to raise the required funds from them. Through this process relatively illiquid assets are converted into securities. Securitization falls under the broad category termed as structured finance transactions.

Structured finance refers to securities where the promise to repay the investors is backed by the value of the underlying financial asset or the credit support of a third party to the transaction or some combination of the two. Thus, securitization is nothing but liquefying assets comprising loans and receivables of an institution through systematic issuance of financial instruments.

Structured financing instruments are derivatives of traditionally secured debt instruments where the credit standing of the instrument is supported by a lien on specific assets or by some other form of credit enhancement such as a guarantee. With a conventional secured bond, the primary source of repayment of the bond is still the earning power and cash flow of the issuer.

In a securitized transaction, the burden of repayment on the bond shifts away from the issuer to a pool of assets or to a third party. The cash flows from the pools of assets which have been securitized provide the funds for repayment to the bond.

Securitized transaction is termed as structured transaction because through specific choices relating to the type and amount of assets in the pool and particular features of the transaction, these securities may be structured to achieve a desired level of risk and a desired level of rating.

Securitization is said to have taken place when a company’s assets are removed in one way or the other form from its balance sheet and are funded instead by investors. The investors receive tradable financial instruments evidencing the investment without recourse to lending institution. The entire transaction, from the accounting point of view, is carried out on the asset side of the balance sheet, that is, one asset gets converted into another.

Mechanism of Securitization:

(i) The process of securitization starts with identification by the company (the originator) the loans or bills receivable in its portfolio, to prepare a basket or pool of assets to be securitized. The package usually forms an optimum mix so as to ensure fair marketability of the instrument to be issued.

Further, the maturities are also so chosen that the package represents one homogeneous lot. The pool of receivables is backed by the underlying securities held by the originator (in the form of mortgage, pledge, charge, etc.).

(ii) The pool of assets so identified is then sold to a specific purpose vehicle (SPV) or trust. Usually an investment banker performs the task of an SPV, which is also called an issuer, as it ultimately issues the securities to investors.

(iii) Once the assets are acquired by SPV, the same are split into individual shares/securities which are reimbursed by selling them to investors. These securities are called ‘Pay or Pass Through Certificates’ (PTC) which are so structured as to synchronize for redemption with the maturity of the securitized loans or bills.

A PTC thus represents a sale of an undivided interest to the extent of the face value of the PTC in the aggregate pool of assets acquired by the SPV from the originator.

(iv) Repayments under the securitized loans or bills keep on being received by the originator and passed on to the SPV. To this end, the contractual relationship between the originator an d the borrowers/obligates is allowed to subsist in terms of the pass through transaction; alternatively a separate agency arrangement is made between the SPV (Principal) and the originator (agent).

(v) Although a PTC could be with recourse to its originator, the usual practice has been to make it without recourse. Accordingly, a PTC holder takes recourse to the SPV and not the originator for payment to the principal and interest on the PTCs held by him. However, a part of the credit risk, as perceived (and not interest risk), can be absorbed by the originator, by transferring the assets at a discount, enabling the SPV to issue the PTCs at a discount to face value.

(vi) The debt to be securitized and the PTC issues are got rated by rating agencies on the eve of the securitization. The issues by the SPV could also be guaranteed by external guarantor-institutions to enhance creditability of the issues. The PTCs, before maturity, are tradable in a secondary market to ensure liquidity for the investors.

From the above, it is evident that the primary participants involved in the issuance of securitization transaction are the originator, obligors, the SPV, the servicer and the credit enhancer. The originator has the assets which are sold or used as collateral for the assets backed securities. Originators are generally manufacturing companies, financial institutions, banks and non-banking finance companies.

The term obligors’ refers to borrowers who have taken loans from the originators resulting in the creation of the underlying asset. The SPV or trust raises funds to buy assets from the originator by selling securities to investors. It uses the cash flow generated by the financial assets in the pool to pay interest and principal to investors and covers its own costs. The servicer/receiving and paying agent is responsible for collecting principal and interest payments on assets when due and for pursuing the collection from delinquent accounts.

The service is usually the originator or an associate of the originator. The credit enhancer provides the required amount of credit support to reduce the overall credit risk of a security issue. Credit enhancement is provided by the originator in the form of senior- subordinate structure over collaterisation or through a cash collateral. Third party credit enhancement generally takes the form of a letter of credit or a surety bond.

Utility of Securitization:

Securitization as a financial instrument is becoming extremely popular the world over with more and more issuers resorting to raising funds through this route. This is for this fact that it confers lot of benefits on the parties to the process.

Securitization serves as handmade to organization in raising additional funds to finance their growth programme. Companies with poor credit standing and therefore finding it difficult to procure resources from the market can obtain funds by issuing asset back securities at lower interest cost due to higher credit rating on such securities. Even if the issuer is not an AAA rated company, it can issue an AAA rated securitized asset.

This can be done by carefully selecting the portfolio on the basis of criteria stipulated by the rating agency. What is more useful is that relatively illiquid assets are converted into marketable securities providing liquidity and alternate funding sources. Another advantage to the company is economy in the use of funds and greater recycling of resources leads to higher business turnover and profitability.

Further, cost of raising funds by way of securitization is cheaper than that involved in funding by way of conventional fund-raising instruments like shares, bonds, debentures, and commercial papers. Through its novel mechanism of diversifying the risk factors, enhancing the credit and removing uncertainties for investors, structured securitization facilitates the originator to access the securities market at debt ratings higher than its overall corporate rating. As a result, the company can secure funds at lower cost.

The cost of raising funds against securitized assets depends essentially on quality of assets to be securitized and image of the issuer in the minds of investors. Obviously, the price at which an asset-based securities is sold or the discount which the buyer gets differs from deal to deal. Further, bargaining powers of the negotiations bear upon the cost of acquiring funds through securitization.

Securitization also facilitates strengthening of capital adequacy of the originating company by isolating the loan-assets from the originator’s balance sheet and by removing or replacing them. Securitization is equally useful to investors. It offers multiple new investment instruments for mutual funds, insurance companies, pension funds and general investors to cater to their needs and preferences. Besides widening the choice and availability, it also provides for higher return and liquidity for the instrument.

The unique benefit which investors derive from securitization is that they can look past the issuing entity to the collateral pool that the issue represents. This transparency reduces uncertainly for the investor as to the risk element. Being a structured asset backed security, the instrument provides higher protection against rating down-grades of the originator, as compared to traditional debt securities.

It also provides opportunity for matching cash flows and managing ALM since securitized instrument carries regular monthly cash flows and has varying maturities. The prevalence of secondary markets would offer liquidity.

As a product of raising funds against receivables, securitization is far superior to bills discounting or factoring. Bill discounting has emerged as a working capital product employed to raise funds out of short-term trade receivables. In contrast, securitization is a medium to long-term source.

Even in a mature bill market, the sheer quantum of paper work in raising money against bills of long maturities would be a deterrent. Although factoring appears to be similar to securitization as the factor buys the receivables of a company at a discount, there has traditionally been no intention to rate the portfolio or create a secondary market for the receivables.

Further, factoring has emerged as a trade financing tool rather than for medium or long-term financing. However, the securitization process, if not carried out prudentially, can leave risks with the originating bank without allocating capital to back them. While all banking activity entails operational and legal risks, these may be greater under more complex activity.

It is felt that the main risk a bank may face in a securitization scheme arises if a true sale has not been achieved and the selling institution is forced to recognize some or all of the losses if the assets subsequently cease to perform. Also, funding risks and constraints on liquidity may arise if assets designed to be securitized have been originated, but because of disturbances in the market, the securities cannot be placed.

Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations (or other non-debt assets which generate receivables) and selling their related cash flows to third party investors as securities, which may be described as bonds, pass-through securities, or collateralized debt obligations (CDOs). Investors are repaid from the principal and interest cash flows collected from the underlying debt and redistributed through the capital structure of the new financing. Securities backed by mortgage receivables are called mortgage-backed securities (MBS), while those backed by other types of receivables are asset-backed securities (ABS).

The granularity of pools of securitized assets can mitigate the credit risk of individual borrowers. Unlike general corporate debt, the credit quality of securitized debt is non-stationary due to changes in volatility that are time- and structure-dependent. If the transaction is properly structured and the pool performs as expected, the credit risk of all tranches of structured debt improves; if improperly structured, the affected tranches may experience dramatic credit deterioration and loss.

The originator initially owns the assets engaged in the deal. This is typically a company looking to either raise capital, restructure debt or otherwise adjust its finances (but also includes businesses established specifically to generate marketable debt (consumer or otherwise) for the purpose of subsequent securitization). Under traditional corporate finance concepts, such a company would have three options to raise new capital: a loan, bond issue, or issuance of stock. However, stock offerings dilute the ownership and control of the company, while loan or bond financing is often prohibitively expensive due to the credit rating of the company and the associated rise in interest rates.

Purpose of Securitisation

Normally, a lender (financier) finances loans to borrowers and gets repayment with interest over a period. The lender would collect the periodic instalments and use them to finance new loans. This limits his capacity to give fresh loans, as he has to wait till, he recovers the instalments along with interest. Instead of waiting for a long time, he can pool the loans together and sell his right to receive future payments from the borrowers of these loans.

This is termed as securitisation of loans. The original lender will receive consideration for the same upfront, i.e. immediately, by securitising his loan portfolio. Of course, he will get the amount at a discounted value. He can then use the proceeds to further develop his business, which is of giving loans.

Securitisation is a form of financing involving pooling of financial assets and the issuance of securities that are repaid from the cash flows generated by the assets. This is generally accomplished by actual sale of the assets to a bankruptcy remove vehicle, i.e. a special purpose vehicle (like Asset Reconstruction Company), which finances the purchase through issue of bonds.

These bonds are backed by future cash flow of the asset pool. The most common assets for securitisation are mortgages, credit cards, auto and consumer loans, student loans, corporate debt, export receivables, off shore remittances etc.

These ‘Securitised loans’ will be purchased by mutual funds, provident funds and insurance companies, which have funds but do not have mechanism to assess, grant and recover loans. Thus, corporate bodies like finance companies having expertise in assessing, granting and recovering loans get the funds from corporate bodies like mutual funds, provident funds, insurance companies etc. which have funds but do not have expertise in loan assessment and disbursal, through process of securitisation. Thus, securitisation helps both.

Securitisation is done through Special Purpose Vehicles (SPVs). These are termed as Asset Reconstruction Companies in the present SARFAESI Act.

Thus, securitisation is a process through which illiquid assets are transferred into a more liquid form of assets and distributed to a broad range of investors through capital markets. The lending institution’s assets are removed from its balance sheet and are instead funded by investors through a negotiable financial instrument. The security is backed by the expected cash flows from the assets.

Securitisation is a process under which a pool of individual homogeneous loans is packaged and distributed to various investors having liquid funds in the form of coupons/pass through or pay through certificates; through SPVs (Special Purpose Vehicles), with the provision that the inflow of cash in the shape of recoveries will be distributed pro-rata to coupon holders.

In securitisation, the lending institution’s assets are removed from balance sheet of that lending institution and are instead, funded by investors. These investors purchase a negotiable financial instrument evidencing this indebtedness.

Basically, all assets which generate cash flow can be securitised e.g. mortgage loans, housing loans, automobile loans, credit card receivables, trade receivables, consumer loans, lease finance etc. A perfectly healthy and normal financial asset is normally securitised. It is not necessary that it should be non-performing asset.

Securitisation and factoring – distinction– Difference between factoring and securitisation is that in case of factoring, the assets are debts which have crystallized but are not due.

Securitization v/s Factoring

• Under factoring there are two parties that is the bank and the company while under securitization there are many investors involved who invest in the securitized asset.
• While factoring is arrangement between the banks and a company in which financial institution purchases the book debts of a company and pays the money to the company against receivables whereas Securitization is the process of converting illiquid assets into liquid assets by converting longer duration cash flows into shorter duration cash flows.
• While factoring is done for short term account receivables ranging from 1 month to 6 months whereas securitization is done for long term receivables of the company.
• Since factoring involves only bank and the company there is no need for any credit rating while securitization involves many investors and therefore it is necessary to take credit rating before going for securitization of receivables.
• While factoring is of many types and can be with or without recourse while securitization is done without recourse.

Securitization

• It is something with loans.
• It is related with loans.
• Medium or long term.
• Agencies will look after collections.
• Originator will take portion of credit risk.

Factoring

• It is something with bills receivables.
• Short term.
• It is related with book debts.
• Factor will look after collections.
• Factor will take 100% credit risk.

Features of Securitization

Commoditization:

Securitization is the process of commoditization, where the basic idea is to take the outcome of this process into the capital market. Thus, the result of every securitization process, whatever might be the area to which it is applied, is to create certain instruments which can be placed in the market.

Merchantable Quality:

To be market acceptable a securitized product should be of saleable quality. This concept, in case of physical goods, is something which is acceptable to merchants in normal trade. When applied to financial products, it would mean that the financial commitments embodied in the instruments are secured to the investors’ satisfaction. To the investors satisfaction is a relative term and therefore, the originator of the securitized instrument secures the instrument based on the needs of the investors.

For widely distributed securitized instruments, evaluation of the quality, and its certification by an independent expert, viz., rating is common. The rating is for the benefit of the lay investor, who otherwise not expected to be in a position to appraise the degree of risk involved.

In case of securitization of receivables, the concept of quality undergoes a drastic change, making rating a universal requirement for securitization. As already discussed, securitization is a case where a claim on the debtors of the originator is being bought by the investors. Hence, the quality of the debtors’ claim assumes significance, which at times enables investors to reply purely on the credit rating of debtors (or a portfolio of debtors) and so, make the instrument totally independent of the originators’ own rating.

Marketability:

The very purpose of securitization is to ensure marketability to financial claims. Hence, the instrument is structured in such a way as to be marketable. This is one of the most important features of a securitized instrument, and the others that follow are mostly imported only to ensure this feature. Marketability involves two concepts:

(1) The legal and systematic possibility of marketing the instrument.

(2) The existence of a market for the instrument.

As far as the legal possibility of marketing the instrument is concerned, traditional mercantile law took a contemporaneous view of marketable documents. In most jurisdictions in the world, laws dealing with marketable instruments (also referred to as negotiable instruments) were mostly limited in relation to what was then in circulation.

The very purpose of securitization will be defeated if the instrument is loaded on to a few professional investors without any possibility of having a liquid market. Liquidity is afforded to a securitized instruments either by introducing it in to an organized market (such as securities exchanges) or by one or more agencies acting as, market makers i.e. agreeing to buy and sell the instrument at either pre-determined or market-determined prices.

Wide Distribution:

The basic purpose of securitization is to distribute the product. The extent of distribution which the originator would like to achieve is based on a comparative analysis of the costs and the benefits that can be achieved Wider distribution leads to a cost benefit, in that the issuer is able to market the product with lower return, and hence, lower financial cost to him. But a wide investor base involves the high cost of distribution and servicing.

Pass Through Certificates

A pass-through certificates is an instrument that evidences the ownership of two or more equipment trust certificates. In other words, equipment trust certificates may be bundled into a pass-through structure as a means of diversifying the asset pool and/or increasing the size of the offering. The principal and interest payments on the equipment trust certificates are “passed through” to certificate holders. A pass-through certificate is an instrument which signifies transfer of interest in receivables in favour of the holder of the Pass-Through Certificate. The investor in a pass-through transaction acquire the receivables subject to all their fluctuation, prepayments etc. the material risks and rewards in the asset portfolio, such as the risk of interest rate variations, risk of prepayment etc., transferred to the investor.

Investors who purchase a pass-through certificate may think that this investment is more secure or less risky than others. The problem is that mortgages in the securitized instrument may not actually be entirely risk free, however. For example, when a mortgage goes into default, the holder of the securitized instrument loses money. This can result in the holder such as a major government-sponsored entity not being able to cover its payments or costs associated with business. This creates a downward cycle of money in the process of buying and selling a pass-through certificate.

Special Purpose Vehicle

A special purpose vehicle, also called a special purpose entity (SPE), is a subsidiary created by a parent company to isolate financial risk. Its legal status as a separate company makes its obligations secure even if the parent company goes bankrupt. For this reason, a special purpose vehicle is sometimes called a bankruptcy-remote entity.

Uses of Special Purpose Vehicles

1. Securitization

Securitization of loans is a common reason to create an SPV. For example, when issuing mortgage-backed securities from a pool of mortgages, a bank can separate the loans from its other obligations by creating an SPV. The SPV allows investors in the mortgage-backed securities to receive payments for these loans before other creditors of the bank.

2. Risk sharing

A corporation’s project may entail significant risks. Creating an SPV enables the corporation to legally isolate the risks of the project and then share this risk with other investors.

3. Asset transfer

Certain types of assets can be hard to transfer. Thus, a company may create an SPV to own these assets. When they want to transfer the assets, they can simply sell the SPV as part of a merger and acquisition (M&A) process.

4. Property sale

If the taxes on property sales are higher than the capital gain realized from the sale, a company may create an SPV that will own the properties for sale. It can then sell the SPV instead of the properties and pay tax on the capital gain from the sale instead of having to pay the property sales tax.

Benefits:

• Isolated financial risk
• Direct ownership of a specific asset
• Tax savings, if the vehicle is created in a tax haven such as the Cayman Islands
• Easy to create and set up the vehicle

Risks:

• Lower access to capital at the vehicle level (since it doesn’t have the same credit as the sponsor)
• Mark to Market accounting rules could be triggered if an asset is sold, significantly impacting the sponsor’s balance sheet
• Regulatory changes could cause serious problems for companies using these vehicles
• The optics surrounding SPVs are sometimes negative

Securitisable Assets

Debt

The advantage of a securitization transaction is that it enables the holder of the underlying debt to refinance that debt. Therefore, securitization involves assets that are typically illiquid (such as household debt), which are impossible to sell directly, since each individual debt is unique and requires separate administrative processing. Securitization also involves debts of smaller amounts, such as consumer debt, which, individually, generate relatively little income (in comparison to the amount of income typically generated by institutional investors) but which can be grouped together to make up a more valuable pool. Therefore, one of the main purposes of securitization is to create a marketable asset by combining several assets that, individually, are not as readily bought or sold, or in other words, to make a market for such assets.

Few examples of assets that can be securitized:

• Residential mortgage loans; this category includesthe infamous “subprime mortgages,” which are home loans issued to individualswith a low credit rating
• Commercial mortgage loans
• Bank loans to businesses
• Commercial debt
• Student loans (mainly in the US)
• Credit-card debt: in this case, the maturity of the security issued will typically be longer than that of the underlying debt; the assets portfolio will have to be “topped up” several times in order to ensure the promised cash flows. Therefore, some of the securitized debt does not exist yet at the time when the security is created. This is referred to as “securitization of future cash flows.”
• Automobile loans

Benefits of Securitization

Securitization, also known as asset-backed securitization or structured financing, has been defined as a financing instrument whereby a company transfers rights in current or future receivables or other financial assets to an entity that serves as a “special purpose vehicle” (SPV), which in turn issues securities to capital market investors and uses the proceeds from the issue to pay for the financial assets. The source of the receivables could be any right of payment or asset that generates an income with a stable cash flow. The existing or future receivables could be the income generated, among others things by residential or commercial loans, credit card receivables, automobile loans, student loans, royalties on intellectual property, tax receivables or any other income source that is regular and predictable.

Balance Sheet Benefits

Securitization accelerates cash receipts from the receivables while removing the accounts receivables from the originator’s balance sheet. This reduces the originator’s debt/equity ratio so that it is better able to:

(i) Comply with financial covenants in respect of its on-balance sheet borrowing;

(ii) Borrow more.

(iii) Improve the return on capital

The International Financial Reporting Standards (IFRS) (which replaced the International Accounting Standards (IAS)) have made securitization structures that allow an originator to remove receivables from its balance sheet harder to achieve. Whether or not these are applied, and the effect of other accountancy practices affecting off-balance sheet treatment, depends on the jurisdiction. However, balance sheet considerations continue to be an element of financial structuring.

Cheaper Financing

By using securitization techniques to separate a pool of underlying receivables, the originator may be able to generate a lower cost of financing than it can through various forms of borrowing. This is because receivables are often a better credit quality than the originator itself. Without securitization, the originator would finance itself through borrowing based on its own creditworthiness, therefore incurring additional debt. This “swapping” of one credit for another is known as credit arbitrage.

Capital Adequacy

In most jurisdictions, financial institutions must hold a minimum capital requirement (essentially equity, reserves and various forms of subordinated debt) against “risk-weighted” assets (that is, the value of assets taking into account a risk weighting which is based on the likelihood of the asset value being realized). The requirement is expressed as a ratio that is set by the relevant regulatory authority in a specific jurisdiction. The sale of receivables for cash effectively removes risk weighted assets from the regulated institution’s balance sheet and reports additional cash instead. This balance sheet “exchange” of receivables for cash improves regulated institution’s capital structure and reduces regulatory cost.

Alternative Source of Funding

Asset securitization provides the originator with additional source of funding or liquidity because this financing technique basically converts an illiquid asset (e.g. receivable deriving from a consumer loan which itself cannot be sold) into:

(i) Cash for the originator.

(ii) A security with greater marketability for investors.

Further, the ability to sell these securities worldwide diversifies the institution’s funding base, which reduces the institution’s dependence on local economies.

New Guidelines on Securitization

The RBI has also provided certain relaxations in relation to residential mortgage backed securities (RMBS) basis the recommendations of the Committee on Development of Housing Finance Securitisation Market in India. RMBS is defined as ‘securities issued by the special purpose entity against underlying exposures that are all residential mortgages’.

Under the Draft Securitisation Framework, the minimum holding period for RMBS will be six months or six instalments, whichever is later. The MRR for RMBS has been limited to 5% of the book value of the loans being securitised. If the value of the exposures underlying an RMBS is INR 500 crore or above, it is proposed that the securities issued must be mandatorily listed.

The revisions suggested, if given effect to, will enable HFCs and NBFCs with exposure to RMBS to package such portfolios and issue securities of different credit tranches and list them. Senior tranches can be issued to investors who are risk averse, while junior tranches can be issued to institutions who subscribe to such instruments. This will certainly provide the much-needed liquidity to HFCs and over time deepen the RMBS market and ensure that these products are available to a wider spectrum of investors.

Exemptions and Prohibitions

While the Draft Securitisation Framework now permits assets purchased from other entities to be securitised, resecuritisation exposures, synthetic securitisation and securitisation with revolving credit facilities as underlying continue to be prohibited. Pooling of purchased loans along with existing portfolios will increase the rating of certain kinds of pools.

Transactions involving revolving credit facilities, loans with bullet repayments of both principal and interest and securitisation exposures continue to be exempt from the applicability of the Draft Securitisation Framework.

Capital Requirement for securitisation exposures

The Draft Securitisation Framework provides for conditions required to be met by lenders for maintenance of capital. Such conditions will come into immediate effect and will apply to existing securitisation exposures as well. Conditions required to be met for de-recognition of the transferred asset by the originator include:

• Significant credit risk associated with the underlying exposures of the securities issued by the special purpose entity (SPE) being transferred to third parties. Significant credit risk will be treated as transferred if:

(i) There are at least three tranches, risk weighted exposure amounts of the mezzanine securitisation positions held by the originator do not exceed 50% of the risk weighted exposure amounts of all mezzanine securitisation positions existing in this securitisation.

(ii) In cases where there are no mezzanine securitisation positions, the originator does not hold more than 20% of the exposure values of securitisation positions that are first loss positions.

• The transferred exposures are legally isolated from the originator and are put beyond the reach of the originator or its creditors;
• The securities issued by the SPE are not obligations of the originator;
• Securitisation does not contain clauses that require the originator to replenish or replace the underlying exposures to improve the credit quality of the pool, in the event of deterioration in the underlying credit quality.

Capital Measurement Approaches

In line with the Basel III guidelines, two capital measurement approaches have been proposed: Securitisation External Ratings Based Approach (SEC-ERBA) and Securitisation Standardised Approach (SEC-SA).

The Draft Securitisation Framework further provides that banks can adopt either of the two approaches. NBFCs (including housing finance companies) shall only apply the Securitisation External Ratings Based approach for calculation of risk weighted assets.

Stockbroking is a service which gives retail and institutional investors the opportunity to buy and sell equities.

Stockbrokers will trade shares both on exchange and over-the-counter, dependent on where they can find the best price and liquidity. Stock exchanges place strict regulations on who can trade shares directly on their books, which is why most individual investors hoping to trade shares will do so via a stockbroker.

Stock Brokers

A stockbroker is a regulated broker, broker-dealer, or registered investment adviser (in the United States) who may provide financial advisory and investment management services and execute transactions such as the purchase or sale of stocks and other investments to financial market participants in return for a commission, markup, or fee, which could be based on a flat rate, percentage of assets, or hourly rate. The term also refers to financial companies, offering such services.

Share brokers in India are governed by the Securities and Exchange Board of India Act, 1992 and brokers must register with the Securities and Exchange Board of India. The National Stock Exchange of India and the Bombay Stock Exchange via brokers, provide an ecosystem to investors to trade in capital markets through various channels- broker offices, investment advisor or screen-based electronic trading system. An individual employed by an investment firm must complete the National Institute of Securities Markets (NISM) exam and apply to SEBI for registration as an Investment Advisor.

Stock market advisory and research services are highly regulated in India. Only SEBI registered stock advisory and investment research analysts are allowed to do so. The complete details of these authorized persons are available on website of SEBI for protection of investors.

There are several different services a stockbroker can provide:

• Advisory stockbrokers will offer advice on where to trade, but only trade on orders submitted by you.
• Execution-only stockbrokers will complete orders on your behalf, but do not offer any advice.
• Discretionary stockbrokers will trade on your behalf, executing trades without your input.

Stock SubBrokers

An Authorized Person (formerly known as a Sub Broker) is a person who is registered with SEBI as such and is affiliated to a member of a recognised stock exchange.

A Stock Market Sub broker or Stock broker partner is a Franchisee company who takes stock broking franchise from the franchiser. Some of the major Stock Broking Franchiser is Angel Broking, Sharekhan, Nirmal Bang & others.

The Sub broker or partner provides stock tips or stock recommendations to its clients based on his assessment of the industry. Some Franchiser provides stock recommendations to their sub brokers but most of them don’t.

Sub Brokers or partners keeps track of their clients & it is their headache to get the trading done from their clients so that they can earn high brokerage.

Benefits of becoming a Sub Broker:

Low Investment Business

A Stock Broking Franchise business can be started with minimum Rs.10,000 investment amount, only a security deposit is paid to the franchiser rest all expenses in incurred by the franchiser. In some cases the franchiser doesn’t even ask for a minimum deposit.

High Revenue Share

The Sub Broker or Partner keeps high percentage of the brokerage generated by the clients; the franchiser gets low brokerage percentage.

Advisory Support

Some Franchiser also provides Advisory, stock tips & recommendations to their sub brokers to help support their client & increase revenue.

Product, Service & Offers

Any new product, services & offers launched by the franchiser can also be availed by the sub broker. This helps the sub broker to keep engaging their client with new things.

Marketing & Training Support

The franchiser being a large organization also help the sub broker with all sorts of marketing support like providing banners, leaflets, hoardings for their branches. They also organize seminars for their broking partners to train them on various aspect of the business.

Foreign Stock Brokers

Stocks of company belonging to a geographical boundary are generally known of, to all the residents of the particular country. The Foreign Stocks however, are the securities of companies located outside one particular nature.

Giant companies which not based out from India are a profitable investment option, just like the blue-chip companies of India are considered to be.

Choose a broker based in India, but have links with foreign brokers. Among all the reputed and high class performing Indian Stock Brokers have direct links and tie with respective foreign brokers. An overseas trading account of such domain can be opened and operated easily, thereby having the means to invest in foreign stocks.

There is also a list of foreign brokers, who let Indian Traders invest in their stock markets. An account can be directly opened by them, making it easy to undertake direct investments in foreign exchanges. Some of the highly active brokers, also have their offices in parts of India, making it easy for the investors to visit them, seeking out for clarification of their query.

Some Indian Mutual funds and ETFs are as well-structured to invest in the foreign markets. So, investors can invest in such funds, where their investment goes directly to the foreign equities.

Investing Options:

• Investment across different nations is possible through international funds.
• Regional investment is as well facilitated through the Regional Funds, through which one can invest in regions like Europe, Asia, Middle East, etc.
• Sector investment is as well facilitated, where one can invest in sectors like gold, energy etc throughout a vast number of countries.
• Country wise investment is facilitated through country funds.
• ADRs and GDRs

Five important entities in the trading system

• Trading Members: are members of Stock Exchanges (SEBI registered) who are authorized to trade either on behalf of their clients or on their own account (proprietary trades). As per SEBI regulations, every trading member has a unique TM-ID.
• Trading cum Clearing Members (TCM): is a Clearing Member (CM) who is also a Trading Member (TM) of the exchange. Most large brokers are TCMs. Such TCMs can clear and settle their own proprietary trades, their client trades as well as trades of other TMs and even Custodial Participants.
• Professional Clearing Member (PCM): Professional clearing member clears the trades of associate Trading Member and institutional clients. PCM is not a Trading Member of the exchange and hence is not authorized to execute trades; they can only clear. Typically banks or FPI custodians become PCM to clear their client trades
• Self-Clearing Member (SCM): A Self Clearing Member is also a Trading Member on the exchange. Such SCMs can clear and settle their own proprietary trades and their client trades but cannot clear and settle trades of other TMs (unlike TCMs)
• Participants: Participant is a client of a trading member. Clients may trade through various trading members but settle through a single clearing member. Interoperability allows seamless transfer of margins and positions across clearing members.

Clearing Members

Broadly speaking there are three types of clearing members

• Self-clearing member: They clear and settle trades executed by them only, either on their own account or on account of their.
• Trading member–cum–clearing member: They clear and settle their own trades as well as trades of other trading.
• Professional clearing member: They clear and settle trades executed by trading members.

Clearing Banks

Funds settlement takes place through clearing banks. For the purpose of settlement all clearing members are required to open a separate bank account with Clearing Corporation designated clearing bank for F&O segment.

Clearing Member Eligibility Norms

Net worth of at least Rs.300 lakhs. The net worth requirement for a Clearing Member who clears and settles only deals executed by him is Rs. 100 lakhs. Deposit of Rs. 50 lakhs to clearing corporation which forms part of the security deposit of the Clearing Member. Additional incremental deposits of Rs.10 lakhs to clearing corporation for each additional TM, in case the Clearing Member undertakes to clear and settle deals for other TMs.

Depository

While traditionally shares were held in a physical certificate format, today it is mandatory to hold them in the electronic or dematerialized form. Hence, a Demat account is mandatory for share transactions. SEBI has created a structure to ensure optimum performance and maximum control over Demat accounts by creating Depositories entities that hold your Demat accounts.

All participants including investors, brokers, and clearing members need to have a Demat account to trade in the stock exchange.

Clearing Corporation

This is an entity associated with a stock exchange that handles the confirmation, settlement, and delivery of shares. It acts as a buyer for the seller and a seller for the buyer. In simpler terms, it facilitates purchase on one end of the transaction and sale on the other. It ensures that the settlement cycles are short and consistent while keeping the transaction risks in check and providing a counter-party risk guarantee.

Order types, order conditions and order matching rules

There are different types of orders that any client can place on the F&O trading system. Broadly, orders can be classified into two condition-based order sets viz. Orders based on Time condition and Orders based on Price condition.

Clearing and Settlement Process When You Sell a Share

Using the example cited above, sale of shares process is as follows:

• You sell shares Day 01 or T Day. The shares are blocked in your Demat account immediately. Hence, you cannot sell the same shares on the same day.
• On Day 02 (T+1 Day), the broker gives the shares to the exchange.
• On Day 03 (T+2 Day), you receive funds in your banking account post deduction of all charges.

Orders based on Time condition

• Day order: is an order which is valid for a single day i.e. the day on which it is entered. Day orders not executed during the day are automatically cancelled by the system at the end of the day.
• Immediate or cancel (IOC) order: has to be executed as soon as the order is released into the trading system. Any unmatched order will be immediately cancelled. At times part of the order is matched and the unmatched portion of the order is cancelled.

Orders based on Price condition

• Limit order: Is an order to buy or sell a contract at a specified price. The user specifies the limit price while placing the order and the system executes the order at or at better price than the limit price (lower for buy order and higher for sell order). Limit order is a good option when executing orders in a volatile market.
• Market order: Is an order to buy or sell at the best available price in the market. Unlike the limit order, the market order gets executed at the best possible in the market subject to availability of volumes. Markets orders work well in trending markets.
• Stop-loss order: Is an order to buy (or sell) a security once the price of the security moves above (or drops below) a trigger price. The stop-loss order gets activated only when the trigger price is reached / crossed. Stop loss orders are an important means of risk management for short-term traders.

Dissatisfied with the old bill market scheme, in February 1970, the Reserve Bank of India constituted a Study Group under the chairmanship of Sh Narasimhan to go into the question of enlarging the use of bills of exchange as an instrument of credit and the creation of genuine bill market in India.

On the recommendations of the report of the study group, the Reserve Bank introduced the New Bill Market Scheme in November 1970 under Section 17 (2) of the Reserve Bank of India Act.

The main features of the New Bill Market Scheme are:

(i) All licensed scheduled commercial banks including the public sector banks will be eligible to offer bills of exchange to the Reserve Bank for rediscounting.

(ii) The bills covered under the scheme must be genuine trade bills relating to the sale or dispatch of goods.

(iii) The Reserve Bank rediscounts these bills. That is why the scheme is also called ‘Bills Rediscounting Scheme’. The rediscounting facility should be available at the Reserve Bank’s offices at Bombay, Calcutta, Madras and New Delhi. To avoid rediscounting of large number of small bills, such bills should be given in bunches.

(iv) The bill should be drawn on and accepted by the purchaser’s bank. If the purchaser’s bank is not a licensed scheduled bank, the bill should in addition bear the signatures of a licensed scheduled bank.

(v) The bills should have maximum of 90 days.

(vi) The bills should bear at least two good signatures.

(vii) The scheme does not cover the bills of exchange relating to the sale of goods to the government departments and quasi-government bodies as well as to statutory corporations to the sale of such commodities which are indicated by the Reserve Bank from time to time.

(viii) According to the modification of the scheme in 1971, the bills of exchange relating to the sale of goods to government departments and quasi government bodies as well as to statutory corporations have also been covered by the scheme.

(ix) With effect from April 1972, the bills of exchange drawn and accepted by the Industrial Credit and Investment Corporation of India (ICICI) were also made eligible for discount under the scheme.

New Bill Market Scheme:

Dissatisfied with the old bill market scheme, in February 1970, the Reserve Bank of India constituted a Study Group under the chairmanship of Sh Narasimhan to go into the question of enlarging the use of bills of exchange as an instrument of credit and the creation of genuine bill market in India.

On the recommendations of the report of the study group, the Reserve Bank introduced the New Bill Market Scheme in November 1970 under Section 17 (2) of the Reserve Bank of India Act.

The main features of the New Bill Market Scheme are:

(i) All licensed scheduled commercial banks including the public sector banks will be eligible to offer bills of exchange to the Reserve Bank for rediscounting.

(ii) The bills covered under the scheme must be genuine trade bills relating to the sale or dispatch of goods.

(iii) The Reserve Bank rediscounts these bills. That is why the scheme is also called ‘Bills Rediscounting Scheme’. The rediscounting facility should be available at the Reserve Bank’s offices at Bombay, Calcutta, Madras and New Delhi. To avoid rediscounting of large number of small bills, such bills should be given in bunches.

(iv) The bill should be drawn on and accepted by the purchaser’s bank. If the purchaser’s bank is not a licensed scheduled bank, the bill should in addition bear the signatures of a licensed scheduled bank.

(v) The bills should have maximum usance of 90 days.

(vi) The bills should bear at least two good signatures.

(vii) The scheme does not cover the bills of exchange relating to the sale of goods to the government departments and quasi-government bodies as well as to statutory corporations to the sale of such commodities which are indicated by the Reserve Bank from time to time.

(viii) According to the modification of the scheme in 1971, the bills of exchange relating to the sale of goods to government departments and quasi government bodies as well as to statutory corporations have also been covered by the scheme.

(ix) With effect from April 1972, the bills of exchange drawn and accepted by the Industrial Credit and Investment Corporation of India (ICICI) were also made eligible for discount under the scheme.

Advantages of Developed Bill Market:

A developed bill market is useful to the borrowers, creditors and to financial and monetary system as a whole. The bill market scheme will go a long way to develop the bill market in the country.

(i) Bill finance is better than cash credit. Bills are self-liquidating and the date of repayment of a bank’s loans through discounting or rediscounting is certain.

(ii) Bills provide greater liquidity to their holders because they can be shifted to others in the market in case of need for cash.

(iii) A developed bill market is also useful to the banks is case of emergency. In the absence of such a market, the banks in need of cash have to depend either on call money market or on the Reserve Bank’s loan window.

(iv) The commercial bill rate is much higher than the treasury bill rate. Thus, the commercial banks and other financial institutions with short-term surplus funds find in bills an attractive source of both liquidity as well as profit.

(v) A development bill market is also useful for the borrowers. The bills are time-bound, can be sold in the market and carry the additional security in the form of acceptor’s signature. Therefore, for the borrowers, the cost of bill finance is lower than that of cash credit.

(vi) A developed bill market makes the monetary system of the country more elastic. Whenever the economy requires more cash, the banks can get the bills rediscounted from the Reserve Bank and thus can increase the money supply.

(vii) Development of the bill market will also make the monetary control measures, as adopted by the Reserve Bank, more effective. As pointed out by the Narasimhan Study Group, “the evolution of the bill market will also make the Bank Rate variation by the Reserve Bank a more effective weapon of monetary control as the impact of any such changes could be transmitted through this sensitive market to the rest of the banking system.”

Defects of Bill Market Scheme:

The bill market scheme is a right step in the right direction. Over the years, the functioning of the scheme has been quite encouraging. The outstanding level of bills rediscounted under the scheme increased considerably from Rs. 10 crore at the end of June 1971 to Rs. 110 crore at the end of March 1980.

But, the scheme has been subjected to criticism due to its various defects:

(i) The scheme has been generally used by the banks and their borrowers to offset the credit control measures of the Reserve bank. Whenever the Reserve Bank tried to control the bank credit without restricting the bill rediscounting facility, the banks increasingly utilised this facility. This made the Reserve Bank’s tight money policy ineffective. As a result, the Reserve Bank was forced first to put restrictions on the bill rediscounting facility, and then to allow the facility wholly on its discretion.

(ii) The bill market scheme has not been successful in developing a genuine bill market. The main reason is that the borrowers as well as the banks still have preference for cash credit and dislike for bill finance.

(iii) The scheme is restricted to banks and some selected financial institutions. It has not been able to cover the indigenous bankers and other constituents of unorganised sector of the Indian money market.

(iv) The scheme has remained mainly concentrated in the fields of industry, trade and commerce. It has not been extended to agricultural sector.

In India, Factoring is subject to the Factoring Regulation Act, 2011 and the RBI Non-Banking Financial Company Factors (Reserve Bank) Directions, 2012. As per the extant laws only certain NBFCs (with atleast 50% of the assets and income representing assets and income from factoring business) or Banks and Gov. bodies can act as factors this resulted in a limited volume of factoring in India, and thus the insignificant global presence. As such the Factoring Regulation (Amendment) Bill, 2020 proposes to widen the scope to all NBFCs along with other proposals to increase factoring volumes in India.

For the Seller

• Reduces the risk of a Working Capital Deficit.
• Positive impact on the balance sheet providing more liquidity and solvency to the company.
• Protects from risk of bad-debt (except in ‘Recourse Factoring’
• Better Administration: The amount of time taken to monitor credit, manage collection and evaluate buyer’s credit worthiness gets saved.

Factoring in India is the selling or discounting of invoices (receivables) by a seller of goods and services, usually micro, small and medium enterprises (MSMEs) to a factoring company or bank. Ideally it should lead to an improvement in collection management, whereby the MSME derives the advantage of realising the receivables quickly against the standard waiting period, which is the usance period of the bill. Large corporates (the buyers) would pay these sellers well after the due dates as per their payment cycle.

These MSMEs play a vital role for the growth of Indian economy, contributing 45 per cent of the industrial output, 40 per cent of exports, 42 million in employment, creating one million jobs every year and producing more than 8000 products for the Indian and international markets. As a result, MSMEs are today exposed to greater opportunities for expansion and diversification across the sectors. The Indian market is growing rapidly and industry is making remarkable progress in various sectors, such as: manufacturing; precision engineering; food processing; pharmaceuticals; textile & garments; retail; IT; agriculture; and service sectors. MSMEs are finding increasing opportunities to enhance their business activities in these core sectors.

One of the key constraints impacting the MSMEs is inadequate finance, particularly working capital. In the case of MSMEs, the need for quick conversion of trade receivables an important component of current assets of their business entities into cash, assumes great importance, since the lack of opportunities affects their liquidity, and thereby their business, quite significantly. It has, however, been observed that, at present, not many avenues exist for these enterprises to convert their receivables before maturity except through availing of a bill finance facility from a bank. One of the principal instruments of working capital is trade finance, including bill discounting and factoring. It is estimated that only 10 per cent of the total receivables market is presently covered under the formal bill discounting mechanism in the financial system, while the rest is covered under conventional cash credit/overdraft arrangements with banks. The MSMEs’ smaller balance sheets and asset quality act as constraint in their ability to avail of banking limits.

Other issues affecting the market environment include weak credit infrastructure and late payment by large buyers. Factoring companies and banks face difficulties in procuring credit information of the buyers, and have to rely largely on self-assessment of these buyers where possible. Late payment has always been an impediment to supplier growth. Most MSMEs can hardly withstand the burden of late payments but still these firms usually extend credit beyond the agreed tenor to accommodate delayed payment, else they can end up losing the buyer’s business. Most of the major corporates, including large public sector enterprises, follow a monthly payment cycle irrespective of the invoice due date. The business orientation of large industries often affects the MSMEs directly, in turn hampering the recycling of funds and business operation of MSME units.

Market Performance and Supply

Letter of credit market share as a trade financing tool is less than 10 per cent of the total country exports, leaving a huge opportunity for open account trade finance. In India, factoring is still to pick up pace, even though it has been around for more than two decades. As per Factors Chain International statistics, 2014 factoring volumes in India stand at around only $5.2 billion, of which $4.2 billion is domestic trade.

Factoring companies in India do offer various types of services depending upon client needs, including recourse and non-recourse factoring, domestic and international factoring, and disclosed and undisclosed factoring. Most deals done in India are with recourse to the corporate, since the factoring company and bank are not able to cover the credit risk on the buyer. This is mainly because credit insurance is not allowed, as per regulations in India, for the purpose of factoring. Thus, there is a need to build a suitable institutional infrastructure which will not only enable an efficient and cost effective factoring and reverse factoring process to be put in place, but also ensure sufficient liquidity is created for all stakeholders through an active secondary market for the same.

In order to address this issue, the Reserve Bank of India (RBI) published a concept paper on ‘Micro, Small & Medium Enterprises (MSME) Factoring-Trade Receivables Exchange’ in 2014. It involved the setting up of an institutional mechanism for financing trade receivable known as a ‘Trade Receivables Discounting System’ (TReDS). The transactions processed under TReDS will be non-recourse to the sellers. TReDS will provide the platform to bring sellers, buyers, and financiers together for facilitating uploading, accepting, discounting, trading, and settlement of MSME invoices. Initially TReDS would facilitate the discounting of these factoring units by the financiers resulting in flow of funds to the MSMEs with final payment of the factoring bill being made by the corporate buyer to the financier on due date. Later on, TReDS would enable further discounting /re-discounting of the discounted factoring units by the financiers, thus resulting in assignment in favour of other financiers. The RBI is expected to release further information on the functioning of the exchange once the TReDS exchange operator is identified.

It is felt by many that things can be done to improve the market opinion and share of factoring in the country, such as: creation of greater awareness, especially among MSMEs, on the benefits of both domestic and export factoring; addressing the liquidity constraints facing factors; factors and regulators simplifying products and transactions; a review of why factoring companies are not allowed to avail of credit insurance; clarification on whether the exemption granted in the Factoring Regulation Act, 2011 overrides existing state stamp laws on assignment; and standardising seller balance sheet treatment with regard to non-recourse factoring.

Future Trends

There have been various measures undertaken recently in trying to address the challenges faced by the factoring industry, and increase the scope for factoring across the country. The Enactment of the Factoring Regulation Act, 2011, was done with the aim of regulating assignment of receivables in favour of factors, and delineating the rights and obligations of parties to assignment of receivables. Broad features of the act include: assignment of debts under factoring being exempted from stamp duty; assignment of debts being provided with legal recognition; and notice of assignment being made mandatory.

In addition to the launch of TReDS, the RBI has introduced factors as a new category of non-banking financial company (NBFC). It has also simplified the eligibility criteria with regard to principal business the NBFC Factor needs to ensure that financial assets in the factoring business constitute at least 50 per cent of its total assets, and that its income derived from factoring business is not less than 50 per cent of its gross income, as against 75 per cent previously. RBI rulings mean factors can now also access credit information from credit bureaus.

In order to facilitate factoring transactions for MSMEs, the government has approved establishment of a Credit Guarantee Fund For Factoring (CGFF), set at  Rs. 500 crores. The credit guarantee for factoring has the advantage of motivating the factors to increase their lending to MSMEs against factored debts by partially sharing their risk, and leading to an increase in actual availability of credit to MSMEs.

Benefit for Corporates

Optimize the working capital by maintaining or extending days payable

If the buyer has a payment term of 30 days with a Micro Small or Medium Enterprise (MSME) then, a buyer can enable early payment to its supplier on TReDS by Factoring or Reverse factoring of invoice. The supplier gets the payment before the due date and the buyer further extends its days payable as per its agreement with the bank. This helps the corporates optimize their working capital availability and regularize their cash flow.

Alternate and efficient funding method for making vendor payments.

Through TReDS, the buyer enables early payment to the supplier without taking any borrowing limits on his books. Here the buyer only needs to confirm the trade transaction uploaded by the vendor on the portal while the vendor gets funding from the financial institution. The transaction is that of a purchase and sale of receivables between the financial institution and the vendor.

Bring down the cost of goods and services purchased

Cost is one of the major components in procuring goods and services from a vendor. Since a corporate helps its suppliers get payment against their invoices before the due date and regularize their cash flows through xchange, the buyer gets the power to negotiate better terms with the supplier while enjoying a more stable supplier base by facilitating their access to competitive financing.

Lower vendor administration costs

This entire transformation cuts processing costs, eliminate discrepancies and optimize the cash flow for smooth operations for large corporates.

Factoring is a financial technique where a specialized firm (factor) purchases from the clients accounts receivables that result from the sales of goods or services to customers. In this way, the customer of the client firm becomes the debtor of the factor and has to fulfil its obligations towards the factor directly.

In a factoring arrangement, there are three parties directly involved namely; the one who sells the invoice (client), the debtor (customer of the seller), and the factor (financial organization).

• Seller of the product or service provider who originates the invoice is called Client and generally is a business firm.
• Debtors or customers of the client are the recipient of the invoice for the goods or services rendered. They promise to pay the balance within the agreed payment terms. They owe the money for the value of goods and services bought from the seller.
• Assignee (the factoring company) or factor is the service provider who purchases the invoice and gives advance payment to business firm.

Factor is thus an intermediary between the seller and buyer. Mechanics of Factoring shown in figure is explained below:

Steps in Factoring Service

• Firstly, the customer places an order with the Client
• Client sends goods and invoice to customer
• Client assigns invoice to factor
• Factor make pre-payment up to 80 % to client
• Factor send statement to customer
• Customer make payment to factor
• Factor makes balance 20% on realisation to client.

Cost:

Flat Rates vs. Variable Fees

Factoring companies typically calculate rates using a variable fee structure. With variable fees, they discount a small percentage (1 to 3 percent) of the invoice for as long as the invoice goes unpaid. So, the longer your customer takes to pay, the more you’ll pay in fees. A factoring company may charge 2% for the first 30 days and 0.5% for every 10 days that the invoice remains unpaid. Fees are often referred to as invoice discounting rates.

Some factoring companies offer a flat fee structure where a one-time fee is charged up front. With a flat fee structure, the fee remains the same no matter how long the invoice remains open. This type of rate structure is common in the trucking industry. Depending on your industry, one or both of these options may be available and can help you control your costs.

Invoice factoring fees also depend on whether you choose a recourse or non-recourse factoring program. Non-recourse factoring poses more risk to the factoring company, so the costs are slightly higher.

Advance Rates

When your company factors invoices, you’ll typically receive a large percentage of the invoice up front and the remainder is held in a reserve until your customers pay the invoice.

Factoring advance rates vary by industry. Industries that are riskier and harder to fund such as medical and construction can expect advance rates between 60% and 80%. Advances for general businesses and staffing companies can be anywhere from 80% to over 90%. Those in the transportation industry typically see the highest advance rates, ranging from 92% to 97%.

We recommend getting quotes from multiple factoring companies to get a good feel of what you should expect to pay for factoring services and to get the lowest invoice factoring fees for your business.

Factoring cost vs. Factoring rate

Businesses that are in the process of choosing a factoring company often focus their negotiation efforts on getting the best the rate. Although a competitive rate is important, it is only one component of your factoring cost.

A better alternative is to focus negotiations on the “Total cost per dollar” of the proposal. This approach helps ensure you pay the lowest amount for each financed dollar. To calculate the total cost per dollar, you need two figures. You need the rate and the factoring advance.

In most cases, you get the best deal by negotiating the lowest possible rate at the highest possible advance. This assumes you are looking for the highest possible advance, which is the case for most business owners. Otherwise, adapt your strategy accordingly.

Factoring is defined as a method of managing book debt, in which a business receives advances against the accounts receivables, from a bank or financial institution (called as a factor). There are three parties to factoring i.e. debtor (the buyer of goods), the client (seller of goods) and the factor (financier). Factoring can be recourse or non-recourse, disclosed or undisclosed.

Forfaiting is a mechanism, in which an exporter surrenders his rights to receive payment against the goods delivered or services rendered to the importer, in exchange for the instant cash payment from a forfaiter. In this way, an exporter can easily turn a credit sale into cash sale, without recourse to him or his forfaiter.

Factoring and Forfaiting:

• Factoring provides only 80% of the invoice. But 100% finance is provided in forfaiting.
• Factoring is both domestic and foreign trade finance. Whereas forfaiting is only financing of foreign trade.
• In factoring, invoice is purchased belonging to the client. Whereas the export bill is purchased in forfaiting.
• Factoring may have recourse to seller in case of default by buyer. But there is no recourse to exporter in forfaiting.
• There is no letter of credit involved in factoring. But there is letter of credit involved in forfaiting.
• Factoring does not provide scope for discounting in the market as only 80% is financed. But forfaiting provides scope for discounting the bill in the market due to 100% finance.
• Factoring may be financing a series of sales involving bulk trading. Only a single shipment is financed under forfaiting.