Bankers' acceptance

A banker's 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. A banker's acceptance is also a money market instrument – a short-term discount instrument that usually arises in the course of international trade.

A banker's 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. [ Bodie, Zvi. "Investments", page 28, 6th Canadian Edition. Canada: McGraw-Hill Ryerson, 2008]

Bankers' acceptances are considered very safe assets, as they allow traders to substitute the banks' credit standing for their own. They are used widely in international 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. Bankers' acceptances trade at a spread over T-bills. The rates at which they trade are called bankers' acceptance 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.

Acceptances arise most often in connection with international trade. For example, 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.

Bankers' Acceptances are typically sold in multiples of US $100,000 (Veale 2001, p. 126). BA's smaller than this amount as referred to as odd-lots.

History

Bankers' acceptances date back to the 12th century when they emerged as one of the early forms of the instruments 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 was formed in 1913, one of its purposes was to promote a domestic bankers' acceptance market to rival London's in order to boost U.S. trade and enhance the competitive position of U.S. 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 banker's 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.

Comparison with other drafts

A draft can require immediate payment by the second party to the third upon presentation of the draft. This is called a sight draft. Cheques 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 a draft is called a time draft. It is said to mature on the payment date. In this example, the importer is both the drawer and the drawee. In a case 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 an 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 banker's acceptance.

Notes

References

*wikicite|id=idVeale2001|reference=Veale, Stuart R. (2001). "Stocks, Bonds, Options, Futures", New York Institute Of Finance.
*wikicite|id=idVeale2001|reference=Bodie, Zvi. "Investments", 6th Canadian Edition. Canada: McGraw-Hill Ryerson, 2008. ISBN-13: 978-0-07-096545-4 ISBN-10: 0-07-096545-5