Insurance · 3 August 2017

What is a bill of exchange and why are they important?

A bill of exchange can be a crucial guarantee of payment

Continuing to help first-time exporters and importers get to grips with some commonly-used yet often misunderstood key terms, Business Advice asks what is a bill of exchange, and why can they be important for small business owners?

Before paper currency, bills of exchange were a lot more widely used than they are now.

In the past they were used frequently by individuals as orders to pay sums of money, but the advent of paper currency meant people had a more efficient way of swapping funds for everyday goods and services than a bill of exchange.

Today, bills of exchange are still used, but almost only in the context of trading between businesses, both locally and internationally. They are written orders of payment, binding one party to pay a fixed amount of money to another party.

What is a bill of exchange?

A bill of exchange is an unconditional order one party makes to its trading partner to get it to pay an agreed sum of money for goods and/or services it has received, on a predetermined date.

It is always written, does not bare any interest, and tends to take one of two forms: a bill of exchange that requires the recipient to pay their balance immediately is known as a “sight bill”, whereas one that requires payment on a fixed future date is called a “term bill”.

A traditional bill of exchange will contain a number of key details. Firstly, it will contain an unconditional order to pay a determined amount of money, and it will contain the name of the person, or company, who must pay that money.

Secondly, it will outline the place or jurisdiction where payment is to be made, and will include the name of the person or company to whom payment is to be made.

A bill of exchange will outline the date and place where the bill was issued, and finally, it will include the signature of the party who issues the bill.

The difference between bills of exchange, promissory notes and bank drafts

A bill of exchange is very similar to promissory notes and bank drafts, which are other forms of so-called “negotiable instruments”, and can similarly be drawn by banks or individuals, but there are some differences.

The key difference between a bill of exchange and a promissory note is that, unlike a promissory note, a bill of exchange is transferable, and can be used to order a third party – one that was not involved on the creation of the order in the first place – to pay. This aspect makes a bill of exchange particularly useful in international trade.

A promissory note cannot be transferred, and is between two parties – a payer and a payee. Although promissory notes can be issued by financial institutions, including banks, they are instruments that enable businesses to get financing from a source other than a bank, whether an individual or another company.

Just like a bill of exchange and a promissory note, a bank draft is also a negotiable instrument, with the key difference being that payment is guaranteed by the issuing bank. A bank draft therefore ensures a payee has a secure way to make payment.

Why is a bill of exchange important?

Exporting often involves a unique set of risks that may be unfamiliar to business owners who are used to trading domestically. Separate laws and customs between states, combined with longer and more complex transport routes and methods, can make exporting a lot more difficult than trading within a country.

A bill of exchange helps to counter some of the risks involved with exporting. Long-term trading arrangements between firms in different countries can be badly effected by exchange rate fluctuations, so the fixed payment terms laid out in a bill of exchange provides exporters with the assurance of a fixed price.

It also provides an exporter with protection. By drawing up a bill of exchange with their bank and submitting it to their importer’s bank, an exporter gains a contingent agreement that it will not have to chase its importer for payment if that company fails to honour the agreement and pay its bill.

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Fred Heritage was previously deputy editor at Business Advice. He has a BA in politics and international relations from the University of Kent and an MA in international conflict from Kings College London.

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