Bills of exchange can be defined as a financial instrument that is short term and negotiable and consists of an order in writing. This written order is essentially used in international trade where one party is bound to pay a fixed amount of money (either on-demand or at a predetermined rate) to another party.
The different parts of the bills of exchange are:
The Seller of goods who writes the Bill of exchange. The instrument is addressed to the buyer.
The buyer must pay the Seller on demand (a sight draft) or at a fixed, determinable time in the future (also called time draft).
A specific sum of money that the buyer owes to the Seller.
Bills of exchange are also known as the draft. The term bill of exchange can also be applied to other instruments of foreign exchange. Some of those include traveller’s checks, express orders, cable and mail transfers, postal money orders and letters of credit.
History of Bills of Exchange
As per history, bills of exchange were a means of settling accounts in international trading. It was used as early as the 8th century by Arab merchants. By the 13th century, it had attained wide use in its present form amongst the Lombard in northern Italy.
Since the merchants or buyers had their assets dispersed in various banks in many trading cities, it was not possible to get immediate payment by the shipper or seller by a banker. The shipper would present a bill of exchange to the banker who would purchase it at a discounted price (since payment was due in the future). The buying merchant's account would be debited at the due date as per the date mentioned in the Bill of exchange. Bills could also be drawn on the banks directly. Once the Seller received his payment, the Bill of exchange continued to function as a credit instrument until it reached its maturity.
Essential Elements of Bills of Exchange
A bill of exchange introduction would require you to get familiarized with a few terms and also the elements of bills of exchange. Let us first learn some terms:
Drawer: This is the maker of the Bill of exchange.
Drawee: The person who has been directed to pay the sum of money mentioned in the Bill is referred to as the drawee.
Payee: The person who will be receiving the money is termed as the payee.
Holder: When the payee is in Bill's custody, he is referred to as the holder. The holder must provide the Bill to the drawee for the latter's acceptance.
Acceptor: When the drawee signs the Bill of exchange as a mark of his acceptance, then he becomes the acceptor of the Bill.
Drawee in Case of Need: At times, another person's name is mentioned in the Bill of exchange, who would accept the Bill in case the original drawee does not accept the Bill. This 3rd person is called drawee in case of need.
Endorser: If the bill holder endorses it to another person, then he will be called an endorser.
Endorsee: This is the person to whom the Bill of exchange has been endorsed.
With this knowledge, let us look at the essential elements of bills of exchange:
The Bill of exchange has to be in writing.
The Bill must be signed by the drawer.
The instrument needs to have an order to pay; the order should be:
All three entities payee, drawer and drawee must be definite individuals.
The amount of money due should be certain.
The payment must be made in the legal tender currency of that specific country.
The instrument must be properly stamped.
The money should be payable to a certain and definite person or as per his order.
The drawer and payee, in most cases, are the same person as the drawer usually draws the Bill in his or her favour.
The drawer and the drawee can not be the same person.
The process of how a bill of exchange flows between different parties is depicted in the flowchart below:
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Types of Bills of Exchange
There are mainly two types of bills of exchange:
Bills of Exchange Payable at Sight – They are payable on demand. When the Bill is given to the drawee, he or she must pay the amount.
Bills of Exchange after a Certain Period– This is also called term draft and becomes payable after a certain time period.
Bills of Exchange in India
The bills of exchange in India are governed by the Indian negotiable instruments act, 1881. It appears in Section 5 of negotiable instrument act. According to this, the order to pay is not “conditional” and the payable amount is “certain”. It also includes future interest and rate of exchange if there is a default in the payment.
The Reserve Bank of India and India’s Government are the only entities that can draw a bill payable on demand to the person who is the bearer of the Bill.
Importance of Bills of Exchange
The need and importance of bills of exchange are most evident when there is export involved. There are some risks related to exports of products which domestic businesses are not aware of. A bill of exchange can help in countering some of those risks related to the export of goods. Some of them are:
The constant fluctuations in the rate of exchange can adversely affect long term trading arrangements. In such a scenario, the fixed term of payment which is laid out in a bill of exchange can give assurance to the exporters of receiving a fixed price.
The exporter is also getting protection with a bill of exchange. The exporter can draw up a bill of exchange with their bank and submit it to the importer’s bank. This way, exporters gain an agreement in which they do not need to chase the importer for payment in the event the company fails to honour the agreement.
Some Examples of Bills of Exchange
Let us get some clarity on what exactly a bill of exchange looks like by considering a few examples.
“Please let the bearer have 100 pounds and oblige” – This is not a bill of exchange since it is a request, not an order.
“We hereby authorize you to make a payment on our account to the order of Mr.X, $200” – This is again not an order hence not a bill of exchange.