What is a Bill of Exchange?

A bill of exchange is a special kind of document. It is used to order someone to make a payment to another person at a later date.

The Drawer Writes the Bill

The person who writes the bill of exchange is called the drawer. They write the bill to tell another person, called the drawee, to pay money to a third person. This third person is called the beneficiary.

Due Date for Payment

When the drawer writes the bill, they say when the drawee must make the payment to the beneficiary. This is called the due date. The due date is always some time after the drawer writes the bill.

Drawee Must Accept the Bill

For the bill of exchange to work, the drawee has to agree to pay the money to the beneficiary. This is called accepting the bill. Once the drawee accepts the bill, they have to pay the beneficiary on the due date.

How Bills of Exchange Work

Let’s say Alice owes $100 to Bob. And Bob owes $100 to Charlie.

Alice Writes the Bill

Alice can write a bill of exchange to Bob. The bill says that Bob must pay $100 to Charlie on a certain date. Alice is the drawer. Bob is the drawee. And Charlie is the beneficiary.

Bob Accepts the Bill

When Bob gets the bill from Alice, he can choose to accept it or not. If Bob accepts it, that means he agrees to pay $100 to Charlie on the date Alice put on the bill.

Bob Pays Charlie

On the due date that Alice wrote, Bob pays the $100 to Charlie. Now Alice doesn’t owe Bob anymore. And Bob doesn’t owe Charlie anymore.

Endorsing a Bill of Exchange

The beneficiary can do something special with a bill of exchange. They can endorse it.

What Endorsing Means

Endorsing means writing your name on the back of the bill. This is how the beneficiary transfers their right to get paid to someone else.

Charlie Endorses to Dave

Let’s go back to our example. Charlie is the beneficiary on the bill that Alice wrote. If Charlie endorses the bill, he can give or sell it to Dave.

Dave Can Collect from Bob

Now Dave has the right to collect the $100 from Bob on the due date. When Bob pays Dave the $100, the bill is complete. Bob doesn’t owe Charlie anymore. And Charlie doesn’t owe Dave anymore.

Negotiable Instruments

When the beneficiary endorses a bill of exchange, it becomes a negotiable instrument.

Negotiable Means Transferable

Negotiable means the bill can be transferred from one person to another. And whoever has the bill has the right to get paid the money.

Endorsing Makes Bills Negotiable

In our example, when Charlie endorsed the bill to Dave, it became a negotiable instrument. Dave now has the right to collect from Bob, even though Bob didn’t make his deal with Dave.

Bank Acceptance of Bills

Sometimes a bank gets involved with a bill of exchange. This happens if the drawee is a bank.

Drawer Writes to Bank

Let’s say Emil wants Fred to pay $500 to Greg. But Emil wants to make sure Fred will pay. So Emil writes a bill telling his bank to pay Greg $500 on a certain date.

Bank Accepts Bill

If the bank accepts the bill Emil wrote, it becomes a bank bill or banker’s acceptance. This means the bank itself promises to pay Greg on the due date.

Greg Gets Paid for Sure

With a banker’s acceptance, Greg knows for sure he will get his $500. Even if Fred doesn’t pay the bank, the bank still has to pay Greg. That’s because the bank accepted the bill.

Benefits of Bills of Exchange

People use bills of exchange because they have some good benefits.

Ensures Future Payment

A bill of exchange makes sure someone will get paid in the future. The drawer writes the date they want the payment to happen. If the drawee accepts, they have to pay on that date.

Can Be Sold or Transferred

The beneficiary can endorse a bill to someone else before the due date. This means bills of exchange can be sold or given to other people. This can be helpful if the beneficiary needs money before the due date.

Safer Than Other Promises

If a bank accepts a bill, it’s a very safe promise of payment. Banks usually don’t fail to pay their bills. People trust banker’s acceptances more than regular people’s promises.

Risks of Bills of Exchange

Bills of exchange also have some risks to think about.

Drawee Might Not Accept

The biggest risk is that the drawee won’t accept the bill. If the drawee refuses to accept, the beneficiary won’t get paid. The drawer can’t force the drawee to accept a bill.

Drawee Might Not Pay

Even if the drawee accepts the bill, they might not actually pay on the due date. The beneficiary would then have to take legal action to try to collect the money. This can be costly and take a long time.

Bill Might Get Lost

A bill of exchange is a piece of paper. It could get lost or destroyed. If this happens, it might be hard to prove who has the right to get paid.