A bill of exchange is a written, unconditional order, signed by the person giving it, requiring the person to whom it is addressed to pay a fixed sum of money, on demand or at a fixed or determinable future time, to a specified person, to that person's order, or to the bearer. It is one of the oldest negotiable instruments and remains the legal basis of the cheque and of the drafts used in trade finance. In the United States the same instrument is generally called a draft.
A bill of exchange involves three parties. The drawer issues the order, the drawee is the party ordered to pay, and the payee is the party to be paid. When the drawee agrees to pay a time bill by signing it, the drawee becomes the acceptor and is primarily liable on it.
History
Bills of exchange developed among Italian merchants in the medieval period as a way to move value between trading cities without carrying coin. A merchant in one city would pay local currency to a banker and receive a bill payable in another currency by the banker's correspondent elsewhere. Because the exchange of currencies across distance and time could embed a return without an explicit loan, bills also offered a way around church prohibitions on usury. Similar instruments existed in other trading systems, including the suftaja of the Islamic world and the hawalah transfer of debt.
By the eighteenth and nineteenth centuries, London had become the center of an international market in bills, which financed a large share of world trade, including cargoes routed through maritime chokepoints such as the Suez Canal after 1869. The English Bills of Exchange Act 1882 codified the law and was widely copied across the Commonwealth. Continental European countries harmonized their rules through the Geneva conventions of 1930 on a uniform law for bills of exchange and promissory notes.
How a bill of exchange works
Sight and time bills
A sight bill is payable on presentation. A time bill, also called a usance or term bill, is payable a set period after sight or after a specific date, for example 90 days after the bill of lading date. A time bill gives the buyer credit while giving the seller an instrument that can be sold.
Endorsement and negotiation
A bill payable to order can be transferred by endorsement and delivery. A person who takes a bill in good faith and for value, without notice of defects, becomes a holder in due course and can enforce it free of many defenses available between the original parties. This negotiability made bills a form of money among merchants.
Discounting and acceptances
The holder of an accepted time bill can sell it to a bank before maturity at a discount reflecting interest and the acceptor's credit. When a bank itself accepts the bill, it becomes a banker's acceptance, a money market instrument backed by the bank's credit. Bills may also be guaranteed by a third party through an aval, common in civil law countries.
Bills of exchange in trade finance
In international trade, the exporter typically draws a bill on the importer or its bank. In a documentary collection, the exporter's bank sends the bill with shipping documents, including the bill of lading and commercial invoice, to the importer's bank, which releases the documents against payment of a sight bill or acceptance of a time bill. Under a letter of credit, the bill is drawn on the issuing or confirming bank. Bills sit between cash in advance and open-account trade in the range of supplier payment terms, offering the seller more security than open account.
Cheques as bills of exchange
A cheque is a bill of exchange drawn on a bank and payable on demand. This is why cheque law in many common law countries sits within bills of exchange legislation. Practices such as franking a cheque or crossing it to restrict payment to an account developed from this framework; see also check or cheque for spelling conventions.
Bill of exchange versus promissory note
A bill of exchange is an order to pay addressed to another party, whereas a promissory note is a promise by the maker to pay. A bill requires acceptance by the drawee before that party is bound; a note binds the maker from the outset. Both are negotiable instruments and are covered by the same statutes in many jurisdictions.