Suppose you decided to sell your car to a used car platform that promised to pay you within 30 minutes. However, what happened next left you feeling both scared and angry. After making multiple follow-ups with the platform and worrying about the possibility of being defrauded, you finally received the payment after 10 long days.
This incident might have left a deep impression on you, making you question whether to engage in such transactions again, right? Many individuals and businesses may have faced similar situations when conducting transactions between two parties. This is where the importance of escrow accounts comes into play, helping to bridge the trust gap and minimize the risk of fraud during such transactions.
But what exactly are escrow accounts? And why are they important for alternative investments? Let us deep dive and help you understand about escrow accounts in a simpler manner.
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What Are Escrow Accounts?
Before we explain to you what escrow accounts are, its important to first understand what is an escrow. Escrow is a legal concept that describes a financial agreement wherein an asset or escrow money is held by a third party, on behalf of the other two parties that are in the process of completing a transaction.
So what is an escrow account? An escrow account is like a neutral third-party account that holds funds or assets for two parties, until the terms of an agreement are satisfactorily met. During the transaction, the buyer first deposits funds into the escrow account, which are then held by the escrow agent. Now, only after all conditions are fully met and satisfied, such as completion of necessary paperwork and fulfilment of contractual obligations, the escrow agent releases the funds to the seller.
Assets such as money, securities, funds and even programming code can be held in escrow.
Why Is An Escrow Account Important?
To explain, let us first take an example!
Imagine a company is selling goods overseas. They want to be sure they'll get paid once the goods arrive safely. Meanwhile, the buyer only wants to pay if the goods are in good condition. In this case, the buyer can put the payment into an escrow account with an agent, giving clear instructions that the money will only be released to the seller when the goods arrive in good shape. This way, both the buyer and seller are protected, and the transaction can go smoothly according to their agreement.
In essence, an escrow account gives both buyers and sellers the security they need for their transactions, eliminating any trust issues between them. This is especially helpful in reducing fraud in high-value deals between two parties.
When Are Escrow Accounts Typically Used?
An escrow account is commonly used in mergers and acquisitions, online purchases, real estate transactions, and various other forms of financial agreements. These accounts turn out to be particularly useful in transactions that either involve huge sums of money or wherever there is a need for certain pre-set conditions to be met before the completion of a transaction.
Role of Escrow Accounts In Financial Transactions
Simply put, escrow accounts help in protecting the interests of all parties involved in a transaction, by ensuring that funds are only released when all the conditions are satisfactorily met, whether it pertains to real estate transactions, mergers and acquisitions, escrow shares, bankruptcy proceedings, etc.
Here are some ways escrow accounts are used in India:
Real estate: Under the RERA Act, 70% of homebuyer advances and bank loans for a housing project must be deposited in an escrow account managed by a scheduled bank in India. These funds are for land acquisition and project development only. An escrow agent holds the property and buyer’s money until all terms are met, then releases the property to the buyer and money to the seller.
Mergers and acquisitions: Escrow accounts hold shares until both companies in a merger or acquisition are satisfied with the deal.
Escrow shares: These are securities held in an escrow account until conditions are met, protecting all parties involved. They are used in complex transactions like bankruptcy, company restructuring, mergers and acquisitions, or ESOP pools.
Alternative Investments: Escrow accounts provide alternative investment platforms like altGraaf, Grip, and Wint Wealth with a strong banking and technology infrastructure. This streamlines transactions, making them efficient, secure, and convenient. In asset leasing, an escrow agent helps manage payments and settlements easily.
Role Of Escrow In Alternative Investments
Till now, we hope you have received a fair bit of understanding about the concept of escrow accounts. Now let us help you understand why escrow accounts are important for alternative investments:
Adds a layer of protection for investors: As escrow accounts hold the investor’s funds until the specific conditions are satisfactorily met, this provides an added layer of protection to investor’s interests, as well as boosts their confidence.
Ensures transparency in transaction: Given that escrow accounts act as a neutral third party, they help ensure transparency and accountability for the usage of funds in the intended manner.
Reduces risk of fraud/scams: Escrow accounts can greatly help in reducing the risk of fraud as well as scams by safeguarding the investor’s funds until all terms and conditions are completely met.
Facilitates smooth transactions: Escrow accounts can help to simplify and smoothen the conduct of complex transactions by holding and releasing funds only upon fulfilment of all conditions required for transaction’s satisfactory completion.
An Example To Help You Assess The Risk vs Returns
Some alternative investment platform do use escrow but its still very much possible that you may end up losing money especially on unregulated platforms. The below example will show how escrow accounts play a key role in driving risk and returns, such as in the case of invoice discounting. The below example assumes you understand invoice discounting as an asset class, if you don’t check out article here.
Suppose a platform like altGraaf is offering two invoice discounting products:
Product A: The repayments from the buyer go into an escrow account controlled by altGraaf. This money is also secured by Trade Credit Insurance (TCI). Once money is received, altGraaf distributes it amongst investors and then repays back any surplus to seller.
Product B: The repayments from the buyer go into an escrow account controlled by the seller. Once money is received, the seller should ideally pay to altGraaf to distribute the money received amongst investors. But, what if the seller chooses not to do that? Even with the presence of escrow, the investor might not be able to do much.
As far as returns are concerned, suppose Product A offers pre-tax IRR of 12%, whereas Product B offers pre-tax IRR of 14%. While you may jump to the conclusion that one should invest in Product B for higher returns, don’t miss out on the extra risk factor about who controls the escrow. Given that Product A involves the safety of an escrow account controlled by altGraaf itself, any claim upon default raised with the insurance company in this case can be settled directly in the escrow account.
Transaction Structure For Product A
Whereas in case of Product B, while the returns seem to be on the higher side, but so is the risk, as the escrow account involved in the deal is not directly controlled by altGraaf.
In the absence of an escrow account controlled by altGraaf itself, the buyer would pay the seller and not to an escrow account controlled by altGraaf. And then, the seller would transfer to investors via a regular collection escrow account (not controlled by altGraaf).
Transaction Structure for Product B
So, if the buyer goes bankrupt, investors may lose their money or there may be delayed recovery of their investments. This clearly shows that product A is less riskier than Product B. So if you think of investing in Product B with the hope of higher returns, don’t forget about the higher risk involved with it even with the involvement of an escrow!
Conclusion
Escrow accounts are crucial for secure financial transactions, especially in alternative investments. They act as a neutral third party, holding funds or assets until conditions are met, reducing fraud risk and increasing trust. This makes them essential in high-value deals like real estate, mergers, and alternative investments.
Like we have mentioned in various examples throughout the article, the use of escrow accounts can significantly reduce risks and protect investors, making them less then an essential component in the financial ecosystem. But to add to this, the structure of the overall financial transaction and where in that structure is escrow placed also become a very important point to ensure that the best interest of investors are protected.
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Please note that this is an opinion blog and not an official research or investment advice. This blog aims to help retail investors make an informed decision in the bond market, and neither encourages nor discourages you from investing in any particular bond or any other asset class.