The Renaissance of Documentary Letters of Credit
The recent global economic crisis has reminded all of us that we live in a world of risk. In the world of international trade this means managing, at the very least, payment risk and performance risk. Other risks exist, of course, such as country risk, transit risk and foreign exchange (FX) risk, which need to be mitigated. With the global downturn in trade there are clear signs of a slowdown on open account trade and a consistent stability on trade with documentary letters of credit (LCs). This shows that our old ‘friend’ has become fashionable again due to corporations looking for safety in terms of credit risk as well as a source of liquidity.
In international trade transactions there are principally four payment mechanisms that can be agreed upon between a buyer and a seller: open account, advance payment, documentary collections and, last but not least, documentary LCs. The choice of which method of payment to use can be quite challenging due to the divergent interests of importers and exporters – each payment mechanism provides a varied level of risk and security to both sides.
Open account is the most secure payment method for importers, but the most risky for exporters. The exporter ships the goods and the payment is made at a pre-agreed date in the future by the importer without any negotiable instrument evidencing the importers’ contractual obligations. Open account is probably the cheapest payment method for international trade but places all the responsibility on exporters for both credit risk and the cost of financing.
In contrast to open account, advance payment (also called ‘cash in advance’) is the most secure payment method for exporters, but the most risky for importers since the goods are not shipped until payment is received in full. There is no guarantee that the goods will be delivered as and when agreed, with full control of the transaction always in the hands of the exporter.
Documentary collections, on the other hand, are a payment method by which international trade transactions are settled through an exchange of documents. The importer’s bank acts as a collecting agent for the importer by effecting payment to the exporter’s bank for the benefit of the exporter once the stipulated set of documents has been received. Documentary collections offer some protection to both importers and exporters as each party retains a certain level of control.
A documentary LC is a written undertaking from the importer’s bank to pay at sight or a future date, up to an agreed sum to the exporter on behalf of the importer, provided that the exporter presents certain documents to the issuing bank, in compliance with the terms and conditions of the LC. Banks play a larger role in documentary credits than in other trade payment methods. Documentary credits provide a high degree of comfort to exporters that they will receive payment if the required shipping and related documents presented to the issuing bank are in compliance with the terms and conditions of the LC; and also to importers that payment will be made on their behalf only if compliant documents have been presented.
LCs are defined in the guidelines of the International Chamber of Commerce (ICC), the Uniform Customs and Practice for Documentary Credits (UCP), which are recognised internationally. It is therefore advisable that any LC issued should be made subject to the current version, which is UCP 600.
LCs can be tailored to meet specific contractual arrangements. Some of the most commonly used LCs are revolving LCs, back-to-back LCs, transferable LCs, red-clause LCs and green-clause LCs.
Revolving LCs represent a commitment on the part of the issuing bank to restore the LC to the original amount once it has been utilised. Revolving LCs can be either non-cumulative, meaning partial amounts expire if not used in the stated revolving period; or cumulative, meaning the amounts not drawn during the revolving period can be added to the next revolving period.
Back-to-back LCs are typically used by trading companies. They enable an intermediary to use the first LC (master LC), issued in their favour by the importer as collateral for the issuance of a second LC in favour of the exporter.
Transferable LCs are an alternative to back-to-back LCs as a method of facilitating transactions arranged by a trading company. With transferable LCs, the first beneficiary instructs the advising bank to transfer all or part of the LC to the second beneficiary. An important thing to note is that the first beneficiary’s right and obligations under the first LC are transferred to the second beneficiary, which must comply with the terms and conditions of the transferred LC in order to receive payment.
Red-clause LCs are LCs that are structured in a way that allows an exporter to obtain pre-shipment finance from the advising or confirming bank, expressed as a percentage of the LC amount. Green-clause LCs are very similar to red-clause LCs with the major difference being that the exporter can only obtain an advance payment from the advising or confirming bank against the actual production of certain documents and not just an undertaking to produce them.
In instances where an exporter is not sure about the political or economic stability of the importer’s country or even the credit standing of the issuing bank, confirmation of the LC is a means of mitigating such risks for the exporter. A confirmed LC means that the exporter’s bank (usually in the exporter’s own country) adds its undertaking to pay to that of the importer’s bank if the terms of the LC are fulfilled. This confirmation mitigates political, country, importer bank and buyer risk for the exporter.
With documentary LCs, documents are key. Banks decide on the basis of documents alone whether to effect payment or not. If compliant documents are presented, banks will make payment whether or not the actual goods are shipped. This may sound quite harsh, but the reality is that banks deal in documents only. However, there are ways for importers to protect themselves against such a risk. An importer’s trade bank should be able to assist them in mitigating this risk.
For exporters, special attention should be paid to the preparation of shipping documents because a simple omission or discrepancy between required and actual documents may lead to additional costs, delays and extra work for both the importer and exporter. Discrepancies in documentation can be caused by late shipment of the goods or typographical errors in the description of the goods. Globally, it is estimated that on first presentation up to 85% of documents are discrepant in one way or another. However, this may only present a problem if not corrected by the exporter and if in the importer’s country it poses a regulatory problem, or if the importer decides to use it as a means not to conclude the transaction.
A number of issues can be attributed to the decline in the use of LCs in the past; the element of cost for both the importer and the exporter; the inefficiencies that can arise due to documentation and improperly structured LCs, and the use or tying up of the importer’s credit lines. Despite these challenges, LCs are currently back in vogue because they protect the interests of the exporter and importer equally, address payment risk, performance risk, credit risk, political and country risk and act as a source of liquidity when discounted.
The renaissance and the success of LCs is a clear testimony of their versatility and usefulness in international trade. An LC can be very complex or very simple – it all depends on the importer and the exporter.
Figure 2: Open Account Versus Risk Mitigated Trade
Source: Standard Bank