The oldest and most common form of short-term trade finance is the letter of credit.
A letter of credit (LC) is essentially a pledge to make a payment – issued by a bank on behalf of its importing client. It is a written undertaking that a bank gives on behalf of its customer to pay the exporter an amount of money within a specified time frame – as long as the exporter complies with certain terms and conditions.
The importer bank provides the LC to the exporter (or exporter’s bank). The document essentially says: “I’ll pay you XX amount – if you ship the right goods to me.”
In this way the exporter is not taking the payment risk on the importing corporate, but on the bank. (Key to the use of LCs is the concept that bank risk is usually considered lower than corporate risk.)
If the exporter presents the bank with the correct documents – proof of shipping the correct goods, such as bills of lading – they can expect to get paid.
Quite often, this transaction will involve one further party – a confirming bank.
A confirming bank will usually be in the country of the exporter (reducing the political risks of waiting on the payment from an overseas bank). This bank will ‘confirm’ the LC provided by the importer’s bank.
The confirming bank will check the documents (proof of export against the LC requirements) and then pay the exporter the due amount (at a fee – paid usually by exporter).
There are many different kinds of LCs and LC structures that might stand behind a straightforward credit line to a client: standby LCs, back-to-back LCs, revolving LCs.
LC BENEFITS:
- Reduces risk of non-payment
- Could be the only way a customer/importer can obtain foreign currency to pay exporter
- Some countries require involvement of a local bank in payment for a significant import contract
LC CHALLENGES:
- Does not wholly guarantee payment
- Bank in importer’s country could go bankrupt
- Political situation could impose freeze on payments
LETTERS OF CREDIT IN CONTEXT:
The general long-term market trend is moving away from letters of credit as, up until the recent financial crisis, importers and exporters were becoming more confident in trading with each other on an open account basis. Companies became more than happy to take on certain risks and deal with certain countries.
What’s more, the trade credit insurance market has been growing. Some trade transactions are conducted with just insurance providing a way of mitigating non-payment risks.
But, in the immediate aftermath of the crisis there was a resurgence in LC use and other trade finance instruments due to a drop in confidence and overall trust.
READ MORE ON TRADE FINANCE:
What is trade finance?
Supply chain finance
Structured trade and commodity finance
Export and agency finance
Trade credit and political risk insurance