Letters of Credit: The traditional solution for secure payment (Part 2/6)
Letters of Credit (LCs) have long been a preferred risk management tool, favoured for their ability to provide security to both buyer and seller.
LCs optimise cash flows by offering sellers a secure method of guaranteeing on-time and full payment while buyers are assured a seller is paid only after delivery and honouring the contract terms. And because LCs are customisable, they allow traders to expand to new markets and are useful when countries require a bank to handle significant import contracts.
However, their popularity is gradually declining, mainly due to the high costs involved for both buyer and seller. Rapid digitalisation has also played a part, fueling global trade and helping exporters in emerging markets to grow more sophisticated in their knowledge of acceptable trading practices, and seek out alternative methods to secure payments.
Is it difficult to obtain an LC?
Banks issue LCs to a buyer after performing due diligence on their background and required documents such as a purchase order, and collecting collateral to cover the guaranteed payment, which can vary based on the buyer’s financial strength or relationship with the bank. Here’s a quick look at the two main types of LCs:
- Irrevocable Letters of Credit (ILCs) provide security against del credere risks (the risks of a buyer defaulting or becoming insolvent) where the buyer’s payment obligation is guaranteed by a bank. They are best used when a seller trades mainly within its domestic market and only occasionally receives large export orders, or is considering trade with a new buyer whose creditworthiness is unknown.
[For a full list of LCs, please see this article.]
- Confirmed ILCs provide security against both del credere risks and the political risks of doing business in a third country, because payment is confirmed by a bank outside of the buyer’s country - normally in the exporter’s country. It is also used when doing business in countries where risks are deemed to be so high that credit insurance coverage is only available where payment is secured by way of a Confirmed ILC.
However, obtaining an LC, which has to be set up for each transaction, can be a time-consuming and challenging process, making buyers reluctant to apply for them.
One key issue is creditworthiness. Securing an LC can be additionally challenging for buyers perceived to be financially weak or those without existing banking relationships. A bank may require the buyer to deposit funds to cover the payment obligation, offsetting any potential benefits to the buyer over trading on cash terms. Then there is the risk, albeit a rare one of a bank defaulting or becoming insolvent.
Most importantly, the ability of a seller to persuade a buyer to provide an LC will depend upon the buyer’s need to transact and the alternatives available to them.
What are the cost and compliance implications?
It is often assumed, incorrectly, that all the costs associated with an LC will be borne by the buyer. On the contrary, the seller is charged by the beneficiary’s bank for services such as general administration and advisory, revisions to the LC and the transfer of funds. These costs can be hefty, with charges for a Confirmed ILC, which involves two banks – one each in the buyer’s and seller’s country – amounting to between 0.1% to 2% of the invoice value.
Yet, ILCs are not absolute guarantees of payment. Because all LCs are subject to strict compliance requirements banks are known to enforce the LC’s terms to the letter. They will conduct stringent checks to ensure the terms - such as the expiry date, fixed delivery timelines and other contract milestones - have been met by the seller. If any of these are incorrect or change, amending an LC’s terms can be complicated and will involve additional costs.
Sellers also have to factor in costs associated with employing staff or seeking outside counsel to ensure an LC’s terms are fully compliant with local regulations, and the documentation required to ensure payment is absolutely accurate. Failing to do so can result in an irrecoverable loss and LC-related legal disputes can be costly and resource-intensive.
ConclusionOverall, while LCs continue to be used around the world, they are being increasingly perceived as unsuited for a technology-driven global marketplace where a host of other options are available to help companies optimise their credit management needs. These include instruments such as invoice discounting, bank guarantees and credit risk insurance. To learn more, you can read about them here and find a snapshot comparison here.
Read our blog series that will provide an in-depth look at each of these credit risk management tools and their strengths and weaknesses.
1 of 6: Credit risk management instruments driving trade around the world
2 of 6: Letters of Credit: The traditional solution to secure payment
3 of 6: Invoice financing: A cashflow management alternative
4 of 6: Bank guarantees: Facilitating and securing high-value transactions
5 of 6: Credit insurance: A holistic and cost-effective risk management solution
6 of 6: Credit risk management: Choosing the right solution can make all the difference