Reducing the Use of Letters of Credit (LCs)
Letters of credit are an instrument used to manage the financial risks in international trade. In this mode of payment, the buyer’s bank will issue a LC to the supplier’s bank guaranteeing that exporter will be paid with the agreed amount upon shipment of the order. If the buyer is unable to make payment on the purchase, the bank will be required to cover the full or remaining amount of the purchase. (Investopedia, 2018)
As a traditional trade finance instrument, the process behind LC’s have been “virtually unchanged” during the past decades even though our economy has evolved into a process or sequence that demands faster trade and faster payments. For this reason, banks and financial institutions around the globe are expecting a decline in the use of letters of credit in the coming years. Based from an annual report from Rethinking Trade of the International Chamber of Commerce (ICC)’s Banking Commission, 80% of those surveyed expected a little or no growth in the existing traditional tools.
However, the ICC claims that Letters of Credit will continue to maintain at least 10% of the global merchandise trade. In fact, in 2013, LC’s made up 41% of all export trade finance. In the Asian-Pacific region itself, 68% of imports and 75% of exports are paid for via Letters of Credit (Bermingham, 2017)[1].
In addition, the use of Letters of Credit has many disadvantages. One major disadvantage of an LC is the fact that it costs a significant amount in documentation and preparation. For an SME (small and medium enterprise), the price that banks charge can be particularly brutal. To take this even further, the most obvious risk with letters of credit is that they don’t provide any guarantee of the quality of the goods. They may not meet the buyer’s expectations at all and although quality certificates can be sought as part of any documentation, it is unlikely that an SME is willing to incur further costs upon itself. Because of these disadvantages, it is strongly recommended to negotiate better payment terms where possible.
To reduce the use of LCs, various sectors and international players have been introducing better alternatives as solutions to some of the LC’s drawbacks.
The following are some of the alternatives for Letters of Credit:
- Invoice factoring – Invoice factoring is an alternative to a letter of credit. Under this type of credit facility, a third party advances a business 80 percent of invoice totals received from their customers. The third party assumes the risk of collecting the invoices. When a customer pays the invoice to the third party, a fee is withheld, and the business gets the remaining balance. This is beneficial for companies suffering from a cash crunch. Invoice factoring however can be quite costly, as a third party assumes all risks of collection.
- Payables Financing – very similar to invoice factoring however this is normally a buyer led program which includes a corporate guarantee behind all approved invoices. With this guarantee in place, third party funders often lend up to 100% of the invoice value
As alternative financing solutions continue to evolve in the global marketplace, Letters of Credit may continue to decline in lieu of technology supported products.
References:
Bermingham, F. (2017, May 15). Banks signal the decline of traditional trade finance | Global Trade Review (GTR). Retrieved from Global Trade Review (GTR): https://www.gtreview.com/news/global/banks-signal-the-death-of-traditional-trade-finance/
Cook, M. (2017, 26 September). The Alternative to a Letter of Credit | Bizfluent. Retrieved from Bizfluent: https://bizfluent.com/way-5364737-alternative-letter-credit.html
Investopedia. (2018, August 3). Letter Of Credit | Investopedia. Retrieved from Investopedia: https://www.investopedia.com/terms/l/letterofcredit.asp
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