You want a Letter of Credit, Really? Part 1

I saw a story on the Internet about how the Babylonians used clay tablets to facilitate trade in Mesopotamia.  I thought, "WOW! Letters of Credit! They'll be around forever."

Most of the readers of this site are lucky they never have to use a Letter of Credit (L/C).  Why?  Simply because they are both a Credit and Document intensive payment instrument that is filled with confusion, technicalities, and usually result in delays in payment with absorbent bank fees.  Nice product for the banks, not so nice for the corporation involved.

If you decompose the value proposition, the L/C offers three benefits  plus one Requirement driven by some Governments:

  • First, it is a payment and settlement instrument involving Banks, mostly used for international trade.  Like it or not, banks are still trust brokers in the game of money movement and settlement.
  • Second, it provides risk mitigation to the seller or exporter.  If the seller complies with the terms of the Commercial L/C, that they are paid by the Issuing Bank (their Buyers bank) or the Confirming Bank (more on this later).
  • Third, it can be used for finance, either by the Seller in some pre shipment finance based off the percentage of the LC or post shipment Finance for both the Seller and Buyer.
  • Fourth, some countries have Exchange Controls when importing goods in USD, and the L/C provides a mechanism to comply with those controls.

So if I am buying textiles from my Bangladeshi or Cambodian factories, an LC provides a means for these suppliers to get finance.  Or if I am selling large commodities into high risk countries, again, I can control the risk of non payment.  So all in all, pretty solid reasons for using.

SWIFT data has shown roughly 15% of world trade by value is on Commercial L/Cs.

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