Banking & finance

Letters of credit (LCs): recognizing the value of simple trade instruments

  • 12 July 2016
Trade facilitation

Swept up in the enthusiasm around new, perhaps more sophisticated, trade finance instruments, it can be easy to overlook the Letter of Credit (LC). David Bischof, policy manager at the International Chamber of Commerce (ICC) Banking Commission, reminds us of its importance.

The trade landscape has evolved. Globalisation has opened doors to relatively untapped markets that present almost unlimited opportunities for both developed and emerging market companies. Yet it is a landscape of opportunity that is balanced precariously upon an unsteady global economic backdrop, and relies on accessing unfamiliar markets with different cultural practices, currencies and regulations.

Trade in 2016 therefore requires sophisticated  trade finance instruments that offer cost-efficiency and streamline the process underlying trade. New products and services have emerged to meet the ever-evolving needs of today’s economy – changing the way trade finance is conducted. Automation around Bank Payment Obligations (BPOs) and systems such as open account programmes, supply chain finance, and forfaiting mean trade companies now have a proliferation of choice with respect to trade finance products.

Yet “in with the new” must not mean “out with the old”. While such sophistication of the trade finance industry is absolutely beneficial, it can make it quite easy to overlook something as well-worn and simple as letters of credit (LCs) – despite their formative position as a lasting trade finance instrument.

The rich history of LCs

Certainly “old” is an adequate description of the LC. Indeed, although known by an array of different names throughout history, the LC can be traced as far back as 3000 BC, where Ancient Babylonian and Egyptian civilisations would use a rudimentary form of the trade instrument to ensure payment between parties.

Further evidence of LCs may be found in Europe during the 12th and 13th centuries. LCs not only removed the danger of travelling with gold, but also ensured payment for merchants and traders throughout Europe, Africa, and Asia – regions where commerce generated currency that was not sufficient to meet the needs of merchants.

Fast forward to World War I – a period characterised by the breakdown of international allegiances, and rising suspicion – where LCs bridged the gap between merchants that were considered no longer trustworthy, by inviting trusted sources such as banks into the trade relationship. This crucially helped cross-border trade continue during a period of devastating economic and political hardship.

Today, the LC is a widely-adopted trade finance instrument that ensures payment for buyers and sellers alike. For sellers, LCs not only ensure payments will be made promptly and in full, they also reduce the production risk in case the buyer cancels or changes an order. LCs also provide sellers with the opportunity to receive financing during the period between the shipment of goods and the receipt of payment.

For buyers, LCs ensure that the seller will honour their side of the deal and provide products or services with documentary proof. LCs also allow buyers to demonstrate solvency and control the time period for shipping goods.

The secure nature of LCs

Throughout history one thing is constant: the LC has been celebrated owing to its low risk nature – something the International Chamber of Commerce (ICC) Banking Commission’s Trade Register reminds us of, using data from 23 global banks and including 13 million transactions that encompass a total exposure of $7.6 trillion. According to the Trade Register, export LCs compare to somewhere between an ‘Aaa’ and ‘Aa’ rating by Moody’s.

Specifically, the customer default rate for export LCs between 2008-14 stood at 0.01%. During the same period, transaction default rate for export LCs was 0.08%,and the exposure weighted default rate for export LCs was 0.02%.

Import LCs remained strong during the 2008-14 period as well, with a transaction default rate standing at 0.08%, and the exposure weighted default rate standing at 0.07% during the same period.

LCs and similar short-term trade finance products all performed well in the wake of the recession, with an average increased default rate of 0.3%. Moody’s Baa corporate default rate, on the other hand, increased by 80%. In fact, the overall Moody’s rated universe default rates tripled during this period.

Even in the unlikely event of default, LCs hold record high recovery rates – attributed to their ability to seize collateral associated with transactions. In fact, import LCs are fully recovered 98% of the time. This lies in stark contrast of performance guarantees, which are fully recovered only 38% of the time.

In addition to high recovery rates, LCs hold quick recovery times. The average recovery time for defaulted transactions between 2008-14 was 178 and 71 days, respectively. In contrast, loans for import and export have a recovery rate of 238 days.

Finally, with globalization opening the door to many different players and markets – and therefore differing laws, practices, and cultures – LCs are governed independently with rules created and regularly updated by the ICC Banking Commission.

A digital rebirth

Of course, just because LCs are old, doesn’t mean they can’t embrace the new. Today’s trade landscape requires security, but it also requires the benefits offered by technology ­ namely efficiency and automation.

While traditionally LCs have been paper­based – the name itself linking to its physical form -the LCs of 2016 are now not only requested and conducted online, but they may also be modified with a click of the mouse. What’s more, their transaction status is available to be viewed instantly online, so each participating party has an accurate and up to date view of each LCs’ status. On top of this, LCs are now customizable and can be tailored to fit the unique needs of each party.

Remembering the LC

The value offered by newer and more sophisticated trade finance instruments and techniques is indisputable – the trade landscape has grown more complex, and trade instruments must evolve in kind. But it is important to remember that sometimes beauty lies in simplicity. And in this case, simplicity means security – a quality that is invaluable against a volatile economic backdrop.

This commentary was originally published in Trade Finance Magazine June/July 2016