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Letters of Credit Are Becoming A Tool of The Past?

Letters of Credit Are Becoming A Tool of The Past?

Letters of Credit (LCs) have long been used in many areas of trade and business to enable ongoing commercial transactions. They are issued by banks as irrevocable guarantees by bank account holders of payment of funds to a beneficiary.

In other words, if you are a business owner or corporate officer, you may obtain a Letter of Credit from your business banker assuring payment to your beneficiary in a transaction. If you fail to meet this financial commitment, the bank must pay the beneficiary. In some cases, the LC itself may be the vehicle of repayment so that the beneficiary can redeem the LC in order to be paid. Although a convenient tool to expedite and ensure the funding of certain types of commerce, these Letters of Credit are now on their way to becoming obsolete as financial tools of the past.

What Steps Are Involved When a Bank Issues a Letter of Credit?

Suppose you, as an importer, wish to purchase $75,000 worth of cellular phones from a Japanese manufacturer. The manufacturer joins in an agreement with you and your company to supply the products provided that you pay for them within 60 days. In some instances, you must also give the manufacturer a 90-day Letter of Credit for the total amount due. Your LC for this transaction can be obtained through the following steps:

1. You request a $75,000 LC from your business bank with the Japanese manufacturer as beneficiary.

2. As underwriter, the bank then extends credit to the beneficiary on your behalf, assuming a contingent liability in the process. If your company is in good financial standing, the Letter of Credit is issued.

3. If your business does not meet creditworthy standards required by your bank, you can obtain an LC, nonetheless, if you offer cash collateral. It is normal for many small companies to be issued CD secured LCs.

4. Your bank then forwards a copy of the Letter of Credit to your Japanese manufacturer's business bank. This Japanese bank then notifies the vendor so the product order can be shipped to you.

This example is actually a very basic LC transaction. If your Japanese product manufacturer intends to be paid quickly for the merchandise shipped to you, this Letter of Credit may serve as the actual repayment source. After providing proof of product order shipment to their own bank, full payment will be received by your merchandise supplier for this business transaction. Two aspects of major importance throughout this repayment process are an immediate business transaction and the fees you incur. These fees may range from 1.5% to 8% of the total worth of the LC.

What Different Types of Letters of Credit are Issued by Banks?

  • Revocable Letter of Credit. – As a “safety net,” this variety of LC can be revoked by the issuing bank. No agreement to this revocation by the beneficiary is necessary.
  • Irrevocable Letter of Credit. – This LC cannot be altered or cancelled without the consent of all parties involved.
  • Standby Letter of Credit. – In the event the transaction beneficiary does not receive payment from the product purchaser, the beneficiary has the right to demand payment directly from the issuing bank. All the beneficiary must do is forward a copy of the product invoice left unpaid to the issuing bank along with any relevant documents.
  • Revolving Letter of Credit. – When a product customer and supplier have an ongoing agreement for the shipment to the customer of a product over a length of time, a Revolving Letter of Credit is often used. This avoids the necessity of the customer's bank issuing an LC for every separate order transaction.

Why Are Letters of Credit Becoming Things of the Past?

Especially in our current uncertain world economies, Letters of Credit are becoming increasingly less popular as viable financial methods to support commercial merchandise sales and other types of trade. Many banks are now hesitant to issue LCs as actual repayment vehicles. There are some serious risks of fraud, including intentional lack of reimbursement to customers for damaged, imperfect or even nonexistent goods. Some beneficiaries may even resort to forgery of agreements. In addition, some governments may interfere with completion of funding transactions.

There is always the added concern that fulfillment of a Documentary Credit may be hindered by unforeseen legal action against either of the parties involved in a product order transaction satisfaction. Also, possible business disruption by wars, domestic conflicts and natural disasters must be considered. Other problems that may arise are: (1) the insolvency of the LC applicant and failure of the issuing bank to meet this obligation for the applicant, or (2) failure of the beneficiary to deliver any of the merchandise ordered.

Without question, Letters of Credit have long been a very convenient and workable method for assuring ongoing commerce transactions where ordering and shipping merchandise are concerned and in other forms of business transactions. Yet in today's fluctuating worldwide economies, their benefits often do not outweigh the risk factors involved. For this reason, these LCs may soon become financial transaction modes of the past.

How Trade Payables Financing is Replacing Letters of Credit

Alternative lending companies the specialize in Trade Payable Financing is replacing the traditional LC transactions that used to dominate the international trade finance industry. Supply Chain financing is becoming the choice for both suppliers and buyers globally. Payments can easily be made with a trade payable servicing agent and financing can benefit all parties. The suppliers submits the invoices to the buyer, then the buyer advises the trade payable finance company to pay the invoice on a certain date. Optional early payments can be arranged and the fees can be negotiated between the buyer and the seller.