Letters of Credit concept and the inherent benefit to business growth

When I started my banking career around 2008 right from the University of Ghana, Legon with a certain global bank, I was privileged and honoured to join their Transaction Banking (TB) team and in fact, that team was the product development and sales specialist supporting the Client Coverage unit within its Corporate and Institutional Banking. I can confidently say those moments were the turning point of my career, I was so much exposed to Cash Management, International Trade Finance and Securities Services products. While I could close my eyes and deal with Cash Management products with no high temperature, Trade Finance was the reverse at the time. Trade Finance appeared so technical and broad.

Thankfully, with years of experience, it was actually less daunting than imagined. This was also because, the products in Trade Finance range from Flow and Financial Institutions (FI) Trade, Open Account Trade (OAT), Structured Solutions, Trade Distributions etc. Having worked in TB, I realise that, very few people knew the importance of opening Letters of Credit (LCs) as a means of payment to clients. This article shall focus on a few aspects of LCs. This piece is very important because LCs are major products and services commercial banks deliver to their customers.

As at 2019, the global Letter of Credit confirmation market size was valued at USD4.30bn and even projected to reach USD4.99bn by 2027, growing at a CAGR of 3.18% from 2020 to 2027.This is according to a report published by Global Opportunity Analysis and Industry Forecast, 2021-2027. Major factors driving the growth of Letter of Credit Confirmation Market size are the rise in demand for customized trade finance solutions and regulatory support in the growth of strict regulations for a secured letter of credit confirmation services.

Interestingly, the increased risk of non-payments is driving the growth of the letter of credit market size. As global trade grows, both importers and exporters are largely taking security steps against their trade documents in order to avoid the risk of payments in the market. Moreover, the seemly lack of confidence between the exporter and the issuing bank located in Countries of high political or economic instability, confirmation of the letter of credit document is considered safe for global trading. Thus, traders today prefer LC confirmation services, thereby increasing the market size.

Furthermore, increased business operations and foreign trade between SMEs and large enterprises offer lucrative opportunities for confirming banks to expand their business in the letter of credit confirmation services in the market.

Importantly, with the emergence of Fintechs, new technological developments are expected to increase the LC market size. Advancements in technologies such as blockchain and Distributed Ledger Technology (DLT) are all expected to create lucrative opportunities for the LC confirmation industry. As a result of these technological advances, credit confirmation providers can create a digitized letter of credit contract in real-time, warn auto alerts to trades, and improve business efficiency in the marketplace.

In addition, in order to ease the conventional & lengthy process of reviewing trade documents by banks and clients, traders are expected to introduce the letter of credit confirmation services, which in turn is expected to provide lucrative growth opportunities. The untapped potential of emerging economies is expected to provide lucrative growth opportunities for the letter of credit confirmation market. Developing economies such as Ghana provide substantial opportunities for confirming banks to increase their business by improving their product offerings and promoting the growth of trade operations. In this piece of article, the focus is to demystify the overall concept of LCs and how businesses can leverage on it to expand their business growth.

Why use Letter of Credit

In simple terms, a letter of credit is where a bank undertakes to make a payment, separated from the sales or other contracts on which it is based. As already mentioned, it is just a way of reducing the payment risks associated with the movement of goods. Expressed more fully, it is a written undertaking by a bank (issuing bank) given to the seller (beneficiary) at the request, and in accordance with the buyer’s (applicant) instructions to effect payment- that is by making a payment, or by accepting or negotiating bills of exchange (drafts)-up to a stated amount, against stipulated documents and within a prescribed time limit.

An LC is essential when a buyer and seller have to consider the mode of payment in the course of negotiating the transaction. Generally, payment can be made in several different ways: by the buyer remitting cash with his order; by opening an account whereby the buyer remits payment at an agreed time after receiving the goods; or by documentary collection through a bank in which case the buyer pays the collecting bank for account of the seller in exchange for shipping documents which would include, in most cases, the document of title to the goods.

In the aforementioned methods of payment, the seller relies entirely on the willingness and ability of the buyer to effect payment which I see to quite risky. Even though the open account option of payment is largely used, the buyer is forced to source for immediate forex to pay the seller. This is not so considerable, on the basis that in the event of dollar liquidity squeeze on the market, a buyer may end up breaching trust with business partner when payments are not made.

Importantly, I have seen that when a seller has doubts about the credit-worthiness of the buyer and wishes to ensure prompt payment, the seller/supplier can insist that the sales contract provides for payment by irrevocable letter of credit.

Furthermore, if the bank issuing the letter of credit (issuing bank) is unknown to the seller based in another country or if the seller is shipping to a foreign country and is uncertain of the issuing bank’s ability to honour its obligation, the seller can, with the approval of the issuing bank, request its own bank- or a bank of international repute such as Standard Chartered Bank - to assume the risk of the issuing bank by confirming the letter of credit. When the seller has doubts about the credit-worthiness of the buyer and wishes to ensure prompt payment, the seller can insist that the sales contract provides for payment by irrevocable letter of credit.

Brief LC Issuance Process flow

Some basic types of LCs

There are three basic features of letters of credit, each of which has two options. Each letter of credit has a combination of each of the three features. In addition to these basic types, there are various specialized formats which meet particular sets of circumstances such as Red Clause Letter of Credit, Transferable Letter of Credit, Back-to-Back Letter of Credit Deferred Payment Letter of Credit and Standby Letters of Credit.

Key Features of LCs

• Being Sight/Usance.

This feature of LCs basically permits you the beneficiary to be paid immediately upon presentation of specified documents (sight letter of credit), or at a future date as established in the sales contract with your supplier (term/usance letter of credit). It means that as soon as all the relevant information’s are provided, you receive the funds.

• Being Revocable or Irrevocable

LCs are revocable. What this means is that it can be cancelled or amended at any time by the issuing bank without notice to you the beneficiary. However, drawings negotiated before notice of cancellation or amendment must be honoured by the issuing bank. Inversely, an irrevocable letter of credit cannot be cancelled without the consent of the beneficiary. Meaning, you the applicant permission is required before any action can be taken.

• Being Unconfirmed or Confirmed

An unconfirmed letter of credit basically carries the obligation of the issuing bank to honour all drawings, provided that the terms and conditions of the letter of credit have been complied with. Inversely, a confirmed letter of credit also carries the obligation of another bank which is normally located in the beneficiary’s country, thereby giving the beneficiary the comfort of dealing with a bank known to him.

Benefits of Letters of Credit

The benefits of using letter of credit for your business are numerous and these apply to all parties, be it the Importer (Buyer), Exporter (Seller) or the Banks issuing or confirming the LCs. For an importer, you have the flexibility of Cash resources not being tied up and this is due to the time it takes for the goods to arrive and the tenor of the LC. You also make sure that payments are made to the seller when the terms and conditions of the letter of credit are compiled and lastly, you can control the shipping dates for the goods being purchased.

For the Seller, as a business deciding to use LCs, you open doors to international trade by providing a secure mechanism for payment upon fulfilment of contractual obligations. While working in Sierra Leone a couple months, I saw even Small and Medium Enterprises opening LCs to pay for their transactions. This is because Financing opportunities, such as pre-shipment finance secured by a letter of credit and/or discounting of accepted drafts drawn under letters of credit, are available in many countries. Importantly, Banks expertise is made available to help complete trade transactions successfully. You are also not limited to specific bank for LCs issuance.

Role of Uniform Customs and Practice (UCP 600) and its importance.

There is no way to transact your Letter of Credit without paying close attention to the Uniform Customs and Practice for Documentary Credits (UCP 600). It is an internationally agreed upon set of rules for all parties involved in all types of letter of credit transactions. The rules, which were adopted by the International Chamber of Commerce in Vienna in 1933, have been revised several times and are used by banks in practically all countries. Currently the UCP 600 which was issued on 1st July, 2007 are this rule guide trade finance transactions. UCP600, currently applicable, is a set of rules which, when not in contravention of local laws, are binding on the parties who have adopted them.

The authority of UCP600 lies in its universal acceptance which is acknowledged by a statement on the letter of credit itself. All Documentary Letters of Credit are issued subject to UCP 600. Copies are available upon request from your Bank.

Basic steps in to open an Import letter of credit

Commercial Banks and other Financials Institutions are able to assist with opening an LC. You can approach your bank to open a Letter of credit. The concerned officer at the bank helps you in filling up necessary application to open an LC. Since the LC is opened on the basis of your purchase contract, a copy purchase order / export contract has to be produced along with other required documents. Some of the key documents required to in the LC issuance process include: Shipping Bill of Lading, Airway Bill, Commercial Invoice, Insurance Certificate, Certificate of Origin, Packing List, and Certificate of Inspection etc.

In summary, with a letter of credit, a bank can neutralize a corporate customer's country and bank risk by offering a confirmed documentary credit once the customer relies on the bank's solvency, knowledge, and professionalism. By conducting export sales transactions under an irrevocable letter of credit, you the seller does not have to determine the credit standing of the foreign buyer. Letters of credit are issued in many different forms from foreign banks and financial institutions. The variations are due to differences in customs and regulations of trade and finance in the country of origin of the issuing bank or financial institution. If, for any reason, a seller cannot comply with one or more conditions of a letter of credit, it is absolutely imperative for the seller to contact the buyer to arrange for one or more amendments to the original agreement

It is important to remember that, you don’t need to use your liquid cash to pay for immediate goods if you can speak to your banks to open a letter of credit, take advantage and free up cash in your operating cycle. As a local business that want to compete globally, building and sustaining credibility and getting the right exposure is very important for business growth, International Trade Finance is the next level.

Thank you for reading.

Disclaimer: The views expressed are personal views and doesn’t represent that of the media house or institution the writer works.

About the writer

Carl Odame-Gyenti, PhD is a Banking, Finance, and Investment professional. Director; Banks Broker Dealers with Global Bank in Ghana. Contact: [email protected] , Cell: +233 200301110