Drawbacks of Letters of Credit
On the flipside, DCs can be very detailed, so strictly complying with the terms and conditions can be problematic for some exporters. The fundamental reason the exporter asks for the DC as the trade settlement method is so they have better control of documents through the banking system and the issuing bank’s protection. As discussed, this protection is weakened if they fail to present compliant documents, which can result in the payment undertaking being waived.
Banks will generally charge handling fees for processing DCs and assuming the payment risk; both exporters and importers may incur fees, so if buyer and country risk are sound, exporters might choose to settle using a method that incurs less cost.
Exporters that have strong credit policies find using DCs appealing as it reduces credit risk by replacing buyer risk with the risk of the issuing bank. Many exporters insist on DCs for all sales, particularly in emerging export markets.
Where the trading relationship with the buyer is a new one, an exporter may wish to use a DC for initial trading, then move to a different payment method once trust and a track record with a buyer has been established.
Letters of Credit and risk
In recent years, DC use declined as exporters became more comfortable with counterparty global risk, given the ability to attain information quickly through electronic sources. The long period of buoyant conditions and the desire to minimise costs saw a marginal decline in DC use. Other payment methods include open account payment, clean settlement by international payment without involving documents through banks; and documentary collections where banks, on behalf of exporters, handle documents without the implicit payment undertaking that a DC provides.
Each method carries its own pros and cons, however, the only way an exporter can gain more safety than a DC is to be paid in full pre-shipment. In many occasions this is not commercially viable as the importer would be take the risk of non-delivery of goods.
With the recent turmoil in financial markets, and subsequent defaults by corporations, including banks, on the rise, exporters have returned to the relative safety of DCs to mitigate payment risk issues and to allow a better control of documents through the sale process.
There will always be a place in the market for DCs as they offer a secure way to facilitate cross border trade. Recent statistics suggest that DC activity has increased during this period of economic turmoil, which is a swing away from trends in the past decade. One could reasonably expect that post-global financial crisis, when exporters confidence returns, the level of DC settlement will again stagnate.
Exporters with strong credit policies have and will continue to use DCs. In some markets, exporters trading on DC terms get better access to credit lines for working capital use.
—Geoff Cox is the general manager of Trade and Supply Chain Finance and National Australia Bank: www.nabgroup.com
