The problem with issuing letters of credit covering the movement of goods that is even more acute with standby letters of credit (SBLC), is acceptability. The issuer must be acceptable to the beneficiary otherwise they feel they have no security. A commercial letter of credit at least has a commercial transaction behind it where the goods being shipped have value and payment can be withheld.
Banks issuing letters of credit are bound by a code of conduct and conduct their business in accordance with Uniform Customs & Practice for Letters of Credit (UCP). This is a set of guidelines covering all aspects of letter of credit operations issued by the International Chamber of Commerce (ICC).
The ICC issued a paper recently on the subject of “non-bank issuance of letters of credit”. It maintains that while legally any entity can issue letters of credit, the advising of those L/C’s may be confusing. Although it may state on the document (usually issued these days by SWIFT) that the L/C is covered by UCP, the opinion of the ICC is that they are not, since UCP is specifically designed for issuance by banks.
Since banks seemingly have the monopoly on issuance of letters of credit they make the cost of issuance expensive and, despite the fact that they are specifically denied the right by the Financial Services Authority (FSA) to tie in ancillary services like invoice finance and foreign exchange to further improve revenue, they will often try to “tie in” their client to an all in service.
As is often the case a low(er) cost alternative is constantly being sought and it is being considered by Fintech companies in the same manner as corporate foreign exchange, which has migrated away from banks in recent years.
Standby Letter of Credit
In the case of a standby L/C(SBLC), the picture is a little clearer. While an SBLC (standby letter of credit) is simply a guarantee, usually of a performance like maintenance of a piece of equipment or regular servicing by a trained engineer, the use of an SBLC makes the whole process easier. That is because the substitution of an SBLC is often cheaper and the wording and payment process are less complicated than a standard guarantee which is a legal as opposed to a commercial document and as such when dealing with parties in two jurisdictions can be open to interpretation.
Standby Letter of Credit Financing
SBLC financing is a common method used by the beneficiary to guarantee the viability of his machinery to his bankers. The bank will be aware that should there be any issue in their client’s production due to a fault in his production he will have a financial fall back that will keep the client financially viable. This provides a level of comfort to the bank to provide funding.
Fintech companies are actively reviewing their ability to issue standby letters of credit as a first step in the process to becoming part of the ICC UCP process. Banks are (generally) sufficiently sound to be able to offer lines of credit, against which they allocate a percentage of capital, to their customers. In the case of Fintech, a system of cash coverage in a similar manner to the deposits taken to cover forward foreign exchange transactions will need to be introduced.
In the current environment, there are very few alternatives to letters of credit, due to the issue of acceptability.
An irrevocable confirmed commercial letter of credit that conforms with UCP 600 of the ICC is the “perfect animal” for the smooth operation of trade finance operations since it provides security to all parties.
Banks will feel that they are the perfect conduit for providing the service, but that was the view regarding foreign exchange transactions ten or fifteen years ago. With the pace of financial services innovation moving at eye-watering speed it is entirely possible that the landscape could change at any time.
About Alan Hill
Alan has been involved in the FX market for more than 25 years and brings a wealth of experience to his content. His knowledge has been gained while trading through some of the most volatile periods of recent history. His commentary relies on an understanding of past events and how they will affect future market performance.”