In international trade, the payment modes have changed over time to meet the trading requisites. However, modern times call for modern financial support to strengthen the legitimacy of a deal. This blog explores alternatives to one such trade payment mode, the Letter of Credit.
What is a Letter of Credit?
A Letter of Credit is a mode of payment used by buyers (importers) and sellers (exporters) to facilitate and authenticate an international trade transaction between them.
It is a written document issued by the bank on behalf of a buyer (importer) to the bank of a seller (exporter). It is a guarantee by the buyer's or applicant's (importer) bank to pay the seller or the beneficiary (exporter). The LC ensures the specified sum of money will be disbursed as per the trade agreement in the agreed currency to the seller once they submit the required purchase documents before or by the trade agreement deadline.
What does an LC do for Importers & Exporters?
International trade dealings are affected by many factors like distance, varying international laws, and the pressure of establishing business ties with a seller or buyer. The biggest issue is trusting a party enough to make a faithful deal involving large-scale payments. Therefore, using a trade finance instrument like a Letter of Credit is extremely important because it helps maintain the sanctity of trade between two parties:
- It minimizes risks in international trade transactions where the buyer and the seller may not know one another
- The bank issuing the LC takes up full financial responsibility if the buyer is unable to pay
- Sellers can use an LC to pledge collateral against working capital loans required to fulfil a buyer’s order
Alternatives to Letter of Credit
With technology and state-of-the-art methods, businesses have moved away from the traditional methods of transferring funds towards using modernized alternatives.
A Factoring Service is a type of transaction where a buyer can sell off all or most of the outstanding invoices or accounts receivable to a third party, called a factor house. This payment mode helps the buyer better manage their cash flow, simultaneously maintaining their revenue stability while the seller is paid on time for their goods.
Here is How Factoring works:-
- A seller provides goods to the buyer as part of the trade deal
- The seller raises invoices for the goods provided to the buyer
- Instead of directing its cash flow to fulfil the seller’s raised invoices, the buyer gives up control and sells them to a factoring house
- The factoring house pays the seller majority of the invoiced amount immediately after verifying the validity of the invoices
- Now the buyer just has to pay back the complete amount of the goods to the factoring house directly
- If need be, the factoring house can chase the buyer to make the full payment
- Once they are paid in full for lending out the amount on behalf of the buyer, in return the factoring house pays the seller the remaining invoice amount, minus their fee
A buyer should use invoice factoring when they regularly have a lot of outstanding invoices to pay which could affect their current cash flow. With the help of this, a factoring house could immediately release cash to be paid, full or at least a large sum of it. With this payment mode, buyers experience:-
1.) Improved and more predictable cash flow 2.) Better chance of business surviving 3.) Cheaper and easier than a bank loan 4.) Reduces business overheads
Purchase Order Financing
When a buyer agrees to buy a certain quantity of goods from a seller at a decided price, they send over a purchase order which contains all these details of the deal.
When a seller receives a purchase order and agrees to fulfil the order, that purchase order document then becomes a legally binding contract between two parties - the buyer and the seller.
Receiving a purchase order is great news for a seller but businesses are not always ready to release the required cash flow to fulfil every order. As cash shortages are part and parcel of international trade, sellers look for purchase order financing solutions.
Purchase Order or PO financing is an international trade transaction arrangement where a seller approaches a third party to give them enough money to fund the buyer's order and become capable to hold up to their end of the trade deal.
This alternative payment process focuses on the customer’s creditworthiness. It ensures that businesses can fill orders for their customers, and customers, in turn, can deliver their goods on time. With PO financing, companies can keep up with enormous demands or those placed during high seasonal growth, maintain existing business, and accept new business opportunities.
Revolving Vendor Accounts
If a buyer has a good history of paying its seller on time, it can qualify for revolving vendor accounts. When a buyer has a revolving account with a seller, then a buyer can order and receive materials on credit.
This payment mode allows a customer to make any number of draws within a certain limit during a specific period. Also known as Commercial LCs, this takes place when the bank makes payment directly to the beneficiary or seller.
Many sellers operate under strict requirements that make payments on invoices within a given time from the time of receipt of goods. Revolving LCs are used for multiple payments within a specific time frame. Typically, they get used to businesses that have an ongoing relationship, with the time limit of the arrangement usually spanning one year.
Bank Payment Obligation (BPO)
According to the Uniform Rules for Bank Payment Obligations, the Bank Payment Obligation (BPO) can be defined as ‘an irrevocable and independent undertaking of an Obligor Bank to pay or incur a deferred payment obligation and pay at maturity a specified amount to a Recipient Bank following Submission of all data sets required by an Established Baseline and resulting in a Data Match or an acceptance of a Data Mismatch’.
The BPO is an inter-bank payment arrangement based on the electronic presentation of compliant data to sanction payment for the trade of goods. It involves four parties in a trade transaction - the buyer, buyer’s bank (aka obligor bank), seller, and seller’s bank (aka recipient bank). This automated process is cheaper, more flexible, and allows faster transactions.
Escrow through Trustee
An escrow payment mechanism helps in establishing a successful international trade environment with is seamless and litigation-free. It is a transparent and fair payment method that helps in minimizing the risks between the business requirements of the buyer as well as the seller without favouring either.
Escrow as a service is offered by an unbiased third-party company. It helps to collect, hold and disburse money as per mutually agreed terms between the buyer and the seller. In an escrow payment mechanism, both parties are protected against the potential risks of trade transaction fraud. It is a mutually beneficial method of payment.
Here is How Escrow Through Trustee Payments Works:
- Buyer deposits agreed on purchase amount to escrow service trustee
- Escrow service provider verifies this payment
- Once verified, the seller is obligated to dispatch goods
- Once goods are shipped and the buyer verifies delivery, the payment held in escrow is released to the seller
- Finally, the escrow transaction fee is paid in full by either the buyer or the seller and later on evenly split between them.
The escrow through trustee payment mechanism, therefore, is one of the preferred modes of international trade transaction as it adds a layer of transparency to all trade transactions and helps build trust.
A standby letter of credit or the SBLC is a legal document issued by the buyer's bank and comes into action when a buyer is unable to pay the seller as part of their trade transaction agreement.
SBLCs are not like other LCs. More often than less, in the case of other LCs, the buyer bank makes the payment for the trade to the seller and the buyer later returns the payment back to its issuing bank. In an SBLC, the issuing bank stands by the buyer and only pays if in case the buyer is unable to pay first and defaults. SBLCs are like a safety net for buyers whenever they cannot fulfil the payment for goods.
Because this payment methodology exposes the issuing bank to the highest of risks in a trade payment process, a bank issues an SBLC only when they are confident about a buyer's creditworthiness.
To get an SBLC:
- A buyer needs to connect with its bank to establish their creditworthiness
- The bank can ask the buyer to deposit additional collateral in case the risks or the trade amount is too high
- After the buyer meets the terms and conditions of the trade transaction, the bank certifies them to be fit enough to receive credit
- Finally, the bank issues the SBLC to the buyer and charges them from 1% to 10% of the total amount as a fee to keep the SBLC document valid for the duration of the trade
Documentation or documentary collection is a type of trade financing where the seller receives the payment of their good from the buyer only after their respective banks have exchanged the required trade documentation.
According to the URC 522 ICC regulations, Documentary Collection means the collection of:
- Financial documents accompanied by commercial documents
- Commercial documents not accompanied by financial documents
The process flows for Documentation Collections is :
1.) A seller and a buyer enter into a trade agreement 2.) The seller ships the goods to the buyer 3.) The seller's bank prepares the documentation for the buyer's bank and shares it with them 4.) The buyer's bank receives the documentation and alerts the seller's bank on the receipt 5.) The buyer's bank now informs the buyer of the receipt and asks to release the payment 6.) On receipt of payment, the buyer's bank approves the time draft 7.) Finally, the buyer can now collect the goods
Meant for more stable export markets, these are considered more convenient and cheaper than LCs for a buyer, though the exporter takes on a little more risk. Banks often assist in obtaining payment. However, banks don’t guarantee a payment or verify the accuracy of documents.
According to the URC 522 ICC regulations, Clean Collection means collecting financial documents not accompanied by commercial documents.
This method is a documentary collection in which the financial document is shared with the banks without a bill of lading or other shipping documents. This, in return, provides lower bank costs and reduced collection time between the remitting and collecting bank.
Therefore, this Clean Collection of documentation means sending financial documents i.e. bills of exchange or promissory notes through the banking system in order to obtain payment from the buyer. Commercial documents like invoices, packing lists, transport documents, documents of origin, etc. are sent directly to the buyer.
This trade financing solution requires a high level of trust between commercial parties as the seller loses physical control of their goods in the process.
Consignment in international trade is a financing solution that depends on the customer. It is a variation of the open-account method of payment in which the payment is sent to the seller only after the goods have been sold by a distributor to the end customer.
An international trade consignment transaction is based on a contractual arrangement in which the distributor receives the goods from the buyer, manages, and sells them on behalf of the seller, who till the time a sale is made retains the ownership of their goods. The seller receives the payment for only sold goods.
Trading using consignment is risky for the seller as there is no guarantee of any payment unless their good is purchased and they also do not have authority over their goods since they are controlled by a foreign distributor or agent.
However, consignments help exporters be more competitive while trading. To battle the risks of consignment, it is advisable for sellers to partner with a reputable and trustworthy foreign distributor. Plus, it is safer if a seller has proper insurance in place to cover the goods under the custody of the distributor and to avoid risks of non-payment.
Forfaiting is a trade financing solution where a seller is paid cash when they sell their medium and long-term foreign accounts receivable at a discount to a forfaiture. The forfaiture then gets the sum due from the buyer on the leased payment date. Forfaiting helps sellers improve their cash flow as they are able to cash in their receivables directly without deferring until the payment date. This allows the sellers to trade with foreign buyers who depend on more long financing terms, stretching preferably over months or years. Sellers often pay higher fees with forfaiting as it removes almost all risks of non-payments.
Can a bond be considered an alternative to a letter of credit?
A bond or a surety bond is like a promise made by one party to be responsible for another party's failure to meet trade payment agreements. The bond is insurance protection that keeps an eye out on completing all services performed by one party on behalf of another. If the services are not provided properly and completed diligently, then the party that is prey to the damages because of the inadequate services will be fully compensated.
How does a bond work?
A bond is a legal pact between the principal, the obligee, and the surety.
- The first party is called the principal. The principal could be a single person or a business getting into a trade agreement to provide a particular professional service. The principal is the party who pays for the surety bond.
- The second part is called the obligee. The obligee could be a single person or a business on the receiving end of the services provided by the principal. The obligee is the party that bears the brunt of the trade agreement if the principal does not deliver the promised professional services.
- The third part is the surety. The surety is the entity that will compensate for the damages incurred by the obligee on behalf of the principal if it fails to deliver the promised professional services. Therefore, with the help of a surety bond, an obligee gets assured that it will be compensated if the principal does not meet the trade agreement.
What are the advantages of using a bond over an LC?
In many cases, bonds can be considered a solution instead of an LC from a bank. To name a few, international obligations, performance obligations, paid loss retro programs, workers compensation self-insurers obligations, and security for appeals of a court decision. Surety bonds can provide more advantages compared to LCs:
Flexible Credit Capacity: Surety bonds offer great financial flexibility as they get credited against a company’s bank line compared to an LC tied to its credit capacity, considerably reducing its financial flexibility.
Better Security: Sureties only require a receipt of signed indemnity agreements to issue a bond as compared to banks who can choose to take an interest in the organization’s assets as a requirement to publish an LC
Default Defense: Surety bonds need to find proof of a company’s default from the obligee and work along with the principal to identify defenses. This investigative approach protects the principal from the obligee's custody of the bond proceeds without merit.
Skilled Claims Handling: Surety bonds provide specialties and legal teams to handle altercations and help with the claims processes compared to banks with no claims staff. In banks, clients are to resolve all disputes on their own.
Steady Rates: Surety rates are upfront and stable compared to LCs that incur additional costs like utilization and issuance fees.
How much does a bond cost?
The cost of a surety bond is decided based on the trustworthiness shown by the principal, the person, or the business purchasing the surety bond in the first place. The principal's credit score is considered when deciding the price for a surety bond—also, the cost of a surety bond changes based on who is purchasing it.
Is the Letter of Credit still relevant?
As international trade commences in full swing post the pandemic, corporations demand faster and more affordable ways to send and receive money. As a result, the rise of newer digital payment options is impacting businesses across the globe. This is where legacy payment tools like the LC are falling back.
The LC is a dated way of ensuring suppliers get paid. The process of payment has not changed for over half a millennium. Thus, in this age and time, the LC lacks the flexibility to support cross-border transactions in a matter of days. The demand of the times is faster trade and even faster payments.
The LC involves manual processing and handling, which has been the cause behind countless B2B payment errors. Being manual, any mistake in the document or lack of agreement among all parties involved starting with the buyer, seller, banks and all other supply chain associates lead to an impasse and ultimately non-payment. This expensive, tedious, and time-consuming methodology is the reason why LC’s relevance in the market is gradually diminishing.
That being said, there are a few instances where Letter of Credit documents are still quite relevant, especially in instances of first time trade partnerships between two parties.
Advantages and Disadvantages of a Letter of Credit
Growing Customer Base: It is difficult to establish a new business connection in international trade. Finding a new buyer who is ready to make an advance payment to an unfamiliar and untested seller is challenging. An LC can help a seller increase their trustworthiness and opportunity of securing a trade order.
Larger Scope of Trade: LC helps sellers expand their scope of a trade by regional means when it is effectively used.
Reduces Default Risk from Buyer: An LC helps mitigate the default risk of non-payment from the buyer and makes the buyer's bank account as the LC is a conditional payment undertaking of the issuing bank.
Discounting Options: LC discounting is a credit option extended by the bank. In this, the bank purchases the bills or documents from the sellers and provides a loan on behalf of the good traded after discounting the bill amount i.e. reducing the applicable charges. Once the LC issuing bank complies with the documents, the respected bank can discount the credit.
Assurance of Creditworthiness: By issuing an LC from a reputed bank, the buyer demonstrates being a financially reputable business.
Favourable Payment Terms: LC provides more options for payments to a buyer. A buyer can convince the seller to adopt a deferred payment plan instead of an on-sight payment through an LC. As the buyer can discount the credit any time after the complying presentation, making deferred payment easy. The most frequently used deferred payment options under the LC are 30 days, 60 days, or 90 days after the bill of lading date.
Defined Shipment Timing: An LC can help buyers define the shipment period. If in case the buyer is unable to ship the goods on time, then they have to face late shipment discrepancy issues.
Lack of LC Knowledge: The LC is one of the most complex international trade financing solutions. Sellers must be cautious while using it as without the right expertise and experience, they might have to encounter unfavourable consequences. The seller could opt for Invoice Factoring or Purchase Order Financing as their trade financing solution to get the support and clarity to make the trade payments.
Costly Bank Fees: Sellers might have to pay higher fees to the bank missing the LC under various titles compared to other payment methods. Sellers could adopt an Escrow payment process where the fees will be split between the two parties or they could also select Standby LCs with a charge between 1-10% of the total amount.
Time-Consuming Process: An LC is a conditional payment undertaking given by the issuing bank. The specified condition is called Complying Presentation - a presentation that is in agreement with the trade terms. Therefore, a complying presentation is challenging and a time-consuming process.
Documentation Fraud: Commonly highly unlikely but there is a possibility that untrustful buyer parties could submit false trade documentation to reach the funds under LC. This could be negated with the Documentation Collection or Clean Collection trade payment arrangements where the various trade documents would be required to conduct the transaction.
Costly Bank Fees: Just like the sellers, even buyers have to pay a higher LC fee to the banks under this trade transaction solution.
Inconsistency in Goods: Once the LC issuing bank complies with the trade presentation, the payment is initiated and it is not easy to stop it. This could result in the buyer ending to pay for the goods, even if they are inconsistent with the pre-decided trade agreement.