Letters of Credit: Still a key tool in global trade

Letters of credit (LCs) remain one of the most vital financial tools in global trade, providing assurance and security to both buyers and sellers. Despite being centuries old, LCs remain relevant in today’s economy, especially during heightened political and economic uncertainty. But what makes this instrument indispensable, and how does it work? SEB’s letter of credit expert Jonne Perä explains.

An LC acts as a financial guarantee provided by a bank, ensuring that a seller receives payment for goods or services if agreed conditions are met. These conditions include shipping details, details of the quality and quantity of the goods, and other contractual obligations. This offers peace of mind for sellers, particularly when dealing with unfamiliar buyers or entering new, high-risk markets.

On the other hand, buyers benefit by ensuring that payments are only made when agreed-upon conditions are met. This mutual safeguard is critical in facilitating trade, especially when trust or legal frameworks are limited.

Why LCs Matter in uncertain times

In volatile markets, LCs become even more critical. They protect exporters from risks such as buyer bankruptcy or unexpected political upheavals in the buyer’s country. Banks can also add layers of security to the exporter, such as confirmations, which mitigate the risks associated with the issuing bank or political climates.

Experts argue that while LCs are often perceived as complex and labour-intensive, their reliability makes them a go-to solution when the stakes are high. For instance, in trade wars or fluctuating currency risks, LCs provide a stable framework that locks in terms at the time of agreement, regardless of what happens later.

Challenges and innovations

Setting up and managing LCs can often be cumbersome, requiring extensive documentation and manual checks. The International Chamber of Commerce (ICC) provides a set of rules collectively known as UCP600, which banks follow globally.  However, the parties often add unnecessary or ambiguous requirements, making document discrepancies common.

Banks, therefore, frequently reject initial submissions due to errors, omissions, or simply differences in interpretation. Sometimes, banks submit their disagreements to the ICC Banking Commission for review and resolution. This involves technical advisors and a voting process among national committees. The result leads to an Official ICC Opinion, which then sets a precedent for similar situations in the future. The ICC calls this an International Standard Banking Practice and they publish them in a digital library.

The seller must make a complying presentation to gain the benefits of LCs. This is crucial to understand as it’s a uniquely challenging element of LCs. It’s too often overlooked, and sellers operate on the premise that the buyer will accept the discrepancies.

The official ICC Opinion 470/TA.936rev, published last year, reminded us that even after accepting four consecutive similar presentations, the issuing bank refused the fifth one. And they had every right to do so. Another overlooked detail related to UCP600 article 16 is that when the buyer waives the discrepancies, it is up to the issuing bank to accept it. This may cause unexpected additional delays for payment.

Close collaboration is highly beneficial

Clients should collaborate closely with their bank to simplify the LCs and pay careful attention to details. Tailoring clauses and keeping requirements minimal can significantly reduce complications.

The ICC has made great efforts to reduce the number of discrepancies by publishing guidance on some of the common causes of disputes, such as the use of drafts in letters of credit and non-documentary conditions. These are freely available in the ICC digital library and are highly recommended for all trade finance practitioners to read. In addition, training sessions, such as SEB's “LC Master Class,” help clients navigate these challenges and improve compliance.

The industry is also exploring digitalisation to streamline LC management. Electronic documents, OCR (optical character recognition) tools, and AI-based systems are being tested to reduce manual work and enhance accuracy. While the complete adaptation of these technologies is still in their early stages, they promise to make trade finance more efficient and accessible.

Looking ahead

As global trade evolves, so too does the role of LCs. Innovations in digitalisation and AI are expected to reduce processing times and make the product more attractive to businesses. However, the fundamental purpose of LCs – ensuring security and trust in trade – remains unchanged. For exporters and importers navigating a world filled with uncertainties, LCs continue to provide a safety net that few other tools can match. Just remember to keep it simple and precise.