LCs Compared with Standby LCs

[John Hamilton]

Is documentary credit more popular than standby letter of credit? What are the advantages and disadvantages of using these two types of credit support from an exporter's point of view? Can exporters rely solely on bank confirmation to counteract country risk?

[Daria Avdeeva]

Dear John,

your 3 questions can easily make for the master's thesis on trade finance as they demand quiet a lot of info. To be very concise: export letter of credit is a PAYMENT instrument, i.e. through which payment to you, as an exporter, will come. Standby letter of credit is a GUARANTEE (passive instrument until default situation occurs) and the payment under transaction will happen outside Standby. Thus, their "popularity" depends on the purpose behind using the instrument.

Without knowing details of the transactions, tenor, country, etc., it is difficult to advise any particular method of payment. However, from what I understood it might be easier to use a letter of credit.
Make sure in this case that issuing bank has a good standing (the better the bank, the less risk and - not least - less cost for confirmation). And yes, confirmation from your bank "added on top" of the letter of credit covers the country risk. However, please bear in mind that confirmation makes sense when you can present compliant documents under the LC.

[Vadim Gusev]

I permit myself to make a compliment to Dasha ... Dasha hi!!! However, Dasha, let me comment on your posting - not only confirmation but in general LC itself makes sense when the bene has a possibility to present the LC compliant dox …. this is the only comment of mine … ooops, only one thing to mention – it seems that LC is somehow better than SBLC because in case LC is used you approach the bank on the very beginning of the “situation”, i.e. the goods are shipped and there is a need to pay – issuing bank HAS to pay and then they may approach the customer for being reimbursed, in case of SBLC all are aware that the payer failed to pay and issuing bank may try to avoid payment with regard to the discrepant document as the case … I personally would always relay on the NOT SB LC if I would an exporter … this is my personal point of view

[ThosHrubecky]

Resurecting an old topic; here is my high-level overview of Documentary Letters of Credit...

Documentary Letters of Credit come in two types: (a) Commercial (a.k.a. Trade) Letters of Credit -which John has refered to simply as an LC - and (b) Standby Letters of Credit. Both types of LC are credit instruments issued by a bank typically requiring establishment of a Line of Credit on behalf of the Applicant. Both types of LC substitute the Issuing Bank’s risk for that of the Applicant. Both types of LC represent the bank’s promise to pay a Beneficiary’s drawing upon satisfactory compliance with the LC’s terms and conditions. Drawings under both types of LC take the form of documents as stipulated within the LC. Without goimg into detail concerning the process of documentary presentation, the Issuing Bank’s LC operations staff will, upon presentation of documents, examine the documents to determine if they comply with the LC’s terms and conditions. When the documents comply, the Issuing Bank is obligated to make payment as per the terms stated in the LC. Both types of LC are issued subject to internationally accepted rules of practice published by the International Chamber of Commerce (the ICC).

Commercial (a.k.a. Trade) Letters of Credit:
As its name implies, this type of LC is used in support of an underlying commercial trade transaction. Typically these are international transactions and, for the purpose of understanding the participants roles and responsibilities, they are often sub-divided into Import LC and Export LC categories. The Import / Export sub-division is simply a relative term referring to a party’s position within the transaction. In other words, the Applicant’s (Buyer’s) Import LC is the Beneficiary’s (Seller’s) Export LC. The LC is the method of payment for the underlying commercial trade transactions and consequently banks expect these LCs will be drawn upon. Commercial LCs are currently issued subject to the Uniform Customs and Practice for Documentary Credits, 2007 Revision, ICC publication number 600 (UCP 600). The Commercial LC is a well established financial instrument; banks have been issuing them for several hundred years.

Standby Letters of Credit:
Typically, this type of LC is used as security that certain actions will/will not occur and provides the Beneficiary redress in an event of default by the Applicant. Consequently, banks expect that these LCs will NOT be drawn upon. They are issued simply to stand-by in the event of a default. Standby LCs are issued subject to either UCP 600 or the International Standby Practices approved by the ICC Commission on Banking Technique and Practice in April 1998 under ICC publication number 590 (ISP98). The Standby Letter of Credit is a relatively recent instrument with its usage increasing from the mid-Twentieth Century.

I hope you find this useful even if it is not very timely. (BTW... First post... Hello!)

[ThosHrubecky]

After re-reading my response, I feel I should better address the OP's queries.

As to which type of credit is more popular, it really comes down to how the instrument is being employed over the period of your relationship with the buyer; horses for courses. Just make certain the obligated bank(s) is (are) financially sound. Ultimately you'll have to agree some form of trading terms with the importer. You should make certain to consider the duration and frequency of transactions and - perhaps most importantly - the associated fees.

From an exporter's point of view, a commercial LC is the logical first choice because, when structured correctly, it accurately reflects the underlying sales contract. It's very straight forward; once you present credit complying documents (perhaps not as easy as it sounds!) you can expect settlement as per the LC terms. A commercial LC is a particularly useful instrument for one-off deals and at the beginning of a relationship between buyer and seller. Keep in mind that each commercial LC will have transaction charges associated with it; you are likely to be responsible for some of the charges. (Pay attention to the LC's charges clause; e.g. All bank charges outside the issuing bank are for the beneficiary's account.)

If there are numerous transactions and the relationship grows more comfortable, the exporter may agree to trade on open account terms. At this point the SBLC backing makes sense to cover the risk of payment default on the open account invoices. The importer would likely want to offer this option when transactions become so numerous that his individual commercial LC transaction fees sum up to more than his SBLC fees. (At this point the exporter can expect his LC transaction costs to go away since he expects settlement outside the LC. If the exporter keeps his unit costs the same as under LC terms he'll see an effective increase in his margin.) As a rule-of-thumb in the USA, SBLC exposure commissions typically cost the SBLC applicant the spread over his base rate of interest (e.g. annual exposure commission would be 1.5% per annum when borrowing costs are LIBOR + 150 bp).

With regard to country risk, exporters can rely on a financially sound bank's confirmation to mitigate country risk. But be cautious about whose confirmation you accept; you may want to set minimum credit rating standards around whose confirmation you'll accept. Mind you, in today's marketplace, that may well narrow your choices significantly!

[Mr. Smith]

I have always wondered why people use the expression 'documentary letters of credit' when the UCP only talks of 'documentary credits' and 'standby letters of credit'.

[ThosHrubecky]

It's interesting that you should say that; I too have wondered why different regions refer to an essentially "universal" product using different nomenclature. It even came up in a Friday evening bar conversation a number of years ago.

In the 23 years that I have been involved in this business, most of my employers (all in the USA) have referred to the instrument simply as a “Letter of Credit” (LC) and then applied a Commercial / Standby sub-classification. Only HSBC insisted on referring to them as Documentary Credits (DCs for short). Back in the early 1990's when I was still in HSBC’s Chicago office, I took some good-natured ribbing from other industry practitioners while making the observation that UCP refers to DCs right on the cover. I remember this because one of the people poking fun at me for over-analyzing the difference subsequently went on to become my wife. Just imagine our dinner parties!