In April 2022's blog, Island Leaf Commodities examines various letters of credit (LCs) and why they're crucial for purchasing physical commodities. Because Island Leaf deals in bulk-commodity marketing, we have first-hand experience dealing with LCs. Thus, we'd like to provide our audience with the historical background and evolution of letters of credit. Then, we'll discuss LC types, the LC application process, and the role LCs playing in executing bulk commodities procurement.
A Simple Transfer Is Not Enough for High-Value Physical Commodities Buying
Over a decade's worth of international trade experience has exposed the Island Leaf team to several commodities procurement situations. Ultimately, we've learned that procurement methods differ greatly from product to product, especially when comparing recycled plastics procurement procedures to those of traditional commodities.
Executing most traditional commodities contracts requires spending exorbitant sums of capital. For example, the total money involved in purchasing just one monthly load of a physical commodity such as ICUMSA 45 sugar or non-GMO soybeans can exceed $25 million, bringing the yearly contract value to about $300 million. Compare this to the monthly transactional value of an average ongoing plastics deal, about $80,000. Obviously, the difference in value immediately becomes apparent.
In the above plastics-purchasing example, the buyer will, most likely, pay the seller in two stages. After negotiation, the first payment stage will immediately (a few days) commence. It comes in the form of a deposit. Then, after the seller loads all the material and provides the needed documentation, such as loading photos, a packing list, weight tickets, and a draft bill of lading, the purchaser will pay the remaining balance. In most cases, the procuring party wires money directly from his or her bank account to the seller's bank account. However, the buyer almost always sends money by telephonic transfer (TT) for plastics transactions.
Because a bulk commodity's shipment value will most likely exceed recycled plastics', sensible sellers exhibit anxiety when collecting their money from buyers. This anxiety can reach acute levels when entering into a contract with unknown buyers.
Fortunately for both parties, the modern financial system has an evolved feature that provides a panacea to soothe sellers' concerns. This panacea for commodities-selling nervosa comes from banks in the form of a letter of credit (LC). Before we delve into the letter of credit application and confirmation process and the varying LC types, we'll briefly describe how LCs evolved into their current form. The Island Leaf team loves telling a good history story.
Letters of Credit: A Historiography
Throughout the centuries, merchants and traders have used a variety of financial instruments to procure commodities and other goods. Ancient- Egyptian checks written on papyrus, 18th-century bills of exchange, and late 19th-century circular letters of credit all highlight how trade financing has steadily evolved. LCs are one result of this evolution. Due to trade-finance history's deep complexity and lengthy-time span, we will dedicate this section to the history of letters of credit only. We realize we could write several thousand words about the history of trade finance—this is something we may consider for a future blog.
Rudimentary precursors to LCs existed in ancient Rome. Romans substituted bank notes for gold coins when dealing with high value transactions such as land-procurement. These notes guaranteed large cash payments to sellers because buyers did not want to physically transport thousands of gold coins across stretches of ocean or land from one location to another. However, it wasn't until the 1200s that financial instruments more resembling today's LCs began to take shape. Almost 700 years after the last Caesar ruled over Rome, Italian bankers had devised a note issuance system similar to the one used by their Roman forefathers.
By the early 1400s, leading members of the famously powerful Florentine family, the Medici, had established themselves as Europe's premier financiers. The Medici family literally constructed brick and mortar banks throughout the European continent, and pioneered new financial innovations. These include methods and instruments financial professionals use to this day, such as double-entry bookkeeping and bank guarantees for debts. These guarantees eventually became known as LCs.
By the 1600s, trade in Europe had drastically changed. Ultimately, the establishment of new colonies throughout the world affected global trade. Continent-hopping merchants needed some form of guarantee that they would receive full payment after having crossed several thousand miles of potentially hurricane-ridden and pirate-infested oceans. As a result, usage of Medici-invented bank guarantees disseminated widely, eventually becoming known as "circular letters of credit." Ultimately, businesses used circular letters of credit until the mid-20th century, when the advent of digital technology eclipsed the need for paper.
Letters of Credit Today
While this article focuses on how commodity buyers and sellers use LCs, companies engaged in various sectors also use LCs. Any transaction that involves a substantial sum of money—such as those involving construction or real estate—can potentially benefit from an LC's guarantee. So just how does a company go about opening a letter of credit? And then, how do letters of credit function during a transaction?
Applicant and Beneficiary
As we stated at the beginning of this article, commodities-procuring parties use LCs as insurance due to the vast monetary sums needed. Additionally, when buyers and sellers use LCs, they naturally bring two more parities into the fray: the buyer's bank and the seller's bank.
So, how does the process of obtaining and subsequently using an LC to make payment work?
First, after the buyer and seller have done background checks on each other and reached an agreement about all aspects of the traded commodity—this includes quantity, payment terms, price, specifications, delivery time, etc.—they will both sign a contract, known as a sales and purchase agreement (SPA). The SPA details all the terms and conditions of the transaction to which the buyer and seller explicitly agree. Then, the buyer will go to his or her bank and apply for an LC by filling out all the necessary paperwork.
Applying for an LC makes the buyer the "applicant." In turn, the seller becomes the "beneficiary." The applicant's (buyer's) bank will determine if the applicant has sufficient funds for the allotted contract period and review other terms and conditions found in the SPA. If the applicant's bank approves, it will send the beneficiary's (seller's) bank a draft version of the potential LC; this is known as a "draft LC." We note that the applicant pays no fee for obtaining a draft LC.
Upon the beneficiary (seller) bank's approval, the applicant will open the LC, which comes with a fee. When the LC opens, the applicant's bank holds the allotted amount of money needed for the transaction in escrow from the applicant's account. The applicant's bank will release the funds to the beneficiary when the beneficiary fulfills specific requirements as per the SPA.
This process of opening an LC is universal. However, each LC has different attributes, which can benefit the applicant over the beneficiary or vice-versa. Ultimately, the SPA will specify the LC type. Below, we'll review LC types and different functions that each LC can potentially perform
DLC vs. SBLC: Nuts and Bolts
LCs fall into two large subcategories: a Documentary Letter of Credit (DLC--also known as an "at-sight LC") and a Standby Letter of Credit (SBLC). First, we'll describe DLC and SBLC similarities.
While differing slightly as per differing bank rules and contract values, the application process tends to be similar for both DLCs and SBLCs. Upon approval of both a DLC and an SBLC, the applicant's bank will hold the fund amount stipulated by the contract in escrow.
Another similarity between DLCs and SBLCs is the ongoing communication between the applicant and beneficiary bank. The applicant's bank confirms that the applicant has opened an LC with the funds required by the contract and then sends a SWIFT 799 message to the beneficiary's bank. This message confirms that the applicant's bank is currently holding the funds needed to execute the commodity's purchase. Both banks will use the SWIFT system to communicate throughout the transaction. Island Leaf Commodities created an infographic describing the SWIFT system, which readers can find on our LinkedIn Business page.
After the beneficiary (seller) has fulfilled the obligations required by the SPA, the seller will submit the proof to his or her bank in the form of documents. The beneficiary's bank then sends the documents to the applicant's bank; the beneficiary must send at least one set of official-document copies to the applicant. At this stage, the difference between a DLC and an SBLC becomes apparent.
SBLC and DLC Differences
DLCs mandate that the bank itself must release the funds after reviewing the documents package. However, when the applicant uses an SBLC, the buyer must notify the bank to release all the funds. Therefore, SBLCs favor buyers because they themselves review all the needed documents and can determine if any document appears strange, unorthodox, or downright fabricated. Bankers, who might not have commodities-industry-specific knowledge, could miss subtle-scam tells when reviewing the required DLC documents. Or, they could miss an SPA-nullifying fine detail found in one of the testing reports.
We also emphasize that SBLCs guarantee the seller will receive the agreed-upon-fund amount for the commodities imposed by the SPA, even if the buyer doesn't have the funds. Where do these funds come from if the buyer becomes insolvent? SBLCs require the bank to purchase the commodity from the seller, becoming the commodity owner.
Sellers working with Island Leaf Commodities prefer to use SBLCs. SBLCs' advantages are that they give buyers more autonomy in the commodity-procurement process, while at the same time guaranteeing that sellers will receive their payment. Bank-guaranteed payment is essential to sellers because sellers often go millions of dollars out-of-pocket to secure the commodity itself and purchase logistics services. Unfortunately, some countries have laws preventing SBLCs' usage, thus accepting only DLCs.
Other LC Functions
Besides the significant differences between an SBLC and DLC described above, an SBLC and a DLC might have some additional functions. These functions can drastically change how the LC's financing operates and introduce helpful features. Keep in mind that both parties agree to these functions in the SPA.
Transferability: Transferrable or Non-Transferrable
Beneficiaries (sellers) must pay money upfront to procure the commodities in question from a processor or pay in advance for logistics services. If the sellers don't have the cash on hand, they will either monetize the LC or request a transferable LC. Using a transferable LC, the applicant's bank immediately gives the seller access to some or all of the capital denoted in the LC. Sellers, in turn, must repay the bank. Repayment usually occurs after the applicant has paid the beneficiary in full.
Revocability: Revocable or Non-Revocable
Revocable LCs are pretty rare, mainly since they overwhelmingly favor the buyer. If an SPA stipulates a revocable LC, buyer has the right cancel the LC at any point in time during the transaction. However, because of the harrowing possibility (to the seller) that the buyer can cancel after the seller purchases the goods from the processing plant, revocable LCs present a gargantuan risk to the sellers. Thus, the vast majority of sellers will not accept revocable LCs.
3rd-Party Bank: Confirmed or Unconfirmed
A seller will use a confirmed LC when he or she is not satisfied with the creditworthiness or asset size of the buyer's bank. In most cases, sellers require buyers to open an LC with a world top-50 bank. This is because world top-50 banks have very deep pockets and heaps of international business experience. Suppose the buyer can't open an LC with one of these financial mammoths. In that case, the seller will have two choices. First, the seller can reject the buyer, shutting off all potential of revenue possibilities for both sides. The second, and more promising option, is for the seller to require a confirmed letter of credit. A confirmed LC brings in a third-party bank. The third-party bank assumes the responsibility of financially backing the buyer and the buyer's bank if the buyer does not reach his or her purchasing obligations. Most of the time, the third-party bank is indeed a world top-50 bank. Usually, acquiring a confirmed LC comes at an extra cost to the buyer. The third-party bank requires that the buyer provides some collateral.
An Ongoing Nature: Revolving vs. Non-Revolving
Because LCs guarantee and facilitate contractual payments that recur for an extended time—usually at least a year—banks offer a feature to make their LCs work in automatic tandem with the payment schedule specified in the SPA. This feature makes the LC revolving. Instead of opening a new LC for each payment in a non-revolving LC, banks automatically block out the buyer's required funds, usually every month (or as mandated in the SPA). Banks tend to prefer this feature as it saves time. However, buyers electing to use revolving LCs need to have their financial ducks in a row. Their bank will continuously block out the vast sum of money required at a set-in-stone time. If the buyer doesn't have sufficient funds when using a revolving LC, they'll encounter financial complications. Usually, only highly-liquid buyers with access to vast amounts of capital use revolving LCs.
Letters of Credit: Essential for Physical Commodities Procurement
For centuries, letters of credit have played a pivotal role in international commodities procurement. Ultimately, by bringing banks into transactions as confirming parties, letters of credit facilitate speedier transaction time and reduce the chances of fraud. As a result, all parties involved in physical commodities procurement and purchasing will continue to use letters of credit for as long as business transactions occur.
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