Problems with Letters of Credit

Signing letters of credit
Growing Problems with Letters of Credit:

It is increasingly evident that there are problems with letters of credit (LCs) which are no longer providing the security that trading parties might expect. It is clear that companies trading in the Middle East, Africa and Asia are facing real collection problems with LCs due to foreign currency reserve shortages.

LC’s are designed to give both buyer and seller certainty about the intentions of the other parties and provide security that they will honour their part of the deal is critical when trading overseas. It is a written undertaking given by a bank (issuing bank) at the request of its customer (applicant), in which the bank obligates itself to pay the exporter (seller/beneficiary) up to a stated amount within a prescribed timeframe upon presentation of stipulated documents that conform to the terms and conditions of the documentary credit.

Increase in Rejections

According to the African Trade Finance Survey Report released earlier, the rejection of L/C requests increased, with about 38 percent of local/privately-owned banks in Africa and 30 percent of foreign banks reporting an increase in rejection rates, respectively. Simultaneously, correspondent banking relationships, major international banks and financiers cancelled and/or reduced their lines of credit limits for African banks, with Europe accounting for about 50 percent of this change. 

The new risk of Central Bank Insolvency and the decline of Forex Reserves

Typically, the cause of a LC dispute is a discrepancy in the documents, but the combined effect of the pandemic, the global supply chain disruption, inflation in global prices for fuel and food, and other factors have combined to cause a significant depletion in foreign exchange reserves globally. Increasingly there are banks in developing countries that are unable to remit foreign currency in agreement a letter of credit either due to a lack of foreign currency or an order of the central bank.

In recent months, more countries than ever are facing a fiscal crisis and find themselves unable to meet the necessary import payments. The countries most widely reported include: Lebanon, Sri Lanka, Nigeria, Nepal, Pakistan and Kenya. 

On the other hand, Libya and Egypt have made the use of letters of credit mandatory in foreign trade transactions. In theory this allows better control of the outflow of foreign currency and allows banks to implement AML regulations. 

Confirmed Letters of Credit

A confirmed letter of credit is one to which a second bank, usually in the exporter’s country adds its own undertaking that payment will be made. This is used when the exporter does not find the security of an unconfirmed credit sufficient due to issuing bank risk or political and/or economic risk associated with the importer’s country.

An irrevocable and confirmed letter of credit has not only the commitment of the issuing bank but also a binding undertaking given by the confirming bank to pay when the documents are presented in accordance with the terms and conditions of the credit. So, a confirmed letter of credit provides more security than an unconfirmed one. Correspondingly, there is more cost involved in confirmed letters of credit

Finding Alternatives to Letters of Credit

Letters of credit are not the panacea they were once thought to be. There are clearly many disadvantages inherent with this trade finance product which this fiscal crises is bringing into sharp focus. Importantly, there are other options which could be better suited to the current economic environment. Fin tech companies such as YataPay Secure offer solutions to enhance payment security for companies trading internationally. The digital platform offers a third party account where funds are held until the mutually agreed terms of the agreement are met. Settlement of funds is quick and not dependent on the issuing bank holding sufficient reserves. 

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