A Letter of Credit (LC) is extensively used as a payment method around the world: LCs account for almost 20 to 30% of global payment volumes and account for 48% of the export trade mix and 47% of import trade mix.
However, between 2011 and 2012 there was a drop in commercial LCs from 44% to 39% and in standby LCs from 10% to 8% as companies see the benefits of moving to open account trading, says Emuel Schoeman, director of Propell Supply Chain Finance, in this month’s SmartProcurement.
LCs are advantageous when the buyer and seller are trying to establish a new relationship: the parties don’t know each other and a LC can protect them both. But once a good working relationship has been established between the buyer and seller, moving to open account terms is more appropriate as it has benefits for both, says Schoeman.
Where suppliers push for the use of LCs as negotiable instruments for early payment, the buyer bears the cost. If the buyer refuses to make payment based on missing or incorrect documentation then the supplier bears the cost of fixing a LC.
Costs further escalate when parties use additional banking partners to create a ‘Confirmed LC’ or ‘LC with Silent Confirmation’. Not only does it carry costs, but it is also time-consuming for buyers and suppliers to prepare and review supporting documents and sound LC instructions.
There are numerous potential discrepancies that can delay payment and consume a lot of time. It is estimated that more than 75% of LCs are rejected the first time they are submitted, noted Schoeman.
As soon as a buyer and seller establish a good working relationship, moving to open account terms is an option as it benefits the buyer and the supplier.
The buyer can offer standard terms and parties don’t have to go through all the LC documentary collections and processing. “It is a simpler way to do business, significantly reducing cost and saving time for both parties,” says Schoeman.
Moving from LCs to open account trading using a supply chain finance platform
A Propell global partner implemented a supply chain finance programme that enabled a buying organisation to stop using LCs for its suppliers in Bangladesh and India.
The strategy utilises the buyer’s freight forwarder to review documents and conduct approvals at Freight on Board (FOB) point. The freight forwarder fulfils the role of the confirming bank in an LCs transaction (in that they are aligning documents for approval). As a result, the buyer is now able to conduct approvals four to six weeks prior to the goods actually arriving at their physical location and the supplier can sell an invoice as soon as it’s been approved.
In this process the freight forwarder generally takes around three days to approve invoices that are being shipped Full Container Load and between five and seven days for invoices where goods must be consolidated.
This approach has added significant value for the buyer and supplier.
The supplier saves time and can receive early payment from a multi-national bank without the cost associated with appointing a local confirming bank for the LC. The buyer saves significant time, avoids all the costs associated with a LC and has the ability to remove third party agents from the process, says Schoeman.
“Truly a win-win for both parties.”