Drawbacks and Limitations of Letters of Credit

Letters of Credit (LCs) are widely used in international trade for their reliability, but they come with hidden challenges. Did you know that 75% to 80% of LC documents have discrepancies, contributing to a staggering $1.7 trillion trade finance gap? These issues often lead to delays and financial strain, particularly for SMEs.

When working in supply chain management, Letters of Credit (LCs) are often seen as a valuable tool to know how to mitigate trade finance risks between import and export companies in international trade. However, as many know, relying solely on LCs can bring several challenges. Let's delve into the specifics:

In this blog, we'll explore how these complexities disrupt global trade, uncovering lesser-known facts about the true impact of LCs on cash flow and operational efficiency. Prepare to be surprised by how significant these issues can be!

Rejection Rates Due to Discrepancies

One of the most cited issues with LCs is the high rejection rate due to discrepancies in documentation. According to the International Chamber of Commerce (ICC) Global Survey on Trade Finance 2022, as much as 75% to 80% LC documents presented to banks contain discrepancies, resulting in payment delays or refusals.

This high percentage highlights the rigid nature of LCs and the administrative burden they place on both buyers and sellers. These rejections can lead to significant disruptions in trade, as payment delays often mean delays in the release of goods.

Processing Delays

A report by the Asian Development Bank (ADB) noted that the average processing time for an LC transaction can range from 5 to 10 days for issuance and confirmation. If discrepancies arise, this time can extend to several weeks. Such delays are particularly problematic in fast-moving industries, like perishable goods or seasonal products.

For instance, during the COVID-19 pandemic, many businesses faced extended delays due to a lack of personnel at banks and increased discrepancies in documentation, which slowed down trade flows significantly. The ADB report estimated that these delays contributed to a $1.7 trillion trade finance gap globally in 2021, with LCs being a major contributor to this shortfall.

Impact on Small and Medium Enterprises (SMEs)

LCs are often prohibitively expensive for SMEs due to high banking fees and collateral requirements. The International Chamber of Commerce’s (ICC) 2020 Trade Finance Survey revealed that 45% of SMEs found LCs too costly to use for their transactions. This financial burden prevents smaller firms from participating in international trade or forces them to use riskier open account transactions.

The same survey indicated that SMEs accounted for 40% of unmet trade finance requests, largely due to the costs and complexities associated with instruments like LCs. This gap has effectively stifled growth opportunities for smaller businesses, particularly in developing economies.

Financial Strain and Cash Flow Issues

LCs require the buyer to lock up significant funds as collateral, which can strain their cash flow. A study by the International Finance Corporation (IFC) reported that firms using LCs often had to tie up 10% to 20% of their liquidity to cover the collateral requirements of the banks.

This limits the buyer's ability to invest in other areas of their business, hampering growth. For instance, in a typical LC transaction involving $1 million, a buyer may need to deposit $100,000 to $200,000 in a blocked account, rendering these funds inaccessible for other operational needs.

Geopolitical Risks and Currency Fluctuations

LCs are susceptible to geopolitical instability, which can interrupt trade flows. In 2019, the World Trade Organization (WTO) highlighted that trade tensions and sanctions affected the issuance and honoring of LCs in regions like Iran and Venezuela. The value of trade disrupted by these geopolitical risks amounted to an estimated $58 billion in 2019, a significant portion of which involved LC-backed transactions.

To reduce these risks, companies must incorporate robust sanction screening software to avoid engaging with sanctioned entities or regions. Additionally, currency fluctuations can impact LC transactions, especially if the LC is denominated in a volatile currency. If the currency depreciates significantly between the time the LC is issued and the time it is paid, the import and export companies could face unexpected losses, further complicating trade.

Disputes Leading to Non-Payment

The rigid nature of LCs also leads to disputes, which can interrupt trade. According to a study by the Society for Worldwide Interbank Financial Telecommunication (SWIFT), 35% of LC transactions in 2020 faced some form of dispute, often related to discrepancies in documentation.

These disputes can escalate to arbitration or litigation, causing long delays in the resolution of trade payments. For example, a shipping company involved in an LC dispute might hold onto goods at a port for weeks or even months while awaiting a legal resolution, disrupting supply chains and increasing costs for both buyers and sellers, as well as occupying space in ports for the duration.

COVID-19 Impact on LC Transactions

The COVID-19 pandemic magnified the weaknesses of LCs in global trade. Due to lockdowns and restrictions, many banks and businesses were unable to process the required documents on time, leading to delays and cancellations of transactions.

The International Chamber of Commerce (ICC) reported a 30% drop in LC transactions in 2020 compared to the previous year, as both issuing and confirming banks faced operational difficulties. The delays not only halted trade but also increased the trade finance gap, contributing to the broader global economic slowdown.

Alternatives to the Letter of Credit

Most companies have been seeking more cost-effective ways to conduct international trade; consequently, most are now considering the use of LC alternatives. The section below discusses some of these alternatives and the statistics telling the story of their adoption.

1. Open Account

Recently, open accounts have emerged as a significant alternative to LCs in the market. This is because of their flexibility and reduced cost. They don't have costs like the banks involved with LCs. According to the ICC's 2022 Trade Finance Survey, around 60% of the world's transactions are carried out under open account terms, especially in well-established trading relationships where the form does not create the costs of LCs if high trust is used.

Big corporations are mostly able to use this type of financing, as it certainly relies upon the creditworthiness of the buyer in question and the strength of the trading relationship, so it is mostly applicable to established trading relationships.

2. Documentary Collections

Documentary collections are one way of settling the payment that is somewhere between open accounts and LCs. ICC's Global Survey indicates that about 20% of trade transactions use documentary collections. In this method, the seller's bank collects the payment on behalf of the seller from the buyer's bank on receipt of the shipping documents.

But this method, although offering less cost than LCs, is less secure because payment is made only after the buyer accepts the documents. This has been increasingly applied to transactions in which the parties have partial trust but are still in search of some form of safety toward financials.

3. Advance Payment

Advance payment helps reduce the risk in the transaction by making the buyer know that they need to pay money prior to the shipping of goods. The 2023 report from the WTO showed that 15% of international transactions are based on advance payments.

It is always employed in large scale high-risk transactions or new buyers; the limitation in large scale trade is due to its influence on the buyer’s trust and negotiation. It remains a vital source for certain high-risk or first-time transactions.

4. Insurance on Trade Credit

Insurance on Trade Credit protects sellers against buyer default or insolvency. As far as the Global Credit Insurance Association is concerned, 22% of exporters use trade credit insurance to protect their receivables.

Businesses looking at penetrating new or unstable markets will find this very instrumental since it allows additional protection compared to LCs. This kind of insurance helps in offering relief from the risk associated with open account sales and is often combined with other means of trade finance.

5. Bank Guarantees

Bank guarantees offer an easier, less costly alternative compared to LCs because they secure a buyer's obligations, in the event of a default. About 10% of all transactions are supported by bank guarantees, according to the 2021 survey by the ICC.

There is already some form of trust between trading parties, but an extra layer of security like bank guarantees is necessary. As a matter of fact, due to the flexibility and reduced cost compared to traditional LCs, recent years have seen a surge in the use of bank guarantees.

6. Escrow Services

Escrow services involve the holding of funds by a third party until the transactional conditions in question are accomplished. This is especially useful in, but not limited to, complex or high-value transactions.

According to the American Escrow Association, about 8 percent of transactions greater than $500,000 use escrow. They bring peace of mind to both parties, ensuring that payment is guaranteed but also when the set conditions are met. This means that they can afford flexibility without compromising security.

7. Standby Credits

Standby LCs are also used as a fall-back to ensure payment in case the first option fails. They are not as administrative and costly as the usual LCs. According to ICC, 5 percent of users of LC use standby LC as an alternative form of safeguard apart from the primary one. They are appropriate when there is a need for further credit security other than the primary means of payment.

8. Consignment

Consignment entails a process where goods are sent without payment, with the seller still claiming the ownership of the goods until the payment is received. 12 percent of all retail and consumer goods transactions adopted this strategy. It is more common in industries with a slightly higher chance of risk for sellers, such as retail. It enables buyers not to freeze up capital in stock.

9. Factoring

Factoring is selling receivables at a discount in exchange for ready cash. The International Factoring Association estimates that factoring is used by about 10% of SMEs to facilitate cash flow management. It enables a business to gain immediate cash flow on their accounts receivable instead of waiting for the buyers to pay. It thereby leads to a higher level of liquidity and operational flexibility.

10. Export Credit Agencies (ECAs)

Export Credit Agencies insure, guarantee, and finance exporters. Countries belonging to the OECD reported that 25% of export finance is facilitated by ECAs. This is of foremost importance to high-risk market exporters, since they have the full range of financial products to use that can cover risks that are not taken care of by LCs. These credit agencies are of great value to SMEs and any ventures in new and unstable markets.

Summing Up

Letters of Credit (LCs) can complicate international trade with their high costs, complex documentation, and slow processes. These issues can disrupt operations and strain cash flow, especially for SMEs.

To address these challenges, businesses are increasingly turning to alternatives. Open accounts, documentary collections, and advance payments offer flexibility and cost savings.

Trade credit insurance and bank guarantees provide security at lower costs, while escrow services and factoring enhance cash flow and transaction management. Export Credit Agencies (ECAs) support high-risk markets, making trade finance more accessible and efficient. Exploring these alternatives helps companies better manage their trade risks and improve their global operations.

Businesses can identify trade finance companies, or ECAs financing shipments by looking at notify parties in shipping data to identify potential financing opportunities in their industry and trade routes.