BusinessFebruary 9, 2023

What is a Letter of Credit & How Does it Works?

Parties Involved; Types & Documents Required 

A letter of credit is an independent undertaking from the issuer, promising that subject to fulfillment of specific terms and conditions the party in whose favor the undertaking has been issued will get paid even if the party on whose behalf the issuer has given the undertaking refuses to pay. Generally issued by an importer’s bank, the letter of credit ensures the beneficiary will be paid once the conditions of the letter of credit have been met.

The letter of credit can be used for both inland and cross-border trade. It is normally issued by the buyer’s bank as an undertaking to the seller. 

Letter of Credit

Parties Involved in Letter of Credit

  • APPLICANT– The buyer of the goods/services (importer) on whose behalf the letter of credit is issued by the issuing bank.
  • BENEFICIARY – The seller of the goods/services (exporter) in whose favor the letter of credit is issued and who obtains payment on presentation of documents complying with the terms and conditions of the LC.
  • ISSUING BANK– The bank which issues the credit and undertakes to make the payment on behalf of the applicant as per terms of the L/C.
  • ADVISING BANK– Banks which advise the LC, certifying its authenticity to the beneficiary, and is generally a bank operating in the country of the beneficiary.
  • CONFIRMING BANK– A bank that adds its irrevocable undertaking to the LC opened by another Bank and thereby undertakes responsibility for payment/ acceptance/ negotiation/incurring deferred payment under the credit in addition to that of the Issuing Bank. It is normally a bank operating in the country of the beneficiary and hence its undertaking adds to the acceptability of the LC for the beneficiary. This is being done at the request/authorization of the Issuing Bank.
  • NOMINATED BANK- A Bank in the exporter’s country which is specifically authorized by the Issuing Bank to receive, negotiate, etc., the documents and pay the amount to the exporter under the LC.
  • REIMBURSING BANK – Bank is authorized to honor the reimbursement claim made by the paying, accepting, or negotiating bank. It is normally the bank with which Issuing Bank has Nostro Account from which the payment is made to the nominated bank.

Type of Letter of Credit:

  • SIGHT/USANCEL/C: Letters of credit can permit the beneficiary to be paid immediately upon presentation of specified documents (sight letter of credit), or at a future date as established in the term/usance letter of credit.
  • CONFIRMED L/C: Confirmed letter of credit is an arrangement where a confirming bank adds its undertaking in addition to that of issuing bank to honor a complying presentation. It is an irrevocable undertaking issued by another bank/entity.
  • REVOLVING L/C: In order to avoid credit that has been partially utilized, a revolving credit may be used for the value of the credit to be restored.
  • TRANSFERABLE L/C: In this type of letter of credit, the seller is allowed to transfer the credit either fully or partially to one or more parties provided the L/C clearly states that it is a transferable letter of credit, also the L/C cannot be transferred by the second beneficiary to a subsequent beneficiary.  
  • BACK-TO-BACK L/C: A back-to-back letter of credit involves two letters of credit to secure financing for a single transaction. These are usually used in a transaction involving an intermediary between the buyer and seller. Back-to-back letters of credit are used primarily in international transactions.

The list of documents normally required in the LC transaction:

  • LC Draft
  • Commercial Invoice
  • Customs Invoice
  • Bill of Lading
  • Air waybill
  • Packing list
  • Certificate of origin
  • Certificate of inspection
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360tf Africa
BusinessSeptember 28, 2021

The Future of Trade Finance in Africa

Trade is one of the most important drivers of economic growth. However, Africa as a continent is still not entirely capturing trade’s growth-enhancing benefits. Although its population has more than tripled over the last five decades to account for around 17% of the world’s population, Africa’s share of global trade has decreased steadily over the same period, from 4.4% to 3%.

Trade Finance plays an important role in the growth of trade globally. The deficit of trade finance is a persistent issue that the current pandemic is likely to aggravate. African trade accounts for only 3% of world trade. Regulatory challenges have emerged as a significant drag on trade finance in Africa. 15% of banks list regulatory challenges as the main constraint to expanding trade finance supply.

Though the unmet demand in trade finance has declined significantly from its peak of $120 billion in 2011 to $81 Billion in 2019. The global trade finance gap was estimated to be $1.5 trillion in 2018, the average unmet demand in Africa represents 5.5% of the global trade finance gap. The global response from key players in the trade finance industry, including Development Financial Institutions (DFIs), undoubtedly contributed to this decline. DFIs are increasingly playing a more active role in Africa trade with facilities for short-term lending of working capital & credit guarantees aimed at SMEs. An average of 60% of banks in Africa that engaged in trade finance activities received some form of DFI Support.

Trade Finance remains a popular activity among banks in Africa, but the participation rate continues to decrease falling by 16% to 71% in 2019, compared to 87% in 2018. Several factors may influence banks’ participation in trade finance transactions. At the country level access to foreign exchange, liquidity, competition, capital requirements & interest rates may impact a bank’s ability to participate in trade finance activities

Characterization of Trade Finance in Africa

Roughly 60% of trade finance assets of banks are unfunded transactions such as letter of credits. On average, trade finance assets accounted for 14% of total bank assets in Africa in the previous decade.

All the letters of credit issued by African banks require a confirmation from large global banks. As global banks pull out of markets that are too risky, they leave many African-based banks at risk of not being able to conduct trade in foreign currency along with reduced confirmation lines on African Banks. Based on SWIFT data analysis, the number of correspondent banking relationships involving US Dollar transactions decreased by about 25% between 2011 & 2017.

To fill the gap in trade finance, especially the confirmation requirements for the LCs issued by 400+ African Banks, many digital platforms are expected to originate. Recently, such an endeavor has been taken by a Singapore-based Digital Trade Finance platform known as 360tf. 360tf enables trade finance by bringing the trade world closer, connecting importers and exporters with a global confirming bank to fulfil their LC confirmation & financing requirements. At 360tf, LCs are confirmed by large and reputed banks located in large financial centers which provide risk mitigation on part of importers and exporters.

Recently, ICC has launched ICC Trade Now, a suite of digital products and services to tackle the global trade finance gap in all its breadth and complexity.

ICC Trade Now will bring together and offer a portfolio of solutions that can address the various facets of the trade finance gap. SMEs will be able to select the solution provider that is most aligned with their needs while a wide array of financiers will be able to leverage ICC Trade Now solutions (providers to service SMEs profitably). Three digital solutions – ICCTRADECOMM, Trade Flow Capital and FQX – have already been announced under the ICC Trade Now campaign with more solutions expected to be added in 2021.

African trade is significantly underserved by banks. For the period 2011-19, banks intermediated about 40% of total African trade, compared to the global average of 80%. While 17% of total African trade is Intra-African, the share of trade finance dedicated to Intra- African trade is 18%. Henceforth, Intra-Africa trade receives its fair share of bank-intermediated trade finance. The contribution of trade finance to bank earnings has decreased from 17% in 2011-12 to about 10% in 2018-19, due to higher processing fees, failing trade volume & additional KYC &AML requirements.

The trade finance transactions are generally assets-backed, self-liquating & short-term in nature. They remain relatively low-risk activities. While average default rates on trade finance activities by African banks are lower than overall bank NPLS in Africa, they are far higher than the default rate on global trade finance activities. Although the SME risk profile has improved, the SMEs Trade Finance application rejection rate has increased by 20% between 2013 & 2019. Addressing the key challenges for Trade Finance gap will require a concerted effort between various actors in the industry including (but not limited to) Trade fintech, multilateral organizations, international & national regulators & commercial banks.

A good starting point is to raise awareness about the challenges new KYC/AML requirements have imposed on banks in the trade finance sector. As economies move to implement new Basel III regulations and stringent anti-money laundering measures, banks have to set aside more risk capital for foreign transactions, including for trade finance assets, as well as investing more in vetting new clients.

Multilateral development banks now play a more active role in the trade finance industry, but the research shows that support is skewed in favor of banks in West & Southern Africa because these regions have the highest gap & need the greatest. Therefore, it is immensely important to address these geographic disparities to boost trade and reduce sub-regional income disparities across the continent.

More should be done to increase support for local banks that participate in trade finance in Africa as well. In the coming years, African trade will experience new challenges and opportunities

The introduction of the new African Continental Free Trade Area (AFCFTA) is expected to eliminate significant barriers to intra-African trade & create a large market for firms across the region. At the same time, the ongoing global health crisis is impacting global supply chains & the region’s trade with the rest of the world, while limiting the availability of dollar liquidity to support trade. Thus, once the crisis recedes, the need for financing to reenergize the region’s trade will be higher & more urgent. Concrete & urgent steps to reduce the trade finance gap in Africa & address the challenges faced by the industry will be equally important.

My special gratitude to African Development Bank, AfrEximBank, and ICC. Their websites were very useful for the information in this article. The 360tf LinkedIn page also has a lot of useful information related to trade finance. Do check it out!

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360tf
BusinessSeptember 13, 2021

Africa Trade Finance – A Gap but a Golden opportunity for Banks & Trade Finance Fintech

Trade is one of the most important drivers of economic growth. However, Africa as a continent is still not entirely capturing the growth-enhancing benefits of international commerce. Although its population has more than tripled over the last five decades to account for around 17% of the world’s population, Africa’s share of global trade has decreased steadily over the same period from 4.4% to 3%.

Trade Finance plays a principal role in the growth of trade globally. The deficit of trade finance is a persistent issue that the current pandemic is likely to aggravate. Furthermore, African trade accounts for only 3% of world trade. Regulatory challenges have emerged as a significant drag on trade finance in Africa with 15% of banks listing regulations as the main constraint to expanding trade finance supply.

Though the unmet demand in trade finance has declined significantly from its peak of USD 120 billion at the beginning of the 2010 decade to USD 81 Billion by the end of the epoch. The global trade finance gap is estimated to be USD 1.5 trillion annually with Africa representing 5.5% of the gap. The global response from key players in the industry including Development Financial Institutions (DFIs) undoubtedly contributed to this decline. DFIs are increasingly playing an active role in African trade by providing facilities for short-term working capital lending and credit guarantees to SMEs. An average of 60% of banks in Africa that engage in trade finance activities receive some form of DFI Support.

Trade Finance remains a popular activity among banks in Africa, but the participation rate continues to decrease declining by 16% to 71% in recent years. Several factors influence bank participation in trade finance transactions. At the country level, these include access to foreign exchange, liquidity, competition, capital requirements, and interest rates which impact the bankability to participate in trade finance activities.

Roughly 60% of trade finance assets of banks are unfunded transactions such as letters of credit. On average, trade finance assets accounted for 14% of total bank assets in Africa in the previous decade.

All letters of credit issued by African banks require confirmation from large global banks. As global banks pull out of markets that are too risky, they leave many African banks at risk of not being able to conduct trade in foreign currency compounded by reduced confirmation lines on African Banks. Based on SWIFT data analysis, the number of correspondent banking relationships involving US Dollar transactions decreased by about 25% over the last decade.

Digitization is the plug to fill the gap of trade finance, especially confirmation requirements for LCs issued by the 400+ African Banks universe. There has been some headway in this space, but more work needs to be done with more support from international trade organizations and financial institutions. Only a handful of FinTech companies are focused on digitizing various aspects of trade financing. 360tffor instance brings the trading world closer by connecting importers and exporters to global banks for fulfilling LC confirmation and financing requirements. On the 360tf platform, LCs are confirmed by banks located in large financial centers providing risk mitigation to importers and exporters.

Recently ICC launched ICC Trade Now, a suite of digital products and services, to tackle the global trade finance gap in all its breadth and complexity.

ICC Trade Now offers a portfolio of solutions that address various facets of the trade finance gap. SMEs can select solution providers that are most aligned with their needs while a wide array of financiers will be able to leverage ICC Trade Now to service SMEs profitably. Three digital solutions – ICC TRADECOMM, TradeFlow Capital, and FQX – have been announced under the ICC Trade Now campaign with more solutions expected to be added in 2021.

 African trade is significantly underserved by banks. For the period 2011-19, banks intermediated about 40% of total African trade, compared to the global average of 80%. While 17% of total African trade is Intra-African, the share of trade finance dedicated to Intra- African trade is 18%. However, the contribution of trade finance to bank earnings has decreased from 17% to about 10% in recent years due to higher processing fees, failing trade volume, and additional KYC and AML requirements.

Trade finance transactions are generally asset-backed, self-liquating, and short-term in nature. They remain relatively low-risk activities. While average default rates on trade finance activities by African banks are lower than overall bank NPLs in Africa, they are far higher than the default rate on global trade finance activities. Although the SME risk profile has improved, the SMEs Trade Finance application rejection rate continues to increase.

Addressing the key challenges of the Trade Finance gap will require a concerted effort between various players in the industry including Trade FinTech, multilateral organizations, international and national regulators, and commercial banks. A good starting point is to raise awareness regarding challenges imposed by new KYC/AML requirements on banks in the trade finance sector. As economies move to implement Basel III regulations and stringent anti-money laundering measures, banks have to set aside more risk capital for foreign transactions, including for trade finance assets as well as invest more in vetting new clients.

Multilateral development banks now play a more active role in the trade finance industry, but research indicates that support is skewed in favor of banks in West and Southern Africa because these regions have the highest gap. Therefore, it is immensely important to address these geographic disparities to boost trade and reduce sub-regional income disparities across the continent. More should be done to increase support for local banks that participate in trade finance in Africa overall.

In the coming years, African trade will experience new challenges and opportunities. The introduction of the new African Continental Free Trade Area (AFCFTA) is expected to eliminate significant barriers to intra-African trade and create a large market for firms across the region. At the same time, the ongoing global health crisis is impacting global supply chains and regional trade with the rest of the world, while limiting the availability of dollar liquidity to support trade. Thus, once the crisis recedes, the need for financing to reenergize regional trade will be greater and more urgent. Concrete and urgent steps to reduce the trade finance gap in Africa and address the challenges faced by the industry will be equally important.

Read more