Trade Finance: Form vs. Format
This article brought to you in conjunction with
By Erika Morphy
As letters of credit enter the electronic mainstream, they often seem to raise the same complaints. But they are slowly shifting more power to the exporter.
Paul Labonte, corporate controller for the online and catalog toy retailer Kid Galaxy, understood why his Asian vendor asked him to take out a letter of credit 60 days prior to shipment. He just didn't want to do it.
The vendor said the longer-term LC would help the company get the financing it needed to fill Kid Galaxy's order. Labonte sympathized, but he didn't want so much of his line of credit tied up for so long.
Fortunately, there was room for a compromise, if the vendor's bank agreed to accept the LC in an electronic format. "We explained to them that manual LCs take a week and a half to process, but that we could get an LC processed electronically within three days," Labonte says. The full week difference in clearing the payment turned out to be enough for the vendor in Asia to accept an LC 30 days prior to shipment.
Labonte is a recent convert to electronic LCs, but he is already one of the many people who now swear by these products, in this case offered by Imperial Bank's SWIFTrade. "I can go right to the website, write the LC, review it, and communicate with everyone using e-mail," he says. Even along the most established of trade routes, Labonte reports the process saves him at least three days per transaction.
So here, at the cusp of the 21st century, is proof that this oldest of trade finance tools -- some trace the first letter of credit to 1210 when King John of England used one to order a load of marble from Italy -- is at last changing for the better. The process is still in its early stages, and the great majority of LCs still travel about the world in paper form, packed in containers or in the parcels of couriers. But many observers expect most if not all LCs to be online within ten years, and perhaps sooner if Bolero, a global finance initiative to remove paper from the trading process, is widely accepted following its September launch.
In many ways, this is good news for the users of LCs. But it may not be quite as good as they had hoped. Automation of the LC, after all, has often been sold as a way to finally do away with all the discrepancies and all the problems that have plagued letters of credit for as long as anyone can remember, problems that have driven generations of traders nearly mad with frustration.
Automated LCs certainly speed up the trading and payment process. But they do not address a fundamental issue affecting their use -- that many of the problems that plague LCs stem from the willful manipulation of the process by banks and importers looking to drag out payment periods and stretch cash flows to new limits.
So going electronic will not, it seems, eliminate all of the heartburn long associated with using LCs. But as the pace of trade quickens with the arrival of new technologies, at least LC users will not have to suffer for nearly as many weeks as has traditionally been the case.
Snafus. There are four basic categories of players in the LC process -- the banks, the freight forwarder/ transport provider, the importer, and the exporter. Of these, fairly or not, it is the banks that are usually the most reviled for the delays and snafus that bedevil the LC process.
This has not gone unnoticed by bankers. Buddy Baker, head of trade services product management, ABN AMRO Bank North America, borrowed a page from David Letterman in drawing up his own top ten list [see box p.49] on the biggest problems with LCs, at least according to views expressed by his clients.
The number one complaint of Baker's clients? "There are just too many banks involved, I can't keep track."
Certainly, the number of banks that participate can seem mind boggling to many customers -- in a standard LC transaction there is usually an issuing or opening bank, an advising bank, a confirming bank and a negotiating bank.
The advent of e-commerce does promise to simplify matters somewhat, Baker says. "Once electronic documents are routinely accepted, the role of the negotiating bank could disappear. You won't have to present paper documents locally; you can present them electronically anywhere you want." With the advent of digital signatures, he adds, advising banks too may find their roles obsolete.
Exactly at what point this will happen is hard to tell, however. "The technology is already there," says Peter Knudsen, senior vice president and general manager of Imperial Bank's international banking division. "But the legal acceptance of what is an original document" in a digital format is not.
For the foreseeable future, Knudsen predicts that traders will have to continue to deal with a bevy of banks, often complaining loudly every step of the way, as Knudsen will attest. "When I tell clients we are not responsible for the authenticity of documents, frequently the response is, 'then what the hell are you responsible for?'"
Ultimately, the real question is whether the LC form itself will be surpassed by some other way for traders to move money.
"LCs are archaic, cumbersome and expensive to the parties that use them," Knudsen says. "In our electronic age I think they either have to be changed substantially or people will find a way to work without them."
Bank Bound. To a certain extent, banks are hamstrung in their ability to streamline their LC processes by the rules that govern letters of credit, the so-called UCP 500 published by the International Chamber of Commerce's Uniform Customs and Practice for Documentary Credit.
Any deviance from these rules means the negotiating bank (the bank that ultimately pays the exporter) might not get reimbursed by the issuing bank if there are any discrepancies.
The biggest problem with LCs, says John Dunlop, president of AVG Trade Group, a San Diego-based company that offers LC services over the Internet, is that "the UCP 500 is infinitely flexible."
For users, this can result in a nightmare in which the very complexity of the rules creates almost an infinite number of loopholes, with the slightest discrepancy in terms or a single typo becoming cause to refuse payment. Even the wording of the rules can often become subject to interpretation.
And banks, being the risk-adverse institutions that they are, will use the most conservative interpretation on everything and anything.
Even more common are "discrepancies" in the terms of the LCs. In the past, these were usually ascribed to human error. As the LC process becomes ever more automated, however, it is becoming clearer just how often the terms are willfully manipulated by the banks themselves. This is especially true for foreign issuing banks though even some U.S. banks have employed similar tactics.
Such tactics, Dunlop says, can include requests for documents or signatures that can be provided only by the applicant, 'legalizations' from embassies, certificates of origin by individual item in the shipment, specific ship routing, unavailable documents, unrealistic shipping and presentation dates, excessive price details and references to unknown or undefined agreements.
"These are not arbitrary accidents of the person who actually types the credit," Dunlop says. "These are problems built-in by design of the bank and the country it is issued from."
In some countries, it is simply that the bank wants to avoid releasing in U.S. dollars because of shortages in that currency. This was often the case with South Korean banks in the months before and after that country's devaluation in December 1997. In other cases, banks will delay payment mainly so they can earn interest off the money put up by the applicant as it sits for months waiting for the "discrepancies" to be worked out.
>For their part, most members of the banking community say such 'built-in' problems rarely if ever happen at their own institutions. "All bankers are concerned about their name in the international marketplace," says Knudsen. "They don't want to get the reputation that they have to be sued to get paid."
>But banks are not the only ones accused of LC shenanigans. "You have to keep in mind that some of the discrepancies are there by design on the part of the importer," says Herve Lacorne, senior vice president and deputy general manager for Imperial Bank. "What is cumbersome to the exporter is good for the importer. One way a lot of importers manage their cash is by delaying payment."
The advent of e-commerce promises to rectify this imbalance, or at least redistribute it. "Right now the exporter bears the brunt of the costs," Knudsen says. With electronic LCs, importers will increasingly have to find other ways to fund production and other costs, he says.
Knudsen remembers when Imperial Bank first introduced SWIFTrade last year. "We were talking to one of our active importers, telling him how much faster we could transmit information." The importer's response? "He said 'why would we want to do that? Usually we are at the top of our credit line and so we blame the bank for being too slow getting the LC out.'"
At times, the discrepancies can affect more than simply the flow of money. Some companies have been known to use a discrepancy to drive down a previously agreed upon price. As Lacorne says, a discrepant document "puts the importer in the driver's seat."
The good news, however, is that the vast majority of times the delays, whatever their cause, are just that -- delays. Even though anywhere between 60% to 80% of LCs issued have discrepancies, says ABN AMRO's Baker, only one out of 1,000 does not get paid eventually.
Bank-Led. What is often overlooked in the Sturm und Drang over LC reform is the fact that it is the banks that are basically driving most LC innovation, using such technologies as document management software, document imaging, interactive forms within web browsers, and password security protocols.
Interestingly, much of this innovation is being tried out first in Asia. DBS Bank, for example, has entered into a joint venture with Singapore-based software firm bex.com to set up IBEX, a regional e-commerce exchange for businesses, which will include electronic LCs.
IBEX's nearest competition is also in Singapore. Citibank's Citicommerce system, which is being readied for global rollout, was deployed first in the city-state this summer.
In general it is the bigger banks that are leading the way. "We are taking some of the treasury products we have and integrating them into trade offerings," says Vincent Maulella, a vice president of Chase Manhattan Bank.
"Some banks like Citibank are now scanning in all negotiable documents before anyone touches them," Dunlop says. The next step for Citibank, he says, will be the acceptance of these digital documents. "In the future, couriers of original documents to banks will be greatly supplemented with the Internet."
Such innovations, Dunlop promises, will mean that many of the current problems will go away, with this next phase or "evolution" of LCs. With an 80% discrepancy rate, it can't happen soon enough.