Chapter 6 The use of documents in trade
intermediary is liable for the second
credit and will need to arrange its own
credit lines with its bank. Revolving.
If the two parties enter into a contract with
regular shipments, it may be easier and
more cost effective to arrange a revolving
letter of credit. A revolving L/C can be
drawn against for each shipment (as long
as the overall sum outstanding remains
below the maximum agreed value). The
buyer will need to evaluate whether this is
an effective use of its borrowing capacity,
as it will need to have committed finance
to cover the L/C facility at all times,
even when the L/C is not drawn against.
A revolving L/C is most likely to be
appropriate when the parties are engaged
in regular and frequent transactions, such
that most of the committed funds are
drawn against most of the time. Standby.
Standby letters of credit provide the seller
with a guarantee against default by its
counterparty within a specified time frame.
These can be used as protection for most
debts and other obligations. They are not
limited to protection against a failure to
pay for a consignment of goods. In the
case of protection against trade debts, the
buyer would arrange a standby L/C with its
bank, which will act as a guarantee of its
future payments to the counterparty until
the standby L/C expires. The buyer’s bank
(the issuing bank) will charge a fee for this
service (whether or not any payment is
made) and will usually require some form
of security against the contingent liability.
The standby L/C will state the documents
required to trigger a payment, as well as
the maximum value of any payment, the
date of expiry, and which parties will pay
fees to the advising and issuing banks.Case study
The use of standby letters of credit to provide liquidity
Standby letters of credit are being used to reduce costs for traders holding
accounts with exchanges and clearing houses. Arranging standby L/Cs allows
a trader to withdraw cash from accounts held with the exchange. This cash is
then available to meet any of the trader’s other liquidity requirements. Any cash
requirements arising from a trade at central counterparts can then be met by
drawing against the standby L/C facility.Banks will typically charge an
arrangement fee as well as annual
commissions for the standby L/C facility.
However, if the trader commits to holding
some of the cash balances with the bank
offering the standby facility, these fees
can be negotiated down, or the return
on any cash held can generate a slightly
higher return.Current low rates of interest may make these
solutions more expensive, even though the
technique, especially the reduction in credit
risk, is still valid. In addition, beneficiaries
of standby L/Cs may experience pressure
on counterparty limits as a result of falls in
banking sector credit ratings. The impact of
current market conditions, and any changes,
will need to be considered carefully in any
solution developed.