The Treasurer’s Guide to Trade Finance

A Reference Guide to Trade Finance Techniques

Case study

Using letters of credit in commodity trading

Trading of commodities is a truly global business, with goods constantly being

shipped from one side of the world to the other, and to all points in between.

Typically, UK-based commodity traders will act as middlemen, sourcing goods

from one country or region and selling them in another, adding value by

providing logistics and other services to facilitate the transaction.

Sales can often be to buyers in
emerging, developing or economically
challenging countries, where the risk
of non-payment is a major concern
for the seller. The value of individual
commodity shipments can be relatively
high (often in millions of USD), and a
failure to collect the sale proceeds can
have a serious effect on the seller’s own
financial condition.

One way to mitigate this risk is for the
seller to insist that the buyer arranges
for its bank to issue a letter of credit
(L/C) in favour of the seller prior to
shipment of the goods. Payment under
the L/C is conditional upon the seller,
through its bank, presenting the required
documents; these typically include,
amongst others, bills of lading (or other
title documents), invoice, certificate of
origin, certificate of weight/quality, etc.
This arrangement provides a degree of
comfort to both parties; the seller can
arrange for goods to be shipped, in the
knowledge that they will be paid for
provided that the appropriate documents
are presented as required under the L/C;
and the buyer can refuse payment if the
documents presented do not conform
to the requirements of the L/C, e.g. the
certificate of quality indicates that the
goods are not of the correct specification.

However, it should be remembered that

the L/C is a bank-to-bank instrument, and

whilst it does provide comfort in respect

of the buyer’s ability to pay (albeit with the

support of the bank), it does not protect the

seller in the event that the buyer’s bank is

unable to make the required payment on

the due date as a result of, for example,

its own liquidity problems, or situations

outside its control, such as the imposition

of foreign exchange controls, etc. Also,

buyers increasingly require extended credit

terms, such that they pay for the goods at

some agreed future date (e.g. 60, 90 or

180 days from the date of shipment), which

puts pressure on the seller’s cash flow and

ability to do more business.

By adding its ‘confirmation’ to the L/C,

the seller’s bank agrees that, providing

the correct documents are presented (the

seller’s bank will check the documents

before sending them overseas), it will pay

funds to the seller on the due date in the

event that the buyer’s bank is unable to do

so – thereby effectively removing the bank

and country risk factors for the seller. If the

L/C allows for payment at an agreed future

date, the seller’s bank may also agree to

discount the proceeds, i.e. advance funds

to the seller (less an agreed discount)

ahead of the actual due date, thereby

improving the seller’s cash flow.