International trade: Why Standby LC is becoming popular

[The first of a three-part write-up titled Standby LC and its operational challenges]

About 20 years back, while working in a bank in Dhaka, one of my key responsibilities was to look after the Bank Guarantee (BG) department. One day, we received a Standby Letter of Credit (LC or SBLC) issued by an American bank on behalf of a US-based company. During that time, Standby LC was a completely new trade finance product with which we were not familiar at all. So, we referred this issue to our Head of International Division who was an expert in international trade. The explanation we received was that Standby LC is nothing but a Bank Guarantee; the term Standby LC is used in the USA instead of Bank Guarantee. After working for so many years in the banking sector of our country as well as in the developed world, I have realised that that definition of Standby LC was not fully correct.  Law in the USA does not allow the use of Bank Guarantee, so Standby LC is used there. However, Standby LC is used in many countries all over the world just like commercial LC (Letter of Credit).

DIFFERENCE BETWEEN STANDBY LC AND BANK GUARANTEE: Although in terms of functionality, nature and scope, Standby LC is almost similar to Bank Guarantee (BG), there are some fundamental differences between these two types of trade finance products. Bank Guarantee is governed by the local law of the country where this instrument is issued while Standby LC is governed by ICC (International Chamber of Commerce) rules particularly ISP (International Standby Practice) and UCPDC (Uniform Customs and Practice of Documentary Credit). Additionally, Bank Guarantee can never be confirmed by third banks, also known as confirming banks. But Standby LCs can easily be confirmed by third banks. For some specific reasons, a bank may not issue its own Guarantee/Standby LC but can easily confirm the instrument issued by a third bank. At the same time, the beneficiary of Guarantee/Standby may have specific preference for issuing banks. So it may not accept this instrument if not issued by their preferred bank. Usually, government entity as beneficiary in many countries including Bangladesh prefer Guarantee/Standby LC issued by only state-owned commercial banks which may not agree to issue Guarantee/Standby LC for any particular customer but can easily confirm Standby LC issued by a third bank. It may be mentioned that issuing Guarantee/Standby involves undertaking direct credit risk on the applicant (party requesting to issue Guarantee/Standby) while adding confirmation involves undertaking credit risk of the issuing bank.

SCOPE OF UNDERLYING TRANSACTION OF STANDBY AND BG: Once upon a time, the scope of underlying transaction of Guarantee/Standby was very limited to undertaking long term projects, particularly where construction work was involved. In addition to this, the use of guarantee and standby is also found in some areas where direct payment obligation is required but its periphery is limited. Few years back, people could not even think of conducting international trade using Standby LC. But this is now an important component of international trade. Recent trend has revealed that the use of commercial LC is disappearing, being replaced by Standby LC. In the developed world, the use of commercial LC is almost absent and trade through open account or contractual arrangement accompanied by Standby LC is now a very popular means of cross-border trade. As a result, the scope of Standby LC has tremendously widened and underlying transaction related to commodity trade, rendering services and even collateral security has come under the use of Standby LC.       

PROSPECT OF USING STANDBY LC IN EMERGING MARKET: It is true that in most emerging markets including Bangladesh, Standby LC has not been used as a widely accepted trade finance product. Its use has started in a limited scale. So far, we know that banks in Bangladesh have not yet started issuing Standby LC for their customers. However, some banks have been receiving Standby LCs issued by American banks. These banks are handling this trade finance product either in the form of issuance of Local Guarantee against Counter Standby LC or adding confirmation to Standby LC or merely advising Standby LC issued by American bank. A Bank does not undertake any credit or operational risk by merely advising any Standby LC. However, issuance of Local Standby LC against counter Standby LC and confirming Standby LC directly involves both credit and operational risk. Moreover, the way the pattern and structure of international trade is changing, Standby LC will soon become a very popular trade finance product in emerging markets, particularly in Bangladesh.

STANDBY LC REDUCES COST OF CROSS-BORDER TRADE:  Standby LC has many advantages in its uses over conventional LC as documentary LC (Letter of Credit) is issued to conduct individual import or export deals. The validity or effectiveness of that documentary LC ceases to exist as soon as that deal is performed. Although there is provision of revolving LCs, this type of instrument is hardly used. On the other hand, the structure and scope of Standby LC is designed in such a way that it can be easily used for continuously carrying out import-export business as long as both trade partners mutually agree to continue. So, repeated issuance of LCs for each specific import-export deal can easily be avoided by introducing Standby LC and as such repeated payment of charges related to LC like issuing charge, advising charge etc. can be substantially reduced. Moreover, LC operation goes through several stages that includes issuance of LC, advising thereof, confirmation if needed, negotiation / discounting, interest on usage period etc. A bank, while handling LC transaction, realises various charge and fees for each of these actions which substantially increases trade finance expense that is eventually loaded with the cost of imported goods.

Standby LC has only two types of fees that include issuance fee and confirmation fee. Besides, historically the rate of Standby LC issuance fee is much lower than that of documentary LC. Since LC is known as documentary credit, bank deals with the documents and preparing document in a perfect manner is uncommon and almost impossible. So, discrepancy is a very common problem in dealing with LC transaction. For handling each set of discrepant documents, banks must charge additional fees. This also increases LC operational expense and thus increases import cost. But the question of discrepancy does not arise at all if transaction is undertaken through Standby LC. It may be mentioned here that cut throat competition prevails in the developed markets. As a result, each extra step leads to additional expense that is technically loaded with the cost of trading goods. No company will compromise their profit margin, so any expense incurred is shifted to the counterpart. On that point, Standby LC enjoys many advantages because all these unnecessary actions are not required. 

HOW STANDBY LC WORKS FOR IMPORT-EXPORT TRADE: Initially, the importer and exporter establish a trade agreement, which is categorically known as Master Trade Agreement (MTA). This MTA incorporates all terms and conditions that among others include pricing, shipment details, payment method, documents exchange and maximum amount of outstanding trade balance at any point of time. Under the executed MTA, the importer issues purchase order for each consignment based on which the exporter completes  shipment and dispatches the relevant shipping documents to the importer. The importer then remits money to the exporter using the payment method described in the MTA. In this way, from exporter's perspective, exporting goods and receiving payment will continue while from importer's perspective, receiving goods and remitting payment to the exporter will also continue on a regular basis as long as both parties desire to continue trade. Risk of uncertainty over the payment of exported goods is well mitigated by issuing Standby LC by the importer's bank in favour of the exporter for the amount equal to the maximum value of outstanding trade at any given point of time. Under Standby LC, the issuing bank or confirming bank where Standby LC is confirmed undertakes to make payment on demand to the beneficiary, who is obviously the exporter. So, if the exporter does not receive any payment from the importer against shipment for any reason, he/she can draw the funds under Standby LC. Two key factors related to managing Standby LC are important: maximum outstanding trade volume at any given point of time must not exceed the value of Standby LC, and expiry of Standby LC must remain valid as long as trade continues and payment remains outstanding. It may, however, be mentioned that payment during any international trade regardless of whether it is under documentary LC or Standby LC, is eventually settled by the importer. Standby LC provides a kind of payment guarantee to the exporter who periodically exports goods under MTA executed with the importer. The necessity of drawing under Standby LC does not arise as long as the importer remits the value of imported goods to the exporter. Apart from payment, all other disputes arising over cross-border trade is settled through either mutual arrangement between importer and exporter or through legal process applicable to cross-border trade when undertaken by documentary LC.           

In the developed world, most commercial banks have taken measures to downsize their documentary LC business. There are many obvious reasons behind such move. Regulatory rules and compliance requirement have made the operation of LC a complex and troublesome process. A bank can hardly recover its expense incurred for maintaining LC operation team. Additionally, rising threat of money laundering and terror finance is compelling many banks to de-risk their relationship. This is adversely affecting cross-border trade through conventional documentary LC. 

Nironjan Roy is a banker, based in Toronto, Canada.

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