The Downfall Of The Letter Of Credit

Global trade volume is up. Recent International Chamber of Commerce analysis predicted an average 5.1 percent year-over-year increase through 2016, with SMEs and middle-market businesses leading this charge.

This growth is both the cause and effect of new payment options for corporations that need faster, more affordable ways to send and receive money internationally.

A new whitepaper by American Express FX International Payments, published Monday (Dec. 7), highlights how this trend is impacting businesses across the globe and points to the legacy tool of the bank letter of credit to underscore how far cross-border B2B payments have come — and how far they still have to go.

The Letter Of Credit

According to American Express, the letter of credit is an age-old way to ensure suppliers get paid. A buyer’s bank issues a document to a supplier’s bank guaranteeing payment, and funds are transferred once an order is shipped.

This process has been “virtually unchanged in over half a millennium,” the paper declared. And while the letter of credit is often the crux of a B2B transaction, today’s economy demands faster trade and faster payment, leaving a world in which the traditional letter of credit doesn’t always cut it.

“The world has evolved — transactions that took months to simply cross an ocean now occur in less than a day,” the paper notes. “Yet, many businesses are still shackled to the old ways of doing things.”

American Express pointed to the manual processing and handling of a letter of credit as the prime culprit in many B2B payment errors. Any error in the document or any lack of agreement among all of the parties involved — buyer, supplier, banks and other members of the supply chain — can lead to gridlock and non-payment, the paper notes.

But the market is shifting away from its dependence on the letter of credit, thanks to the recent rise in FinTech players dedicated to cross-border payment solutions.

A Better Alternative

“There is no question that businesses are moving away from traditional methods of transferring currency and towards modern alternatives,” the report concluded. “A clear and marked decrease in the use of letters of credit and an increase in corporate FX providers is evident — for good reasons: ease of use, speed and lower cost.”

According to the latest figures, today, letters of credit make up 41 percent of the export trade finance products handled by financial institutions — down from 44 percent three years prior. Import trade finance has seen an even more drastic decline, with an 8 percent decline in the handling of such documents between 2011 and 2013.

While the letter of credit remains common, ePayment service providers are changing the game for both buyers and suppliers.

For instance, American Express pointed to the drop in foreign exchange currency transfer transaction costs. This will be especially beneficial to mid-market companies, the paper noted, as FX maintenance and setup fees, which often disproportionately burden smaller companies handling smaller transaction volumes and values, will get eliminated thanks to the rise in cross-border payments players.

These players are also lowering the threshold for minimum nominal transfers, reducing accounts receivable burdens by remitting funds into local accounts and making it easier for overseas buyers to pay. This shift, American Express said, means businesses will no longer have to depend so much on letters of credit.

“For your relationships with established clients, with a history of trust and reliable payments, your business can forego establishing a letter of credit,” the paper said, adding that faster payments mean stronger trust between the buyer and supplier. These payments players also provide a more affordable option for one-time deals, ensuring payment without the need to establish a long-term relationship.

The emergence of foreign exchange payments players means businesses can nix bank transfer fees, which often cut into the savings some suppliers offer their buyers through early payment discounts.

Further, “the ability to transfer funds fast and easily translates into the ability to anticipate and respond to foreign exchange currency fluctuations,” the report said.

When it comes to outbound payments, buyers can benefit from the rise in currency transfer service providers, too. These companies can more adequately handle time-sensitive payments or payments for unexpected orders. Buyers can take advantage of early payment discounts and can have their scheduled and recurring payments supported through digital payment scheduling.

These payments players connect buyers to the suppliers in emerging markets, like the Asia-Pacific region (which is experiencing the most dramatic global trade growth on the planet today), that were previously unattainable due to the complexities of establishing a relationship with a local bank and the struggle of maintaining bank accounts abroad in foreign currencies.

[bctt tweet=”Buyers and suppliers are building trust without a letter of credit.”]

Collectively, the trend among businesses to migrate towards digital payments providers means buyers and suppliers are more easily building trust without the need for a traditional bank letter of credit.

An Ongoing Shift

The letter of credit is far from history. Still, nearly half of all import and export trade finance deals include such a document. Indeed, with the Asia-Pacific region experiencing the greatest global trade volume growth today, the market still depends on letters of credit, with 68 percent of imports and 75 percent of exports paid for by the tool.

But American Express envisions a global market that may soon phase out these documents, made possible by the rise in international FinTech and payments players that are focusing on cross-border corporate payments solutions.

The industry means businesses no longer have to depend on a bank and can often access international payments services that are faster and more affordable than legacy tools. It’s all a part of the modern market’s demand for a better way to do business.

“Making or receiving the payments for those deals is also happening faster,” the paper concluded, “and the old way of making those payments is often no longer the best way to execute payment.”