Trade Financing and Letters of Credit
Why Trade Finance Matters for Investors
International trade creates a fundamental problem: a buyer in one country wants goods from a seller in another country, but neither party trusts the other enough to act first. The buyer does not want to pay before receiving goods; the seller does not want to ship before receiving payment. Trade finance bridges this trust gap.
The trade finance market is substantial. The World Trade Organization estimates that 80-90% of global trade relies on some form of trade finance, with the market value exceeding $10 trillion annually. Banks that provide trade finance generate significant fee income, and companies that depend on trade finance carry financing costs and counterparty exposures that affect their financial statements.
For US investors analyzing internationally exposed companies, understanding trade finance reveals hidden costs, risks, and competitive advantages.
Trade Finance Basics
Trade finance encompasses several instruments and techniques that facilitate international transactions:
| Instrument | Risk Profile | Typical Use Case |
|---|---|---|
| Open account | High seller risk | Established relationships, low-risk markets |
| Documentary collection | Moderate risk | Medium-trust relationships |
| Letter of credit | Low risk for both parties | New relationships, high-value transactions |
| Cash in advance | High buyer risk | Risky markets, new suppliers |
| Export credit insurance | Risk transfer | Emerging market exposure |
| Supply chain finance | Working capital optimization | Large buyer-small supplier relationships |
The choice of instrument depends on the relationship between buyer and seller, the credit quality of each party, the country risk involved, and the transaction size. Higher-risk situations demand more protective (and expensive) instruments.
Letters of Credit: The Workflow
A letter of credit (LC) is a bank guarantee that payment will be made if the seller provides documents proving the goods were shipped as specified. The bank substitutes its creditworthiness for the buyer's, giving the seller confidence to ship.
The Four Key Parties
- Applicant - The buyer (importer) who requests the LC from their bank
- Issuing Bank - The buyer's bank that issues the LC and guarantees payment
- Advising Bank - The seller's bank that authenticates and forwards the LC
- Beneficiary - The seller (exporter) who receives payment under the LC
Step-by-Step LC Workflow
Step 1: Application (Day 0) The buyer applies to their bank for an LC, providing transaction details: goods description, quantity, price, shipping terms, required documents, and expiration date. The bank evaluates the buyer's creditworthiness.
Step 2: LC Issuance (Days 1-3) The issuing bank creates the LC and transmits it to the advising bank in the seller's country via SWIFT (the global financial messaging network).
Step 3: LC Advising (Days 3-5) The advising bank authenticates the LC and notifies the beneficiary (seller). The seller reviews the LC terms to ensure they can comply with all document requirements.
Step 4: Shipment and Document Preparation (Days 5-30) The seller ships the goods and prepares the required documents:
- Commercial invoice
- Bill of lading (proof of shipment)
- Packing list
- Certificate of origin
- Insurance certificate
- Inspection certificates (if required)
Step 5: Document Presentation (Days 30-35) The seller presents documents to the advising bank. The documents must exactly match the LC requirements (the "doctrine of strict compliance").
Step 6: Document Examination (Days 35-40) The advising bank examines documents for compliance. Under UCP 600 rules (the international standard for LCs), banks have 5 banking days to examine documents.
Step 7: Payment (Days 40-45) If documents comply, the advising bank forwards them to the issuing bank and receives payment. The advising bank pays the seller. The issuing bank releases documents to the buyer upon payment or acceptance.
Step 8: Goods Release (Days 45-50) The buyer presents the bill of lading to the shipping company to claim the goods.
Sample LC Timeline
| Stage | Day | Action |
|---|---|---|
| Application | 0 | Buyer applies to issuing bank |
| Issuance | 2 | Issuing bank sends LC via SWIFT |
| Advising | 4 | Advising bank notifies seller |
| Shipment | 15 | Seller ships goods |
| Document prep | 20 | Seller compiles required documents |
| Presentation | 22 | Seller presents to advising bank |
| Examination | 27 | Banks complete document review |
| Payment | 30 | Seller receives payment |
| Goods arrival | 45 | Buyer receives goods |
Total cycle time from LC application to goods receipt: approximately 45 days, though this varies based on shipping routes and document complexity.
Risk Mitigation Role of Letters of Credit
Letters of credit mitigate multiple risk categories:
Payment Risk
The issuing bank's guarantee replaces reliance on the buyer's promise. Even if the buyer becomes insolvent after shipment, the seller receives payment from the bank if documents comply.
Country Risk
For transactions involving unstable countries, a confirmed LC adds a second bank guarantee. The confirming bank (usually the advising bank) guarantees payment even if the issuing bank or its country defaults.
Document Risk
The strict compliance requirement creates paper evidence of exactly what was shipped. Disputes over quantity, quality, or specifications are easier to resolve when documents specify each detail.
Performance Risk
The seller must provide documents proving shipment occurred as specified. A seller cannot receive payment by shipping substandard goods if inspection certificates are required.
Example: Confirmed LC for Emerging Market Transaction
A US machinery exporter sells $2 million of equipment to a buyer in Turkey. The Turkish buyer obtains an LC from a Turkish bank. Given currency volatility and banking sector concerns, the US exporter requests a confirmed LC.
The confirming bank (a major US bank) adds its guarantee. If the Turkish bank cannot pay due to currency controls, sanctions, or insolvency, the US confirming bank pays the exporter. The confirming bank then pursues reimbursement from the Turkish bank.
The exporter pays for this protection: confirmation fees typically run 0.5-2.0% of the LC value, depending on the issuing bank's country and credit rating.
Fees and Typical Timelines
Trade finance is not free. Costs accumulate across multiple fee categories:
LC Fee Components
| Fee Type | Typical Range | Paid By | Calculation Basis |
|---|---|---|---|
| Issuance fee | 0.125-1.50% | Buyer | LC amount, annualized |
| Advising fee | 0.10-0.25% | Seller (often) | LC amount |
| Confirmation fee | 0.50-2.00% | Seller | LC amount, based on issuing bank risk |
| Amendment fee | $50-200 | Requester | Per amendment |
| Negotiation fee | 0.10-0.25% | Seller | Drawing amount |
| Discrepancy fee | $50-150 | Seller | Per set of discrepant documents |
| SWIFT charges | $30-50 | Both | Per message |
Sample Fee Calculation
A $500,000 LC transaction with a 90-day term might incur:
| Fee | Calculation | Amount |
|---|---|---|
| Issuance (0.75% annual, 90 days) | $500,000 x 0.75% x (90/360) | $938 |
| Advising (0.15%) | $500,000 x 0.15% | $750 |
| Confirmation (1.25% annual, 90 days) | $500,000 x 1.25% x (90/360) | $1,563 |
| Negotiation (0.125%) | $500,000 x 0.125% | $625 |
| SWIFT messages (3 x $35) | $105 | |
| Total fees | $3,981 | |
| As percentage of transaction | 0.80% |
For a company with $100 million in annual LC-financed imports, fees might run $800,000 or more, affecting operating margins.
Processing Timelines
| Process | Standard Timeline | Expedited (additional cost) |
|---|---|---|
| LC issuance | 2-5 business days | Same day to 1 day |
| Document examination | 5 banking days max | 2-3 days |
| Payment after compliant presentation | 5-7 business days | 1-2 business days |
| Amendment processing | 2-5 business days | Same day to 1 day |
Practical Implications for Investors
Analyzing Trade-Dependent Companies
When reviewing companies with significant international trade, look for:
Working Capital Impact LC-financed transactions tie up cash longer than domestic sales. A company waiting 45-60 days from shipment to payment needs more working capital than one with 30-day domestic receivables.
Fee Expense Trade finance fees appear in cost of goods sold or operating expenses. Companies heavily reliant on LCs may have 0.5-1.5% higher costs than competitors with open account relationships.
Contingent Liabilities Outstanding LCs represent contingent obligations. Check the notes to financial statements for LC exposure, especially for companies importing from or exporting to higher-risk countries.
Bank Relationship Quality Companies with strong banking relationships obtain better LC pricing and faster processing. This competitive advantage is difficult to quantify but real.
Questions to Ask About Trade Finance Exposure
| Question | Why It Matters |
|---|---|
| What percentage of sales/purchases use LCs? | Higher LC usage increases costs but reduces risk |
| What is the average tenor of trade finance facilities? | Longer tenors indicate better bank relationships |
| Does the company have uncommitted trade finance lines? | Uncommitted lines can be withdrawn in credit crunches |
| What countries require confirmed LCs? | Confirmation needs signal higher country risk exposure |
| How often do document discrepancies occur? | High discrepancy rates suggest operational issues |
Red Flags in Trade Finance
- Declining trade finance availability during economic stress (2008-2009 saw trade finance shortages that contributed to trade collapse)
- Increasing confirmation requirements suggesting counterparty or country risk deterioration
- Rising discrepancy rates indicating operational problems or document fraud attempts
- Shift from LC to open account in risky markets may signal credit standards loosening
Alternative Trade Finance Structures
Beyond traditional LCs, other structures serve specific needs:
Supply Chain Finance (Reverse Factoring)
Large buyers use their credit rating to help suppliers access cheaper financing. A supplier sells receivables at a discount to a bank, receiving immediate payment. The bank collects from the buyer at maturity.
This shifts financing cost from the supplier's credit profile (often higher) to the buyer's (often lower). Major retailers and manufacturers use supply chain finance extensively.
Export Credit Agency Support
Government agencies like the US Export-Import Bank provide guarantees and direct financing for exports. Ex-Im Bank supported $8.2 billion in US exports in fiscal 2023, primarily for capital goods and aircraft.
Trade Credit Insurance
Private insurers (Euler Hermes, Coface, Atradius) and government agencies offer insurance against buyer default. Coverage typically runs 0.1-1.0% of insured receivables annually.
Practical Takeaways
Trade finance infrastructure enables international commerce by solving the trust problem inherent in cross-border transactions. For investors, the key analytical points are:
- Trade finance has costs - Companies with high LC usage face measurable fee expenses and working capital requirements
- Trade finance availability is cyclical - Credit crunches can freeze trade finance, amplifying economic downturns
- Country risk matters - Confirmation requirements and costs reveal how banks assess country exposure
- Bank relationships are competitive advantages - Better pricing and faster processing benefit companies with strong banking ties
When analyzing trade-dependent companies, examine their trade finance arrangements as you would any other financing structure. The costs, terms, and availability of trade finance affect margins, cash flow, and risk exposure.