The Letter of Credit’s Demise
14.02 The demise of the letter of credit is intimately linked with the growth in popularity of ‘openaccount’ and prepayment terms, which has in turn been driven by a renewed interest in SCF.
Whilst it is unclear whether the increased use of ‘open-account’ and prepayment terms is a cause or consequence of letters of credit becoming less popular (or, more likely, both), the data is clear: trade parties’ use of letters of credit has reduced steadily over time and ‘the slump continues’, with the volume of letters of credit being issued through SWIFT falling by a further 3.9% in 2019 alone.[1338] That said, the drop in documentary trade finance is not uniform. A more fine-grained analysis of the data highlights a number of variations:[1339] in terms of the type of instrument, letters of credit available by negotiation continue to represent the lion’s share of documentary trade instruments;[1340] import letters of credit were used far more extensively in the Asia-Pacific region (in particular China, India, South Korea, and Bangladesh), followed by the Eurozone and the Middle East some way behind (with the United Kingdom and Germany seeing particularly sharp declines in use);[1341] and the use of export letters of credit has largely followed the same pattern with the Asia-Pacific region leading the pack, followed by the Eurozone and non-eurozone Europe lagging behind (with Italy and Switzerland experiencing notable drops in letter of credit use).[1342] These regional variations in letter of credit use may be explained in part by whether the particular jurisdiction is economically developed or developing, by a variety of geographical factors (such as the distance to major commercial centres or trading partners),[1343] and by the presence (or otherwise) of international banks within the particular jurisdiction.[1344] That said, whilst the outlook for the letter of credit is generally grim, a silver lining of the global coronavirus pandemic has been that documentary trade finance has proved popular with trade parties seeking a proxy for counterparty trust. Indeed, in the context of the current pandemic, the International Chamber of Commerce (‘ICC’) has indicated that ‘[t]he risk mitigating properties of documentary trade may grow in popularity (reversing the ongoing shift to open account trade), although this may be less pronounced than in previous crises as more attention has been placed on how to apply risk mitigation to SCF’.[1345] Accordingly, like the Global Finance Crisis before it, the coronavirus outbreak has ‘reversed the trend in recent years in which revenues have shifted from documentary to open account trade’.[1346] The ICC’s current prediction is, however, that this is a ‘temporary shift away from open account trade and back to documentary trade’[1347] The reason for this view is that ‘[t]he Covid-19 environment may have finally convinced everyone that paper-based trade is outdated and unsustainable accelerating the move to digitisation’.[1348] As a result, whilst it may be too early to speak of a ‘new normal’ heralding a resurgence of documentary letters of credit, the longer the global pandemic and the Sino-US trade tensions continue,[1349] the more uncertainty in the supply chains will drive traders to precisely such ‘safe haven’ trade-finance instruments. Like so much with the coronavirus pandemic, its impact on trade finance remains a guessing game.Assuming that, once the global coronavirus pandemic is over, the letter of credit continues 14.03
its steady decline, it is important to determine the causes behind this phenomenon. Some of the causes are not difficult to identify and have already been considered in earlier chapters.
A. Technology
In a world that has become so conscious about transaction speed, there appears to be little 14.04 future for documentary trade finance.[1350] Indeed, in an era of social distancing and sanitisation, it seems almost incomprehensible why the participants in an international sale would want to pass bundles of documents from hand to hand and jurisdiction to jurisdiction.
Whilst the ICC introduced the eUCP to facilitate the letter of credit’s transition from a paper-based world to the digital era,[1351] this has not proved a great success: trade parties have been reluctant to digitise the documents that would be required for an electronic presentation under a letter of credit, as a result of concerns about increased fraud and how bills of exchange and lading could be effectively transmuted into electronic form.[1352] There also remains a heathy degree of scepticism about how transformative technology might be, in particular whether distributed ledger technology can live up to its hype.[1353] That said, there are increasingly the technological[1354] and legal[1355] frameworks in place to make digital trade finance a reality. Whether the letter of credit is able to survive depends upon its adaptability to this new electronic environment.B. Regulation
In recent years, banks have faced something of a regulatory onslaught. This only accelerated 14.05
in the period following the Global Financial Crisis. Trade finance has been no exception.
policy-responses∕covid-19-and-international-trade-issues-and-actions-494da2fa∕> 22 February 2021. See also ICC, Trade Financing and Covid-19 (May 2020).
Accordingly, banks issuing and confirming letters of credit face an increasingly heavy regulatory burden that has driven up their compliance costs and has made letters of credit increasingly inaccessible to trade parties lacking an established trading relationship with a particular bank. There are three particular areas in which the regulatory burden has fallen particularly heavily.
14.06 The first area of regulatory activity concerns the prudential supervision of banks, in particular how the Basel capital adequacy and liquidity regimes should apply to banks' tradefinance operations.
Indeed, as the regulatory requirements of the Basel regimes have increasingly intensified over time, so has uncertainty grown about their application to letters of credit in particular. Initially, under the Basel I regime, bank assets were risk-weighted according to the borrower's default risk, which in turn determined how much capital a bank had to set aside (no less than an 8% minimum capital ratio of riskier assets' notional value), so that banks could cover any potential losses in straitened times.[1356] The Basel I regime, however, recognised the low-risk character of trade-finance liabilities,[1357] by providing a more favourable regulatory environment for ‘short-term self-liquidating trade-related contingencies (such as documentary credits collateralised by the underlying shipments)'. Pursuant to this more liberal regime, banks only needed to carry 20% of the capital that they would otherwise have had to carry if the same amount had simply been advanced as a loan.[1358] Accordingly, as letters of credit were considered to involve a low-risk exposure, the ‘capital cost' for a bank's trade financing activities was relatively low compared to other forms of lending. Under the Basel II regime, the basic position remained the same, although there was an increased recognition of the cyclical nature of business activity with the result that a bank's particular credit risk had to be determined by reference to a wider set of economic risk categories. Of particular concern to the trade finance area was the fact that banks had to use ‘country risk' (rather than ‘counterparty risk') in calculating their capital ratios, at least when the former was higher than the latter. This was the so-called ‘sovereign floor' principle. As a result of this principle, trade finance (including traditional letters of credit) became comparatively expensive for banks (when compared to other forms of lending) in terms of ‘capital cost' when the letter of credit was issued by a bank on behalf of an applicant in a ‘high-risk' country, such as one in recession or one that had recently defaulted on sovereign debt.[1359] The other difficulty, besides the operation of the ‘sovereign floor principle', was that Basel II also operated a one-year ‘maturity floor' for all lending commitments,[1360] which meant that trade-finance instruments, despite generally having a shorter maturity than one year, nevertheless attracted a ‘capital cost' appropriate to longer-term commitments.[1361] Thislatter concern was mitigated to some extent by national regulators being given the discretion to disapply the one-year ‘maturity floor’ for ‘short-term exposures with an original maturity of less than one year that are not part of a bank’s ongoing financing of an obligor’,[1362] but there was no guarantee that such a discretion would be exercised.
14.07
Both the ‘sovereign floor principle’ and the one-year ‘maturity floor’ were subsequently addressed by the Basel Committee for Banking Supervision in October 2011, when it agreed to waive the former principle for trade-finance activity with low-income countries and to disapply the latter as a rule for short-term trade-finance instruments, rather than leaving this to the discretion of national regulators.[1363] This position has now been crystallised under Basel III.
The Basel Committee on Banking Supervision has confirmed that the original one-fifth risk-weighting from Basel I (without either of the earlier qualifications)[1364] ‘will be applied to both the issuing and confirming banks of short-term self-liquidating trade letters of credit arising from the movement of goods (e.g. documentary credits collateralised by the underlying shipment)’.[1365] This has now been implemented into the new Basel Framework when determining the ‘capital cost’ for banks of risk-weighted assets.[1366] The concern over the application of the Basel III regime to trade finance has, however, lain in a different direction, namely the requirement that regulators supplement risk-based capital requirements with a leverage ratio. For the purposes of this ratio, banks must apply a considerably higher risk-weighting to off-balance-sheet liabilities. The leverage ratio’s underlying rationale is clear: banks are discouraged from accumulating off-balance-sheet items (such as derivative exposures) that might ultimately become toxic and damage the wider financial system. Despite this good sense, however, a possible ‘unintended consequence’ of the leverage ratio was to make the issuance and confirmation of letters of credit far more ‘costly’ for banks in capital terms.[1367] As letters of credit are only moved onto a bank’s balance sheet following the verification of the presented documents,[1368] they are effectively off-balance sheet items before that time. Accordingly, concerns were expressed that the ‘capital cost’ of letters of credit might increase by as much as 40%,[1369] and that, as margins for such instruments are generally low, banks would tend to divest themselves of trade-finance business in favour of more profitable activity.[1370] This position was finally regularised on 12 January 2014, however, when the Basel Banking Committee indicated that it would reverse its previous position, so that the obligations of issuing and confirming banks would from 2018 be given a lower weighting under Basel III for the purposes of the leverage ratio.[1371] This has now been implemented into the new Basel Framework when determining the leverage ratio,[1372] so that letters of credit are once again relatively ‘cheap’ for banks in capital terms. Unfortunately, this beneficial change has arguably come too late, as the uncertainty over the years has caused traditional banks to restrict their letter-of-credit activity or to exit the sector altogether.[1373] The regulatory impact on the shape of the trade finance sector will be considered further below.14.08 The second regulatory area concerns the application of domestic anti-money laundering and anti-terrorist financing legislation,[1374] both of which are generally derived from the recommendations of the Financial Action Task Force (‘FATF’),[1375] to the trade-finance area, in particular letters of credit. From an early stage, FATF perceived trade-based money laundering (or ‘TBML’) as a particular problem requiring an international response.[1376] As well as conducting the usual ‘know your customer’ checks in relation to their instructing party, banks that issue or confirm letters of credit must be alert to certain ‘red flags’ indicating the existence of TBML in relation to the underlying sale transaction.[1377] These include deviations from a trade party’s usual business patterns; related-party transactions; transactions with frequent documentary changes, multiple discrepancies or missing information; the use of complex financial or corporate structures; the future-dating of bills of lading; trade-party reticence to provide information; and even the fact that goods are dual-use or shipped via an unusual route.New Roman",serif;color:black'>[1378] Whilst technology can certainly assist banks in carrying out these anti-money laundering checks more efficiently,[1379] the very fact that such checks need to be carried out at all strikes at the heart of the letter of credit. According to the UCP 600, the foundational principles of letters of credit are that ‘[a] credit by its nature is a separate transaction from the sale or other contract on which it may be based’[1380] and that ‘[b]anks deal with documents and not with goods, services or performance to which the documents may relate’.[1381] TBML requires banks, however, to do precisely the opposite. Not only does this increase the time and costs associated with examining and processing documents under letters of credit, but it also raises the spectre of civil or criminal liability for banks who rely on the letter of credit’s traditional autonomy as a justification for not investigating matters too much. Moreover, at common law, banks can only generally refuse payment under a letter of credit when it is ‘clearly established at the interlocutory stage that the
only realistic inference is... that the bank was aware of the fraud’;[1382] yet, in England, a bank is required to make an authorised disclosure on the mere ground that it ‘suspects’ another to be engaged in money laundering.[1383] There is no requirement that the bank’s suspicion be reasonable, although ‘the suspicion so formed should be of a settled nature’,[1384] in the sense that there should be a sufficiently strong evidentiary basis for the suspicion that it cannot simply be dismissed. In such circumstances, the bank’s disclosure to the relevant authorities suspends (and potentially terminates altogether) the issuing or confirming bank’s obligation to pay,[1385] until the appropriate consent is forthcoming from those authorities.[1386] Accordingly, the regulation of TBML risks weakening the twin pillars of strict compliance and autonomy; contradicting the safeguards carefully erected by the courts around the fraud (and other) exception; and undermining the basic irrevocable nature of commercial credits. In such a regulatory environment, it is hardly surprising that the letter of credit has come under such strain.
14.09
The third area of regulation impacting upon letters of credit stems from the sanction regimes imposed by the United Nations, the EU Council, or individual countries to achieve various political and economic ends. Not only does the violation of such sanctions invalidate the banks’ payment undertakings under a letter of credit, but those banks may also become subject to significant criminal penalties. Just as with TBML, issuing and confirming banks may no longer just deal with the documents alone and ignore all extraneous matters;[1387] rather, banks must nowadays inform themselves about the details of the underlying sales transactions (particularly the ultimate destination of the goods and funds to be disbursed under the credit) in order to determine whether honouring the letter of credit would potentially violate a particular sanctions regime.[1388] Indeed, the high number and broad range of applicable sanctions regimes now requires banks to carry out extensive and onerous checks before honouring a letter of credit. This is at odds with the essentially ministerial task envisaged by the UCP regime[1389] and represents a significant inroad into the autonomy and irrevocability of such instruments.[1390] Indeed, in order to facilitate their task, some banks have developed a practice of inserting a ‘sanctions clause’ into their letters of credit. The ICC has, however, objected to such a practice: to the extent that the ‘sanctions clause’ simply performs an ‘advisory’ function by informing counterparties of the relevant bank’s intention to comply with applicable sanctions regimes, the ICC has stated the clause to be unobjectionable;[1391] but, where (as is increasingly the case) the clause purports to confer a discretion upon the issuing or confirming bank whether or not to honour its commitment in light of relevant sanctions regimes,[1392] or allows such banks to refer to their own ‘internal sanctions-related policy',[1393] the ICC has declared the clause to be fundamentally at odds with the traditional approach to letters of credit. Whilst these clauses undoubtedly differ in formal terms, it may be wondered whether in practice the first type of clause is any more consistent with traditional letter of credit principles given that it may still provide a basis for an issuing or confirming bank refusing to honour a letter of credit following investigation into the surrounding circumstances. In light of such difficulties, banks have unsurprisingly abandoned letters of credit.
C. Competition
14.10 As a consequence of technological advances and the increased regulatory burden in the trade-finance area, letters of credit have been subjected to increased competition. This takes two forms. First, the letter of credit increasingly faces competition from cheaper, quicker, and technologically more advanced payment mechanisms, with the ‘Bank Payment Obligation' or ‘BPO' being the most obvious recent example.[1394] Indeed, the development of ‘open-account' trading and SCF has been greatly facilitated by the development of electronic platforms that enable the parties to deal with one another, as well as facilitating a degree of automation. Technology is not, however, the whole story. Other trade-finance mechanisms have similarly displaced the letter of credit where they are better adapted to serving particular sections of the trading community (such as financing that respects Islamic principles)[1395] or assisting trading parties in extremis (such as countertrade).[1396] One observable consequence of these competitors seizing the territory previously occupied by the letter of credit is that the latter instrument has increasingly been re-purposed for other uses. This has led to the development of ‘synthetic' or ‘structured' letters of credit. According to Calderon v US Department of Agriculture, Foreign Agricultural Service,[1397] such instruments have certain hallmarks, including the letter of credit indicating that documents would be considered acceptable ‘despite any and all discrepancies' or ‘acceptable as presented'; that photocopies would be acceptable in place of originals; and that the letter of credit's issue date is later than the date on the bill of lading. Although ‘synthetic' letters of credit may take a number of different forms and have a number of different specific aims, they tend to share one key feature: although the transaction resembles a letter of credit, there is in fact no underlying sale transaction, since the credit's primary aim is simply to provide a loan or liquid funds to a particular entity,[1398] rather than to effect the applicable anti-boycott, anti-money laundering, anti-terrorism, anti-drug trafficking, and economic sanctions laws and regulations is not acceptable.'
payment for goods. That is not to say, however, that there is never a sale contract in the background: the drawdown of the funds will usually be conditioned upon a documentary presentation, although the required documents may be from a completed sale contract between the parties or merely documents that have been recycled on a number of occasions from earlier sale transactions. The rationale for adopting such a synthetic structure is to take advantage of the letter of credit’s (now) more favourable regulatory treatment under Basel III, which was considered above. Despite this apparent evasion of the Basel III regime, there is some judicial support for the validity of synthetic letters of credit. In Fortis Bank (Nederland) NV v Abu Dhabi Islamic Bank,[1399] Schweitzer J indicated that ‘[t]he fact that [the transaction] was ‘structured’ as a trade financing, while perhaps unusual, is not by itself a fraudulent or illegal scheme’. It is less clear whether national bank regulators would agree with such a characterisation given that the documents perform a security function under a traditional letter of credit, which is patently not the case with a synthetic structure. Ultimately, however, traditional letters of credit may become tainted by association with such evasive practices, which may in turn further damage their standing.
14.11
Secondly, as well as there being increased competition from other payment mechanisms, banks have equally become subject to increased competition from other finance-providers. The reason why this has impacted upon the documentary letter of credit is because such trade finance instruments are generally viewed as ones that only banks can issue. Indeed, under the UCP 500, the ICC made clear that, whilst it was not possible for the UCP to proscribe non-bank entities entirely from issuing letters of credit, this was certainly not desirable and should be strongly discouraged. According to the ICC Banking Commission:[1400]
New Roman">The UCP reflects that state of practice, namely a situation where the issuer or other actor on a letter of credit is a bank. As a result, although there is no affirmative rule in the UCP prohibiting entities that are not banks from issuing confirming, paying, negotiating or advising letters of credit, its vocabulary (‘issuing bank’, ‘confirming bank’, etc) assumes that these entities are banks. This assumption is based on the recognition that there are three principal advantages to bank issuance and handling of letters of credit: namely that banks have the operational expertise to handle issuance and presentation under letters of credit in a professional manner, that they have the tradition of independence from the underlying transaction which is the basis of the commercial reputation of the letter of credit, and that in virtually all countries banks are specially regulated with a view toward protecting those who rely on their undertakings. These matters are of considerable importance to the integrity of the letter of credit as an instrument of commerce and to its dependability as an instrument of payment.
Similarly, according to the UCP 600, a ‘credit’ is defined as ‘any arrangement, however named or described, that is irrevocable and thereby constitutes a definite undertaking of the issuing bank to honour a complying presentation’.[1401] As a result of the uncertainty over
Enterprises Inc, Bankr Lexis 2720 (BC Del, 2010); Re Allied System Holdings Inc, 556 BR 581 (DC Del, 2016); Re Ashnic Corporation, 683 Fed Appx 131 (3d Cir, 2017).
the capital treatment of letters of credit and the application of money-laundering and sanction regimes, banks have become increasingly reluctant or unable to issue letters of credit in order to meet the demands of trade parties, resulting in the so-called ‘trade finance gap' of US$1.6 trillion.[1402] The position is particularly acute in relation to SMEs, as the regulatory burden on banks is heaviest when dealing with such counterparties.[1403] Some traditional banks have simply exited the trade-finance sector altogether, whilst others have suffered capacity-constraints meaning that they are unable to service trade parties' needs. As a consequence, a raft of alternative finance-providers (including insurance companies, pension funds, and ‘shadow banks’, which are not directly affected by the Basel regime) have effectively stepped into the breach by filling the trade financing void left behind by the traditional banking sector.[1404] Fintech companies and other technology-based start-ups in particular have been active in using technological solutions to address the ‘trade finance gap'.[1405] Given that these alternative finance-providers are not considered by the ICC to be sufficiently creditworthy to issue letters of credit subject to the UCP regime, these entities have instead sought to provide the necessary finance through other cheaper, faster, and more flexible means, in particular SCF. Accordingly, as a result of the ‘trade finance gap’ it is almost inevitable that there should be a growth in alternative forms of trade finance and, as trade parties become accustomed to those alternatives, it is equally inevitable that the demand for letters of credit would become more constrained. Indeed, having seen the opportunities presented by SCF, banks themselves are now embracing this as an alternative.
D. Efficiency
14.12 The causes of the letter of credit's demise are not, however, entirely exogenous. Besides being documentary in nature, letters of credit have increasingly suffered from their own limitations. The high fees associated with the issue, confirmation, and amendment of letters of credit make them an expensive form of finance;[1406] indeed, as occurred during the Global Financial Crisis, those fees are likely to track even higher during the coronavirus pandemic as banks become increasingly risk-averse and seek to protect their own balance- sheets.[1407] Moreover, given that letters of credit are designed to provide beneficiaries with a reliable paymaster, the high discrepancy rates and rejection rates associated with such instruments make them far less reliable than intended.[1408] This erodes confidence in their use. In no small part, this position has not been helped by the doctrine of strict compliance: as originally conceived, this doctrine represented one of the letter of credit's real strengths, since it enabled banks to deal with documents rapidly and in a purely ministerial capacity; increasingly, however, the doctrine’s strictness is effectively providing banks with a discretion (usually acting upon their customer’s instructions) whether or not to make payment in a particular case, since it would be unusual for documents to contain no discrepancy at all. As a consequence, discrepancy rates were high when the UCP 600 was adopted[1409] and, as ‘the ICC’s attempt to introduce uniformity as regards details of compliance—made in the International Standard Practice (known as ‘ISBP’)—has not achieved its object’,[1410] rejection levels have remained stubbornly elevated.
III.