Module XIII·Article I·~4 min read
Trade Finance Instruments: LC, Collection, Guarantees, and SCF
Trade Finance and Treasury Management
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What is Trade Finance?
Trade finance is a set of financial instruments and products that enable buyers and sellers in international trade to manage risks and finance the gap between shipment of goods and receipt of payment. Banks, non-bank financial institutions, and specialized platforms ensure transactions by reducing credit risk, payment risk, and country risk.
The trade finance market exceeds $10 trillion per year. In the UAE, this market is particularly significant: Dubai is the largest trading hub in MENA and South Asia, through which a substantial share of re-exports passes.
Letter of Credit (LC)
Letter of Credit is a documentary instrument whereby a bank (issuing bank), at the request of the buyer (applicant), undertakes to pay the seller (beneficiary) a specified amount upon presentation of documents conforming to the terms of the letter of credit.
Types of Letters of Credit
Revocable: Can be amended or revoked by the issuing bank without the consent of the beneficiary. Practically never used.
Irrevocable: The market standard. Cannot be amended without the consent of all parties. Governed by UCP 600 (ICC Uniform Customs and Practice for Documentary Credits).
Confirmed: The seller’s bank (confirming bank) adds its confirmation—the payment is guaranteed regardless of the solvency of the issuing bank. Necessary in cases of high country risk.
Transferable: Allows the beneficiary to transfer rights under the LC to third parties (intermediaries, sub-suppliers).
Stand-by LC (SBLC): Used as a security instrument rather than for settlement. Analogous to a bank guarantee, but in LC format under ISP98 rules.
Process of Working with LC
- The buyer submits an application to the issuing bank to open an LC
- The issuing bank opens the LC in favor of the seller and sends it through the correspondent bank
- The seller ships the goods and provides documents (bill of lading, invoice, insurance policy, certificate of origin)
- The bank checks the documents for compliance with LC conditions (compliance check)
- If the documents comply, the bank makes the payment or accepts the draft
- The issuing bank receives the documents and seeks reimbursement from the buyer
Expenses: Bank commissions are 0.1–0.5% of the deal amount. A hidden risk is document discrepancies—even minor errors can block the payment.
Documentary Collection (DC)
A less reliable, but cheaper instrument compared to LC.
Mechanism: The seller instructs their bank to obtain payment from the buyer in exchange for transfer of documents. Governed by URC 522 (ICC rules for collections).
Types:
- D/P (Documents against Payment): Documents are released to the buyer only after payment
- D/A (Documents against Acceptance): Documents are released after the buyer accepts the draft (i.e., promises to pay in the future)
DC Risks: The bank does not bear payment obligation (unlike an LC). If the buyer refuses to pay/accept, the seller is left with the goods in a foreign territory.
Bank Guarantees
Guarantee is an unconditional obligation of the bank to pay the beneficiary a specified amount upon occurrence of the guarantee event (non-payment, non-performance of the contract).
Types of Guarantees in Trade and Development
| Type of Guarantee | Purpose |
|---|---|
| Tender (Bid Bond) | Ensures participation in the tender |
| Performance (Performance Bond) | Guarantees contract performance |
| Advance Payment Guarantee | Refund of advance in case of non-performance |
| Payment Guarantee | Ensures buyer’s payment |
| Customs Guarantee | Ensures customs payments |
Demand Guarantees vs. Conditional Guarantees: Demand guarantees are paid upon first request without proof of breach. Conditional guarantees—only upon submission of evidence. In international practice, demand guarantees dominate (ISP98, URDG 758).
Supply Chain Finance (SCF)
SCF is a set of technological and financial solutions allowing buyers to optimize payment terms for suppliers with the involvement of a bank or financial platform.
Reverse Factoring
The main form of SCF. The buyer approves supplier invoices, after which the bank or platform finances the supplier at a reduced rate (using the buyer’s credit rating).
Example: A corporation with a rating of A- approves supplier invoices. Suppliers receive payment immediately (minus a discount of 0.5–1.0%/year), the buyer pays the bank in 90–120 days. Suppliers obtain liquidity at the buyer’s rate (lower than their own).
Dynamic Discounting
The buyer uses their own excess cash funds for early financing of suppliers in exchange for a discount. The discount rate decreases with a later payment request.
SCF Platforms
Largest platforms: C2FO, Taulia, PrimeRevenue, Greensill Capital (bankrupt since 2021—lesson about SCF risks), J.P.Morgan SCF, Citibank Trade. In the UAE, Emirates NBD is actively operating with SCF solutions for local supply chains.
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