Low default rates, increased flexibility, technological advancements and evolving regulations are fuelling the adoption of standby letters of credit (SBLCs), a potent instrument.

Buyers and sellers should take note: the use of SBLCs is gaining momentum as a payment of last resort in international trade.

SBLCs have evolved as an essential financial instrument, protecting parties against defaults in performance and financial obligations. Parties may include buyers of large projects who rely on the performance of contractors, or sellers needing assurance of payment.

What are SBLCs?

At its core, an SBLC is an undertaking or commitment by the issuer (typically a bank or financial institution), made at the request of the applicant (also referred to as the obligor), to pay the named beneficiary a stipulated amount, provided the beneficiary satisfies certain documentary conditions.

Generally, an SBLC is established to provide assurance to the beneficiary that the applicant will fulfil certain obligations arising from a separate transaction between the two parties. These obligations could involve the satisfactory performance of a service, delivery of goods, full performance under a contract, or payment. Unlike a commercial letter of credit, where the beneficiary’s right to payment is tied to their own performance or non-performance, in an SBLC, the right to payment depends on the applicant’s performance or non-performance.

The history of SBLCs

The genesis of SBLCs can be traced to the Glass-Steagall Act of 1933, which restricted US banks from issuing guarantees involving secondary liability for another party’s debt or default. To meet the demands of international trade, banks and regulatory agencies developed the SBLC, an instrument that provides the same assurance as a guarantee but is triggered by the presentation of complying documents or a simple demand, without concern for the actual default by the principal. This makes SBLCs akin to bank or independent guarantees, operating under the principles of independence and strict compliance.

SBLC volumes have increased significantly over the last 10 years. According to the ICC Trade Register, in 2022, the flow of documentary trade (including LCs, SBLCs, and bank guarantees) surpassed US$2.5tn. The popularity of SBLCs has surged outside the US, with volumes and amounts far exceeding US numbers of US$600bn to US$1tn, as reported by DCW.

The global growth of SBLCs is attributed to the flexibility in their application, technological advancement, widespread adoption of International Chamber of Commerce (ICC) rules, low default rates, banks’ focus on fee-based income, and favourable capital regulations.

Popularity of the instrument

SBLCs have become instrumental in facilitating global trade by providing a secure and reliable method of payment in international transactions. For the industrials sector, where contracts are long-term or revolving, this instrument helps secure contracts, provides leverage for negotiating favourable contract terms, and protects against currency and political risks.

The flexibility to customise SBLCs to specific contract requirements, along with features like transferability and assignment, all add to their merit and promote confidence among parties.

The usage of SBLCs spans a broad spectrum of obligations. For example, surety companies often accept SBLCs in lieu of collateral when issuing appeal bonds. In virtual power purchase agreements, SBLCs are used as synthetic letters of credit to safeguard against project delay risk. Insurance companies use SBLCs to secure insurance premiums, and, in some cases, posting an SBLC is a state-mandated requirement.

Trade facilitation programmes of multilateral development banks, such as the IFC (the private sector arm of the World Bank), the Asian Development Bank, and the Inter-American Development Bank, also use SBLCs to underpin trade transactions.

Above all, SBLCs are used as a counter-support for international bank guarantees, which may be tied to sureties and lease instruments on performance bonds.

Rules and regulations governing SBLCs

International Standby Practices (ISP98), which celebrated its silver jubilee in 2023, provides comprehensive and clear guidelines for the SBLC lifecycle. These rules are well-understood by banks and regulatory bodies worldwide.

The rules were initially published by the Institute of International Banking Law & Practice (IIBLP). Later, an agreement was reached with the ICC to also publish them as ICC Publication No. 590. Along the way, the IIBLP prepared and published model forms for use with ISP98. The model forms contain detailed, educational endnotes that reference various ISP98 rules, explain why particular LC provisions were drafted in a certain way, suggest alternatives that may be appropriate in certain circumstances, and provide clear instructions on how to fill in blank spaces or choose from bracketed alternatives.

Today, ISP98 is so widely adopted that it is integrated into Swift message types in much the same way that ICC rules – such as UCP 600 – are embedded for commercial LCs. There is no doubt that ISP98 has become the rule set of choice for SBLCs. It continues to grow in popularity, and it has been cited in court cases and guided courts to resolve LC disputes.

The rules have also anticipated the trend towards increased digitisation, and contain provisions that support electronic presentations under SBLCs.

Low default rates and capital charges

SBLCs are attractive instruments for issuers due to their historically low default rates. The ICC Trade Register provides a global view of the credit risk profiles in trade finance, including SBLCs. In 2022, the ICC adopted a more granular approach to ensure reliable analysis, comparability across banks, consistency in the application of the formula, and replicability of results.

According to the data, the obligor-related default rate (using the Basel methodology) stood at 0.26% in 2020. When the ICC extended its analysis to include exposure-related and transaction-related default rates over the 2015-2020 period, the results were even smaller. In fact, the drawing rates for performance SBLCs and BGs for both defaulted and non-defaulted obligors were estimated to be below 1%.

These data support an average Credit Conversion Factor (CCF) of less than 10%, which justifies the maintenance of a 20% downturn Exposure at Default (EAD) when calculating risk-weighted assets for capital purposes.

Recognising the favourable risk profile of trade finance instruments, both the European Parliament and the European Council have approved a CCF of 20% for trade finance off-balance sheet items.

However, US regulators have proposed a higher capital requirement for the so-called Basel Endgame. The proposed rule focuses on increasing capital against credit, market and operational risks, significantly impacting lending costs and availability.

Revenue contribution to global trade

The popularity of SBLCs is also reflected in revenue contribution to the banking community. According to BCG Global Trade Model 2023, documentary trade products (including LCs and BGs) accounted for 41% of total trade finance bank revenues, amounting to US$58bn in 2023.

SBLCs generate significant fee-based income through high-volume, low-margin activities such as LC advising fees, amendment fees, processing fees, and more. In addition to these direct revenues, SBLCs create opportunities for banks to cross-sell additional products and services to their customers.

Risks associated with SBLCs

While SBLCs offer benefits and payment security, it is important to consider the risks associated with their use.

A crucial document in an SBLC transaction is the reimbursement or letter of credit agreement. This document typically establishes the applicant’s contractual obligation to reimburse the issuer for any payments made under the SBLC. In addition, the reimbursement or letter of credit agreement should provide other important terms with respect to reimbursement. Some issuers have the applicant execute a promissory note in the amount of the SBLC as evidence of the applicant’s reimbursement obligation.

Several key factors must be considered when issuing an SBLC, including the financial stability and creditworthiness of the issuer, the risk of documentation errors or potential disputes, the possibility of fraud or abusive drawing, and the need for strict legal and regulatory compliance. Before accepting an SBLC application, the issuer must confirm that the applicant’s instructions are clear and can be easily followed. If the applicant’s instructions are unclear and the issuer fails to follow the instructions, the applicant may have grounds to contest the reimbursement.

Issuers should also be cautious of situations where an applicant attempts to modify or amend the underlying agreement with the beneficiary by imposing complex conditions for payment under the SBLC. Such situations could place the issuer in a difficult position and potentially lead to disputes.

The key to success when issuing an SBLC is to fully understand the issues that may present themselves during the transaction as well as the rights and obligations of parties to the transaction.

SBLCs and international trade

In conclusion, standby letters of credit are a valuable tool in international trade, providing payment security, risk mitigation, and confidence among the parties involved. Understanding the complexities, considerations and risks associated with using SBLCs can help businesses make informed decisions and navigate the global market with greater assurance and success.