The Role of Letters of Credit in Payment Transactions

Abstract

Part I of this Article briefly describes the basic letter-of-credit transaction. Part II describes the discrepancies that appear in those transactions, providing detail from the data I collected. The data generally support the anecdotal information that led me to conduct the study: the documents presented in the 500 transactions I examined conformed to the letter of credit only 27% of the time. The payment transactions rendered the discrepancies irrelevant because the buyer waived the discrepancies in all but one case and provided full payment for the shipment in spite of the discrepant presentation. Part III uses the data and the interviews described above to assess the possible reasons for the common use of letter of credit. First, I reject the possibility that businesses use letters of credit out of irrational habit or custom because the ready availability and frequent use of alternative payment transactions strongly suggests that businesses rationally use letters of credit. Second, I evaluate the persuasiveness of the classic payment-assurance story and conclude that the payment-assurance story probably still has some plausibility, at least in contexts (such as many exports from the United States) where parties select the letter of credit to compensate for the weakness of relational ties between the buyer and the seller. Finally, I consider some alternative reasons that might motivate commercial enterprises to use letters of credit. Specifically, I argue that the issuing bank’s ability to verify information about the purchaser and the transaction provides the most compelling reason for widespread use of letters of credit.

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