What it means
A documentary letter of credit (an undertaking by a bank to pay a seller once specified documents prove that goods have been shipped) is one of the oldest tools in trade finance. In a normal letter of credit the bank promises to pay but the buyer may only have a credit line or may fund the payment later.
In a fully funded version the applicant puts up cash, or a blocked deposit, equal to the full value before the credit is issued. For the seller, this changes the risk picture.
The bank still pays only against documents that comply with the credit terms, such as the bill of lading, the commercial invoice and the insurance certificate. But the seller no longer worries whether the buyer will have the money when the documents arrive, because the funds are already earmarked.
For the buyer, the cost is tied-up cash. Money held as security cannot be used for stock, wages or marketing in the meantime, so a fully funded credit is usually used when the buyer is new, the amount is large or the buyer's credit standing is weak.
The issuing bank also charges fees, which commonly depend on the amount and the length of the credit. The strictness of document checking is the main practical hazard.
A mismatch in a name, date or description can allow the bank to refuse payment even when the goods were shipped perfectly, which is why traders check drafts of the documents before shipping. Both sides should also confirm that the credit is governed by the widely used international rules for documentary credits.
The label FFDLC is also used in offers from intermediaries and brokers, and some of those offers are not genuine. A real credit comes from a regulated bank with a verifiable reference and is confirmed through that bank's own channels, so any unfamiliar offer should be checked directly with the bank before anyone ships goods or pays a fee.
In practice
Real-world examples.
Example
A furniture manufacturer in Vietnam receives an order from a new importer in Germany. The manufacturer asks for an FFDLC so that it can start production knowing the buyer's money is already locked at the issuing bank.
Example
A food distributor buying $200,000 of spices from a first-time supplier chooses to fully fund the credit. The supplier, reassured, offers a better unit price than it would on open account terms.
Example
A mining equipment buyer in Chile has a weak credit history after a difficult year. Its bank will only issue the credit if the buyer places the full contract value on deposit, which turns the instrument into an FFDLC.
Formula
Calculation
The cost of funding the credit can be measured as the interest given up on the blocked cash:
Opportunity cost = Funded amount x Annual rate x (Days blocked / 365)
A buyer arranges an FFDLC for $500,000 and blocks the full amount for 90 days. If the buyer could otherwise earn 6% a year on that cash, the opportunity cost is $500,000 x 0.06 x (90 / 365) = $30,000 x 0.2466 = about $7,397. If the bank also charges a 0.5% issuance fee, that adds $500,000 x 0.005 = $2,500, so the total cost of the structure is roughly $9,897.Case study
Seen in the real world.
Brightwater Textiles is an illustrative, fictional exporter that received a large first order from an overseas retailer it had never met. The retailer offered open account payment, but Brightwater's owner had been burned before and wanted certainty.
The two sides agreed on a fully funded documentary letter of credit. The retailer placed the whole order value on deposit with its bank, and Brightwater began production once its own bank had confirmed the credit through proper channels.
In this illustrative story one shipment was delayed because the invoice described the fabric differently from the credit, and the bank queried it. Brightwater corrected the document within days and was paid in full. The owner now checks every draft document against the credit terms before the goods leave the warehouse.
Watch out
Common mistakes.
- Believing that a fully funded credit guarantees payment regardless of the paperwork, when the bank pays only against compliant documents.
- Accepting an unsolicited FFDLC offer from an intermediary without verifying it directly with a named, regulated bank.
- Forgetting the buyer's financing cost, so that the price quoted to the seller does not reflect the cash tied up in the deposit.
Questions
People also ask.
How is an FFDLC different from a standard letter of credit?
In a standard credit the bank takes the buyer's credit risk, whereas in an FFDLC the buyer has already supplied the full cash, so the bank carries almost none.
Does the seller need a confirming bank as well?
It can help when the seller is unsure about the issuing bank or the country it operates in, because the confirming bank adds its own payment promise.
Who bears the cost of the credit?
The applicant normally pays the issuing bank's fees, and the beneficiary pays advising and confirming charges unless the contract says otherwise.
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