An example of financing a letter of credit using warehouse receipts
The example involves a grain trader in Minnesota who purchases a shipment of grain from a producer and then plans to resell the same grain to a buyer in the Middle East. Using what is called the “warehouse receipt financing” method, the Minnesota merchant purchases the grain and “deposits” it in a recognized public warehouse and, in return, receives a warehouse receipt, identifying, among other things, the type of grain, its quality, quantity and the date it was received in the warehouse. The merchant takes this deposit receipt to his bank as proof of ownership and, assuming everything is in order, the bank will make a loan to the merchant, a loan based on the estimated market value of the grain, less a percentage amount (a sometimes called a “haircut”). The merchant then contacts the buyer in the Middle East, who agrees to purchase the goods from the seller’s public warehouse in Minnesota.
The L/C mechanism in this case is as follows:-
1. The contract of sale is agreed between the Minnesota seller and the Middle Eastern buyer and both parties agree to do business on the basis of a letter of credit.
2. The buyer asks his bank to issue an L/C. This bank is the issuing bank. The L/C specifies that the seller must present certain documents to the bank before receiving payment and, in this case, the main documentary requirement is the deposit receipt.
3. The issuing bank notifies the seller through the correspondent bank (advising bank) by SWIFT and then sends the original letter of credit to the seller.
4. The seller presents his bank with a bill of exchange (giro) based on the conditions of the L/C together with the deposit receipt and requests the negotiation.
5. The seller’s bank verifies the conditions of the L/C and the deposit receipt document. If the terms of the L/C are determined to be consistent with the documents, the seller’s bank pays the seller. However, the seller must be very careful as the bank cannot pay the bill of exchange if there is any discrepancy between the conditions of the L/C and the documents provided by the seller. If a discrepancy occurs, the seller has to inform the buyer and ask him to apply to the issuing bank for an amendment of the L/C accordingly.
The rules for letter of credit transactions are comprehensively addressed in the International Chamber of Commerce (ICC) rules called “UCP 600”, which were updated this year.
For more information on developing Depository Receipts, Letters of Credit, or UCP 600, please contact the author of this article, Daniel Day-Robinson, Day Robinson International (UK) +44 1392 271222 or [email protected]