Although it can be gathered letters of credit serves as a form of security because of the presence of a middleman and that the exchange of monies takes place through bank transfers and debits, there are still a number of enumerated risks involved. Letters of credit become subject to risk because its cycle can have loopholes that may facilitate fraudulent activities. In addition, given the nature of the transaction, letters of credit are still subject to many legal factors that can put the process at risk thereby causing a delay or a cancellation in the undertaking.
Transacting parties acting under the context of international trade agreements are subject to delays as the deal may be blocked by the government. There are certain aspects of the letter of credit that may have to comply with certain regulations such as its transferability or assignment; in certain cases, this can be challenged in some national jurisdictions. Since that the transaction can involve international arrangements or two entities coming from different national jurisdictions, the actual transaction may be also subject to certain regulations that may cause the government to step in and stop the process.
This is a risk that transacting parties should consider. This can be also related to the legal risks involved especially should a legal action towards any of the parties may cause a hindrance to the processing of the transaction (Baker, 2003). Risks can also take place in the form of a seller who does not deliver the goods, and the issuing bank should an insolvency takes place. Each actor in the transactions has certain obligations thereby subjecting them, to a certain degree, some responsibilities that may entail a legal standing.
For instance, the obligation of the advising bank is to accept the instructions that come from the issuing bank; with the advising bank’s role in the entire process, it is therefore subject to that responsibility in the context of a contractual process. There is also the aspect of risk when it comes to the international nature of the trade; this includes credit risk and exchange risk. The risks can be therefore seen in the potential incompatibility of the credit systems of the involved parties and the foreign exchange rate which may take a drastic turn due to uncontrollable forces such as currency movements.
Such risks are ideally supported by the legal mechanisms supporting letters of credit. As letters of credit do have a contractual nature, such contract lies between the buyer and the seller. The letter of credit in itself is an instrument signifying the contract of these two entities which is why when it comes to the contract of sale, the legal obligations that come with the letter of credit that involves the issuing bank is basically independent from the contract of sale or any contracts outside this specific mode of payment.
This therefore shows that when it comes to the legal obligations of the bank in these transactions, the involvement is only in the credit and the relevant payments associated with the credit. Should there is problem in the sale contract, neither the buyer nor the seller could involve the banks because in the aspect of the sale itself, the bank is not liable. When it comes to the involvement of the banks, their concerns lie in the documents and not in the goods.
The legal aspects that can be regarded to protect the letter of credit transactions is limited; letters of credit are protected during its processing, and its function is defined according to the stages in which it is initiated for: to facilitate the business or trade transaction. An issued letter of credit somehow automatically provides the green light to the business arrangement between the buyer and the seller, with the banks merely serving as the mechanisms to implement the deal.
The risks surrounding letters of credit and the legal platform in which it operates from can be observed to be disproportionate; this is to say that letters of credit, in the legal context, have localised protection and security yet the amount of risks it can be exposed to is far more significant. The liabilities are somehow blurred because the document is isolated from the other aspects of the entire buying and selling agreements.
As the important document that can facilitate trade involving significant amounts of money and goods, letters of credit are subject to many fraudulent channels because the liability outside the transaction still ends with the buyer and the seller. The banks, albeit having important roles in the processing, are only liable in their own roles. Should criminal activities such as fraud take place, the liability has been usually in the grey area (Blodgett & Wilson, 1993).