Understanding the nature of letters of credit as an international financial device and the reason why they have become widely used by merchants all over the world requires us to find out its historical origins.
Some scholars believe that the origins of letters of credit go back to ancient Egypt and Babylon, which had an adequate system of banking. A clay promissory note of Babylon dating from 3000 B.C., is exhibited in the University Museum of Philadelphia, USA, which provided for repayment of an amount and the interest on a specific date.
Another discovery is an evidence of an obligation made in 248 B.C. in Egypt “for the repayment, in wheat, or upon default double its value, of a loan of money from one Zenon, which ends with ‘and the right of execution shall rest with Zenon and the person bearing the note on behalf of Zenon". It is also verified that banks of ancient Greece prepared letters of credit “on correspondents with the view to obviating the actual transport of specie in payment of accounts”.
With the collapse of the Roman Empire the role of the banks as well as the great extent of commerce between trading nations diminished. It was not until the 12th and early 13th century that banks in Genoa, Venice, Florence and other European cities were re-established. At this time merchants had to face two major problems:
(a) travelling with gold was very dangerous; and
(b) commerce generated currency that was not sufficient to satisfy the needs of traders.
The earliest devices with which merchants tried to solve these problems were with the bills of exchange and letters of credit. In their early history these payment instruments operated in a very similar way, and letters of credit were used to supplement the bills of exchange. There are scholars who believe that their development in Europe was inspired by the discoveries made by Marco Polo in the 13th century who reported the use of currency and other negotiable documents in China, concluding that such a measure was one of the reasons for “the ways and means by which the Great Chan can have and indeed does have more treasures than all the kings in the world”.
In any case, it was impossible to conduct commerce via caravan without some sorts of documentary letters. To explain their early operation Professor Dolan gives the following example:
“… a Florentine merchant who bought wool from an Amsterdam merchant could issue a bill of exchange to the Dutch merchant’s agent in Florence directing a third party (the drawee) to pay the sum due for the wool. The agent, having taken the bill in payment for the wool, could travel across Europe or by sea to a commercial center, where he would meet the drawee and ask the drawee for payment.The drawee would pay the draft either
(1) in gold (though such payment would be rare);
(2) by “clearing”, that is, by setting the draft off against sums due from the Dutch merchant on other drafts; or
(3) by accepting the draft and returning it to the agent.
In the third case, the holder had a readily marketable instrument, which he could use to trade or which he could take with him to other commercial centers. He could do so armed with the knowledge that such “currency”, while valuable to merchants, was of little value to the brigands who stalked the highways and the pirates who sailed the seas. It did not take long for some enterprising merchant, whose paper was suspect, and, therefore, subject to heavy discount or to outright rejection in the trade, to strengthen his bills by obtaining the drawee’s announcement that he, the drawee, would pay or accept the bills. The announcement was a letter of credit.”
De Roover also refers to letters of credit used by the Medici Bank in Bruges and in Italy between 1385 and 1401. The various provisions of the letters are strikingly similar to those of the modern letters of credit. They stated for example that
(a) payments are to be made as requested by a named beneficiary
(b) the payments could not exceed a specific sum
(c) the payor shall obtain receipts from the beneficiary
(d) the payment shall be charged to the account of the issuer with the payor; or
(e) upon receipt of a written notice from the payor that the amount has been paid, the issuer shall credit the payor’s account accordingly.
By the 17th century letters of credits were common financial instruments both in the European continent and in England. At this time they functioned more like a traveller’s cheque.
By the 19th century British banks had a virtual monopoly on the issuance of letters of credits. This was due to the fact that in world trade the Pound Sterling was the most accepted currency and the bankers of London gained a pre-eminent position in the field of international finance.
In the United States letters of credit emerged from the “competition of factorage houses for business, which led to the issuance of promises to accept drafts against shipments”. The growing number of manufacturers and their relationships with foreign traders, the specialization of banking activities and the technological development such as the more frequent use of telegraph for communicating the terms of the contracts facilitated the increasing use of letters of credit.
On the other hand, letters of credit were not used exclusively by merchants. The outbreak of World War I broke the well-established and trusted trading links that had existed between the merchants worldwide. In order to keep on trading, merchants were forced to create new links with firms often unknown or not trusted. These circumstances were favourable for the extensive use of letters of credit which invited a trustworthy paymaster, a bank, into the merchants’ relationship. By the 1950s letters of credit had earned a predominant position in domestic commerce of the United States and were also widely used in international transactions.
Since World War II the use of letters of credit in world trade remains steadfast. Although from time to time the emergence of alternative means of trade finance overshadows the use of the letter of credit, it has “proven to be a flexible instrument, which can be readily attempted to the needs of changing conditions in international trade”. In a world of shrinking distances and increasing trade there will be a continuing need for such a highly reliable and flexible means of payment and financing.