What is a Letter of Credit
The Oldest form of Trade Finance
How does a letter of credit work?
The oldest and most common form of short-term trade finance is the letter of credit also known as a Documentary Credit.
A letter of credit (LC) is essentially a pledge to make a payment – issued by a bank on behalf of its importing client. It is a written undertaking that a bank gives on behalf of its customer to pay the exporter an amount of money within a specified time frame – as long as the exporter complies with certain terms and conditions.
The importer bank provides the LC to the exporter (or exporter’s bank). The document essentially says: “I’ll pay you XX amount – if you ship the right goods to me.”
In this way the exporter is not taking the payment risk on the importing corporate, but on the bank. (Key to the use of LCs is the concept that bank risk is usually considered lower than corporate risk.) Letter of Credits are particularly useful where the buyer and seller may not know each other personally and are separated by distance, differing laws in each country and different trading customs. It is generally considered that Letters of Credit offer a good balance of security between the buyer and the seller, because both the buyer and seller rely upon the security of banks and the banking system to ensure that payment is received and goods are provided. In a Letter of Credit transaction the goods are consigned to the order of the issuing bank, meaning that the bank will not release control of the goods until the buyer has either paid or undertaken to pay the bank for the documents.
If the exporter presents the bank with the correct documents – proof of shipping the correct goods, such as bills of lading – they can expect to get paid.
Quite often, this transaction will involve one further party – a confirming bank.
A confirming bank will usually be in the country of the exporter (reducing the political risks of waiting on the payment from an overseas bank). This bank will ‘confirm’ the LC provided by the importer’s bank.
The confirming bank will check the documents (proof of export against the LC requirements) and then pay the exporter the due amount (at a fee – paid usually by exporter). In the event that the buyer is unable to make payment on the purchase, the seller may make a demand for payment on the bank. The bank will examine the beneficiary's demand and if it complies with the terms of the letter of credit, will honor the demand.
There are many different kinds of LCs and LC structures that might stand behind a straightforward credit line to a client:
Import/export — The same credit can be termed an import or export letter of credit depending on whose perspective is considered. For the importer it is termed an Import LC and for the exporter of goods, an Export LC.
Revocable — The buyer and the issuing bank are able to manipulate the LC or make corrections without informing or getting permissions from the seller. According to UCP 600, all LCs are irrevocable, hence this type of LC is obsolete.
Irrevocable — Any changes (amendment) or cancellation of the LC (except it is expired) is done by the applicant through the issuing bank. It must be authenticated and approved by the beneficiary.
Confirmed — An LC is said to be confirmed when a second bank adds its confirmation (or guarantee) to honor a complying presentation at the request or authorization of the issuing bank.
Unconfirmed — This type does not acquire the other bank's confirmation.
Restricted — Only one advising bank can purchase a bill of exchange from the seller in the case of a restricted LC.
Unrestricted — The confirmation bank is not specified, which means that the exporter can show the bill of exchange to any bank and receive a payment on an unrestricted LC.
Transferrable — The exporter has the right to make the credit available to one or more subsequent beneficiaries. Credits are made transferable when the original beneficiary is a middleman and does not supply the merchandise, but procures goods from suppliers and arranges them to be sent to the buyer and does not want the buyer and supplier know each other.
Untransferable — A credit that the seller cannot assign all or part of to another party. In international commerce, all credits are untransferable.
Deferred — A credit that is not paid/assigned immediately after presentation, but after an indicated period that is accepted by both buyer and seller. Typically, seller allows buyer to pay the required money after taking the related goods and selling them.
At Sight — A credit that the announcer bank immediately pays after inspecting the carriage documents from the seller.
Red Clause — Before sending the products, seller can take the pre-paid part of the money from the bank. The first part of the credit is to attract the attention of the accepting bank. The first time the credit is established by the assigner bank, is to gain the attention of the offered bank. The terms and conditions were typically written in red ink, thus the name.
Back to Back — A pair of LCs in which one is to the benefit of a seller who is not able to provide the corresponding goods for unspecified reasons. In that event, a second credit is opened for another seller to provide the desired goods. Back-to-back is issued to facilitate intermediary trade. Intermediate companies such as trading houses are sometimes required to open LCs for a supplier and receive Export LCs from buyer.
Standby Letter of Credit: — Operates like a Commercial Letter of Credit, except that typically it is retained as a "standby" instead of being the intended payment mechanism.
Letter of Credit benefits:
Reduces risk of non-payment
Could be the only way a customer/importer can obtain foreign currency to pay exporter
Some countries require involvement of a local bank in payment for a significant import contract
Letter of Credit drawbacks:
Does not wholly guarantee payment
Bank in importer’s country could go bankrupt
Political situation could impose freeze on payments
Letter of Credit Language
To better understand letters of credit, it may help to know the following:
Abbreviations for 'letter of credit' include L/C, LC, and LOC
Applicant - the buyer in a transaction
Beneficiary - the seller or ultimate recipient of funds
Issuing bank - the bank that promises to pay
Advising bank - helps the beneficiary use the letter of credit
Irrevocable - the letter of credit cannot be changed or canceled without permission from everybody involved
Letters of credit in 2018:
The general long-term market trend is moving away from letters of credit as, up until the recent financial crisis, importers and exporters were becoming more confident in trading with each other on an open account basis. Companies became more than happy to take on certain risks and deal with certain countries.
What’s more, the trade credit insurance market has been growing. Some trade transactions are conducted with just insurance providing a way of mitigating non-payment risks.
But, in the immediate aftermath of the crisis there was a resurgence in LC use and other trade finance instruments due to a drop in confidence and overall trust.
All too complicated?
Running a business is hard enough, if you want some advice on you can take advantage of this type of funding, feel free to contact us.
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