TRADE FINANCE THROUGH LETTER OF CREDIT

LETTER OF CREDIT

1.   Introduction of Letter of Credit

LCs are flexible and versatile instruments (we will talk about the different types of LC below). The LC is universally governed by a set of guidelines known as the Uniform Customs and Practice (UCP 600), which was first produced in the 1930s by the International Chamber of Commerce (ICC).

Most trade in the world is done internationally. In order to facilitate this, a business needs to have trade agreements with their partners and counterparts.

Trust is incredibly important when agreeing payment terms. Putting this on a scale, at the riskier end, trade can be done on open account terms – where the seller bears the risk of not being paid. A Letter of Credit, or LC is less risky

Here at Trade Finance Global, we help companies find debt funding in the market – with various financing structures to meet the business needs. We want to help you explain debt terms to your clients, and help grow your clients or help them recognize future cash flow challenges.

A Letter of Credit is relevant where there is an exporter and an importer; and there needs to be prepayment or a confirmation of payment in order for goods to be shipped.

A letter of credit is an instrument from a bank, which guarantees a buyer’s payment to a seller if certain criteria are met.

If the buyer can’t pay up, due to the agreed contract through the Letter of Credit, the bank will cover the remaining price.

Letters of Credit are fundamental components of international trade. They’re governed universally by a set of guidelines called the UCP 600, which are issued by the International Chamber of Commerce.

Importers and exporters normally require intermediaries such as banks or alternative financiers to guarantee payment and also the delivery of goods. Cash advances or trade credits on open accounts are usually used after the buyer and seller develop a trusted relationship. Therefore trade finance structures are used to support these relationships.

2.   Meaning of Letter of Credit.

An LC is a promise written on a legal document that comes from a bank with a promise to pay the holder if the holder fulfills certain obligations. Obligations include payment when the goods are shipped if certain criteria are met.

A Letter of Credit is usually used when the buyer and seller do not know each other well and this is why it is used so frequently in international trade.

Letters of Credit are incredibly specific and a close attention to detail is required. If there is a misspelling in the contract, for example, the name of the goods is incorrectly spelt, there may be non-payment until a new, corrected LC is issued and accepted. 

3.   Advantage of Letter of Credit.

For the buyer, they are certain to receive the goods as stipulated in the letter of credit, and they do not need to pay for the goods upfront. For the seller, they’re somewhat protected against non-payment from the buyer.

There are lots of different types of LCs, and I’ll cover most of them today. Often people get confused between commercial letters of credit, which acts as the primary payment mechanism for a transaction, and a standby letter of credit, the secondary payment mechanism, a fail safe guarantee.

Depending on the perspective of the buyer or the seller, there are also import Letters of Credit, set up by the importer or buyer of goods or services, and export Letters of Credit, which are set up by the exporter or seller.

4.   How does the Letter of Credit Work?

On behalf of a buyer, the issuing bank promises payment to a seller or beneficiary

An advising bank may act on behalf of the seller. The advising bank will receive payment, normally when they’ve been presented of specified documents representing the supply of goods.

5.   Why are Letter of Credit used?

I.                   Safe – Letters of Credit are usually legally binding and so all parties need to agree to cancel them;

II.               Clarity – The goods defined in an LC are specific and well defined so the details of a transaction are generally very transparent;

III.            Risk reduction – Exporter or payment to the seller is guaranteed providing the terms of the LC are met;

IV.            Allows Safe Trading – Letters of Credit are a focus of international trade, and allow companies to trade safely in unfamiliar markets with unfamiliar suppliers;

V.                Efficiency – Letters of Credit can be raised electronically using an online trade banking service.

6.   Different types of Letter of Credit.

I.                   Recoverable

Notably, the Letter can be canceled or amended at any time by either the buyer or the issuing bank without any formal notification. What must be remembered, is that in the latest version of the UCP 600, revocable Letters of Credit have been removed for any transaction undertaken within their jurisdiction.

II.                Irrevocable

The irrevocable letter of credit allows cancellation or amends to the letter of credit by the buyer, if the buyer’s bank, seller and/or sellers bank agree

III.             Confirmed

In this case, the Letter of Credit will be granted “confirmed” status once the exporters confirming bank has added it’s obligation to the issuing bank. With this in mind, the obligation will either be in the form of a guarantee or Assurance of Payment.

IV.             Unconfirmed

On the contrary, an Unconfirmed Letter of Credit is only guaranteed by the issuing bank – meaning there is no confirmation from the exporter’s advisory bank. However, this type of confirmation is most common in LC’s, although in areas of economic instability or political uncertainty, payment could be at risk.

V.                Transferable

In scenarios where the Beneficiary is an intermediary for the real suppliers of goods and services, the payment will need to be transferred to the actual suppliers. In this way, it is transferable to the next supplier in the chain of trade.

VI.             Un-Transferable

On the other hand, an Un-transferrable Letter of Credit, payments are prevented from being transferred to any third parties, as the beneficiary is the recipient.

VII.          Straight

A Straight LC or ‘Straight Credit’ is defined by the Bank only being allowed to make payment to the beneficiary named in the Letter. In short, they are not permitted to send any payment to any third parties or intermediaries.

Consequently, the named beneficiary must present documents to the paying bank on or before the expiration date, otherwise, the Letter is nulled.

VIII.       Negotiable

The issuing bank is obligated to pay the beneficiary but also permitted to make payments to any third party nominated by the original beneficiary.

IX.             Restricted

To explain, in the case of a Restricted LC only one nominated bank can be used for negotiation. Therefore, the authorization of the issuing bank to make payment to the beneficiary is restricted to a specific, nominated bank.

X.                Unrestricted

In contrast, with an Unrestricted LC the bank is not specified, which means the Letter of Credit can be negotiated through any bank of the beneficiary’s choice.

XI.             Term (Usance)

In this case, payment can be deferred with a Usance Letter of Credit, which gives time for the buyer to inspect or even sell the goods.

XII.          Sight

Lastly, if the  LC is ‘Sight’, it is payable as soon as the documents have been verified and presented to the corresponding bank.

7.   How is payment collected on letters of credit?

To receive payment, the beneficiary must present documentation of completion of their part in the transaction to the issuing bank and must present documents, such as:

§  Invoices;

§  Bills of Exchange;

§  Government documents

8.   A LC transaction generally happens as follows.

Ø  An importer agrees to buy goods off an exporter – a purchase order (PO) is issued

Ø  The importer will approach an issuing bank (trade financier) who will issue an LC if it fulfils their criteria (e.g. they are creditworthy)

Ø  The exporter will work with a confirming bank who will request the LC documents to be shipped from the issuing bank of the importer

Ø  The confirming bank will then check the LC and if the terms are correct, the exporter can then ship the goods

Ø  The exporter then sends the relevant shipping documents to the confirming bank, who will then process the payment

Ø  Once the confirming bank has examined the shipping documents in strict compliance against the LC terms from the issuing bank, they will forward these documents on to the issuing bank

Ø  The importer pays the issuing bank

Ø  The issuing bank then releases the shipping documents so that the importer can claim the goods that were shipped

Ø  The issuing bank then transfers money to the confirming bank who will then transfer this money to the exporter

9.   Summary

LC’s have many different variations. Likewise, each of these different types of Letters of Credit help protect traders on both sides of a transaction from the many difficulties associated with cross-boarder trade.

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