(AEN) – Unexpected events like late payments, financial difficulties, and delayed delivery are linked to global transport.
Long distances, shifting political environments, and various international trade laws are some of the factors that make it essential for sellers to obtain a payment guarantee before shipping perishable goods by sea.
These issues are addressed by international letters of credit, which include a financial institution to lower exporters’ credit risks.
In order to guarantee that the seller would be paid in the event of a buyer default, a Letter of Credit was first written from the buyer’s bank to the seller’s bank in international trade.
The Letter of Credit was created in the modern world to reduce credit risks for exporters by involving a financial institution as a third party and simplifying these concerns. Letters of credit have supplanted the conventional payment method globally as globalisation has increased.
What is a Letter of Credit?
A Letter of Credit (LC) is a document issued by the buyer’s bank to ensure that the seller gets paid for their goods. It’s like a promise from the bank that the seller will receive the money as long as they follow the rules agreed upon in the document.
How Does It Work?
In international trade, the buyer (importer) asks their bank to create this document. The seller (exporter) is the one who benefits from it. The bank promises to pay the seller on time if they provide the necessary documents, like receipts and shipping papers. The bank doesn’t need to check the actual goods; it just needs the right paperwork.
Why Is It Important?
This system helps both buyers and sellers trust each other more, even if they’re far apart and don’t know each other well. It reduces the risk that the seller won’t get paid, which can happen in international trade. As long as the seller provides the correct documents, the bank will make the payment, giving the seller a guarantee of getting their money.
Features/Characteristics of a Letter of Credit
A letter of credit is distinguished by specific principles that apply universally to all types of LCs. These include:
- Negotiability: The terms of an LC can be modified with mutual consent. A negotiable LC must include an unconditional promise of payment upon demand or at a specified time.
- Revocability: LCs can be revocable or irrevocable. Revocable LCs can be canceled without prior notice, while irrevocable LCs require consent from all parties before modifications or cancellations.
- Transfer and Assignment: The LC beneficiary has the right to transfer or assign the LC. The effectiveness of the LC remains intact, regardless of how many times it is transferred.
- Sight & Time Drafts: Payment is made upon maturity of the LC once the beneficiary presents the required documents to the issuing bank.
Documents required for a Letter of Credit
- Shipping Bill of Lading
- Airway Bill
- Commercial Invoice
- Insurance Certificate
- Certificate of Origin
- Packing List
- Certificate of Inspection
How does a Letter of Credit Work?
An LC arrangement allows the issuing bank to act upon the request of the importer (applicant). The issuing bank either pays the exporter directly or authorizes another bank to handle the transaction.
Types of Fees and Charges
Opening Charges
- Commitment Fees: These are charged upfront when the LC is issued. They typically range from 0.75% to 1.5% of the transaction value, depending on the bank and the size of the LC.
- Usance Fees: These are charged for the duration of the LC, often as a percentage per month or quarter. For example, some banks charge 0.125% per month for any period beyond the LC’s validity.
Retirement Charges
- Advising Fees: Charged by the advising bank for notifying the beneficiary about the LC. These fees are usually small and can include SWIFT charges.
- Confirming Bank Fees: If the LC is confirmed, these fees are charged by the confirming bank for guaranteeing payment. They can vary based on the bank’s credit strength.
- Reimbursement Costs: These include fees for the reimbursement of funds between banks, often involving SWIFT charges.
Other Charges
Amendment Fees: Charged when changes are made to the LC, such as increasing the amount or extending the period. These can range from USD 150 to USD 1,250, depending on the bank and the nature of the amendment.
- Cancellation Fees: Applied when an LC is cancelled. These fees can be flat, such as USD 250, plus additional SWIFT charges15.
- Confirmation Charges: If the LC is confirmed, these charges apply, often including foreign bank charges and SWIFT fees.
Sharing of Fees
Fees for LC transactions are typically shared between the buyer (importer) and the seller (exporter), though the exact distribution can vary based on the agreement between the parties.
The buyer usually covers the issuance and confirmation fees, while the seller may pay advising fees if they are on the exporter’s account.
Parties Involved in a Letter of Credit
1. Applicant
The applicant is typically the buyer or importer who initiates the process by requesting their bank to issue a Letter of Credit. This is usually done to ensure that payment is made only when the seller meets specific conditions, providing a safeguard for the buyer.
2. Beneficiary
The beneficiary is the seller or exporter who benefits from the Letter of Credit. They receive payment once they present documents that comply with the terms and conditions of the LC. This ensures that the seller gets paid as long as they fulfill their obligations.
3. Issuing Bank
The issuing bank is responsible for creating and issuing the Letter of Credit at the buyer’s request. It guarantees payment to the seller if the documents are in order, acting as a financial intermediary between the buyer and seller.
4. Advising Bank
The advising bank plays a crucial role by verifying the authenticity of the Letter of Credit and forwarding it to the beneficiary. This bank is usually located in the beneficiary’s country and ensures that the LC is genuine and valid1.
Other Key Parties
5. Confirming Bank
If the exporter is not confident in the issuing bank’s guarantee, a confirming bank can add an additional layer of assurance. This bank guarantees payment alongside the issuing bank, providing extra security for the exporter.
6. Negotiating Bank
The negotiating bank is responsible for reviewing the documents submitted by the exporter to ensure they comply with the LC terms. Once verified, it processes the payment to the exporter and claims reimbursement from the issuing bank.
7. Reimbursing Bank
The reimbursing bank handles the settlement of payments from the issuing bank to the negotiating bank. It ensures that the funds are transferred smoothly and efficiently.
8. Second Beneficiary
In cases where the original beneficiary is unavailable, a second beneficiary can act on their behalf. This is typically allowed if the LC permits transferability, ensuring that the payment process can continue without interruption.
Letter of Credit Process: A Step-by-Step Guide
The Letter of Credit (LC) process is a secure way for buyers and sellers to conduct international trade. It involves several key steps that ensure both parties fulfill their obligations.
Step 1: Issuance of LC
The process begins when the importer requests their bank to issue a Letter of Credit. This LC is then sent to the advising bank, which verifies its authenticity and forwards it to the exporter. This step is crucial as it sets the terms and conditions for the transaction.
Step 2: Shipping of Goods
Once the exporter receives and verifies the LC, they proceed to ship the goods. This step is important because it ensures that the exporter fulfills their part of the agreement by delivering the goods as specified.
Step 3: Submission of Documents
After shipping the goods, the exporter prepares and submits the necessary documents to the advising or confirming bank. These documents must comply with the terms of the LC, ensuring that the exporter has met all the requirements.
Step 4: Payment Settlement
The advising or confirming bank reviews the documents to ensure compliance with the LC terms. If everything is in order, the bank processes the payment to the exporter. The documents are then sent to the issuing bank, which verifies them again. Once verified, the issuing bank obtains payment from the importer and releases the documents, allowing the importer to claim the goods.
Example: Mr. A and Mr. B’s LC Transaction
Let’s consider an example involving Mr. A, an Indian exporter, and Mr. B, a U.S. importer, who decide to use a Letter of Credit for their transaction due to the distance and lack of familiarity between them.
- Request for LC: Mr. B requests his bank (the issuing bank) to issue a Letter of Credit. This request outlines the terms and conditions under which payment will be made.
- LC Issuance and Verification: The issuing bank creates the LC and sends it to an advising bank in India. The advising bank verifies the LC to ensure it is genuine and then forwards it to Mr. A.
- Shipping and Document Preparation: Upon receiving the LC, Mr. A verifies its details and ships the goods. He then prepares the necessary shipping documents, such as the bill of lading and commercial invoice.
- Document Submission and Payment: Mr. A submits these documents to a negotiating bank, which reviews them to ensure compliance with the LC terms. If everything is in order, the negotiating bank processes the payment to Mr. A.
- Verification and Payment Settlement: The documents are then sent to the issuing bank for final verification. Once verified, Mr. B makes the payment to the issuing bank, which then transfers the funds to the negotiating bank, completing the transaction.
This process ensures that both Mr. A and Mr. B fulfill their obligations securely and efficiently, with the Letter of Credit acting as a trusted intermediary.
Types of Letters of Credit
- Revocable LC
- Irrevocable LC
- Confirmed LC
- Unconfirmed LC
- LC at Sight
- Usance LC
- Back-to-Back LC
- Transferable LC
- Standby LC
- Revolving LC
- Red Clause LC
- Green Clause LC
Application Process for a Letter of Credit
The process of applying for a Letter of Credit (LC) is straightforward and involves several key steps that ensure both the importer and exporter fulfill their obligations securely.
Step 1: Importer Applies for an LC
After signing a sales agreement with the exporter, the importer applies to their bank for a Letter of Credit. This request outlines the terms and conditions under which payment will be made, providing a safeguard for both parties.
Step 2: Issuing Bank Drafts and Sends the LC
The issuing bank drafts the LC based on the importer’s request and sends it to the exporter’s bank. This step is crucial as it sets the terms and conditions for the transaction, ensuring that both parties are aware of their responsibilities.
Step 3: Exporter’s Bank Evaluates and Approves the LC
Upon receiving the LC, the exporter’s bank evaluates it to ensure it meets the exporter’s needs and complies with international standards. Once approved, the LC is forwarded to the exporter.
Step 4: Exporter Ships Goods and Submits Documents
After verifying the LC, the exporter ships the goods according to the agreed terms. They then prepare and submit the necessary documents, such as the bill of lading and commercial invoice, to their bank.
Step 5: Exporter’s Bank Sends Compliant Documents to the Issuing Bank
The exporter’s bank reviews the documents to ensure they comply with the LC terms. If everything is in order, the bank sends the documents to the issuing bank for final verification.
Step 6: Issuing Bank Verifies and Releases Payment
The issuing bank verifies the documents again to ensure compliance with the LC terms. Once verified, it releases the payment to the exporter, completing the financial part of the transaction.
Step 7: Importer Receives Documents to Claim Shipment
Finally, the issuing bank sends the documents to the importer, who can then claim the shipment. This step ensures that the importer receives the goods as agreed upon in the sales contract.
This process provides a secure and reliable way for importers and exporters to conduct international trade, ensuring that both parties fulfill their obligations as agreed.
Benefits of Letters of Credit
Letters of Credit offer numerous advantages for both exporters and importers:
Reduced Payment Risk for Exporters
- Guaranteed payment upon compliance with LC terms
- Protection against buyer default or insolvency
- Mitigation of country and political risks
Enhanced Creditworthiness for Importers
- Demonstrates financial stability to suppliers
- Increases negotiating power for better terms
- Builds trust with new trading partners
Ensured Timely Payments for Exporters
- Predefined payment terms and schedules
- Reduced cash flow uncertainties
- Faster payment processing compared to open account transactions
Facilitation of International Trade
- Bridges the trust gap between unfamiliar parties
- Enables transactions in new or challenging markets
- Supports complex multi-party transactions
Flexibility in Financing
- Various LC types to suit different transaction needs
- Potential for discounting to improve cash flow
- Can be used as a basis for trade financing
Bank Guarantee vs. Letter of Credit
While both Bank Guarantees and Letters of Credit are financial instruments that provide security, they have distinct characteristics and use cases:
| Aspect | Bank Guarantee | Letter of Credit |
|---|---|---|
| Primary Function | Ensures payment if a buyer defaults on obligations | Ensures payment upon fulfilling specified trade terms |
| Payment Trigger | Beneficiary’s claim of default | Presentation of compliant documents |
| Document Requirement | Minimal documentation | Extensive documentation required |
| Payment Responsibility | Bank pays only if the applicant defaults | Bank has primary payment responsibility |
| Typical Use Cases | – Advance payment guarantees | – International trade transactions- Complex multi-party deals- High-value purchases |
| Risk Level for Banks | Generally lower risk | Higher risk, more stringent checks |
| Flexibility | Less flexible, specific to stated obligations | More flexible, can be structured for various trade scenarios |
| Cost | Usually lower fees | Generally higher fees due to complexity |
| Revocability | Typically irrevocable | Can be revocable or irrevocable |
Key Considerations Before Obtaining an LC
Before securing a Letter of Credit, businesses should carefully evaluate the following factors:
Strict Compliance with LC Terms
- Understand that even minor discrepancies can lead to payment delays or rejections
- Implement a thorough document review process before submission
- Consider using document preparation services or software to ensure accuracy
Verify the Issuing Bank’s Credibility
- Research the bank’s financial stability and reputation
- Check international ratings from agencies like Moody’s or Standard & Poor’s
- Consider requesting a confirmed LC from a trusted local bank if unsure
LC Costs vs. Other Payment Methods
- Compare LC fees with alternatives like open account or advance payment
- Factor in potential discounting costs if early payment is needed
- Consider the value of risk mitigation against the overall transaction cost
Choose the Appropriate LC Type
- Assess whether a standby, irrevocable, or other LC type best suits your needs
- Consider the transaction’s complexity and duration when selecting an LC type
- Evaluate if specialized LCs like red clause or transferable LCs are necessary
Negotiate Favorable Terms
- Work with your bank to structure LC terms that protect your interests
- Clearly define document requirements to avoid ambiguity
- Agree on a reasonable timeframe for document presentation and payment
Assess Your Own Performance Capability
- Ensure you can meet all conditions specified in the LC
- Evaluate your ability to produce and deliver goods within the stipulated timeframe
- Consider potential challenges in document preparation and submission
Understand the Regulatory Environment
- Familiarize yourself with UCP 600 rules governing LCs
- Be aware of any country-specific regulations or restrictions
- Stay informed about sanctions or trade embargoes that may affect the transaction
Conclusion
Letters of Credit (LCs) play a crucial role in facilitating international trade by ensuring secure and timely payments for both exporters and importers.
Given the complexities of global transactions—ranging from financial uncertainties to regulatory challenges—LCs provide a structured mechanism that minimizes credit risk and builds trust between trading partners.
By involving banks as intermediaries, LCs offer a guarantee of payment, provided that all required documents meet the agreed-upon conditions.
This not only protects exporters from non-payment but also reassures importers that their funds will only be released once contractual obligations are met.
As global trade continues to expand, the use of LCs has become increasingly vital, replacing traditional payment methods and offering flexibility through various types tailored to specific business needs.
While obtaining an LC involves costs and meticulous documentation, its advantages in mitigating financial risks and ensuring smooth trade operations make it a preferred choice for businesses worldwide.
Understanding the intricacies of Letters of Credit—from their types and processes to associated costs and key considerations—empowers businesses to make informed decisions and optimize their trade transactions.
By leveraging LCs effectively, companies can enhance their credibility, improve cash flow management, and navigate the complexities of international commerce with confidence.
