Many attempts have been made to replace the Letter of Credit but with not much success. The reason Letters of Credits are still here is because via the Letter of Credit a third party bank irrevocably guarantees payment to the Seller if the Seller performs with the terms that the Buyer and Seller have agreed on. The irrevocable nature of this ‘guaranty’ issued by a bank, allows the Exporter’s bank to provide pre-export (pre-shipment) financing. The Letter of Credit is one of the main means of financing international and domestic trade.
Letter of Credits are unique financial instruments that connect the movement of physical goods that are being bought and sold with the funding of these goods as they move through the channels of trade. Over the years, certain terms and modality have been established which are reflected through specific Incoterms through which the Buyer, Seller and the transporting company know when the responsibility for the goods move from one party to another and when title to the underlying goods transfers from one party to another.
Generally a Letter of Credit will be irrevocable and at sight. This means that the Letter of Credit issuing bank is irrevocably committing to paying the Seller once the seller meets the terms of the Letter of Credit. ‘At Sight” means that when the Letter of Credit issuing bank receives the documents from the Seller and ‘sees’ them then the issuing bank is obligated to pay if all the Letter of Credit documents are in order.
It is important to note that Letters of Credits deal with documents not with goods. In other words the Letter of Credit requires that to be paid, the seller has to provide certain documents such as an Invoice, Packing List and Bill of Lading showing the goods have been taken over by the shipping company. If these documents are correct, then the issuing bank will pay. The issuing bank will not physically verify that the goods have actually been shipped but will do reasonable due diligence to make sure that the documents are authentic. For this reason, it is important to have the goods inspected by reliable third parties such as the shipping company and the freight forwarders who are reputable, established credit-worthy companies. If something goes wrong the buyer will have redress to financially strong companies.
Other than ‘at sight’ Letters of Credits, there are Letter of Credits where the payment is made after a certain period of time. The starting point should be from the date on the Bill of Lading, or the date the draft was accepted by the issuing bank, etc.
Letters of credit can help you forge strong relationships with suppliers, and ensure that trust is established quickly. Post-recession, suppliers are more cautious about offering credit to buyers and, particularly if you are trading internationally, there can be a funding gap between receiving goods and being able to send full payment.
That’s where letters of credit can be helpful as a trade finance tool, which establishes better relationships and enables you to trade freely with less concerns about payment times or creditworthiness.
Normally a decision to offer a line of credit will be based on an assessment of your ability to pay. Once a line of credit has been agreed with you, letters of credit will be on the basis of each individual transaction. If you have agreed a sale with another party, lenders will need to understand the terms that need to be fulfilled before the seller can receive full payment, and document these in a ‘letter of credit’. Essentially, this guarantees that once the documented terms have been fulfilled, the seller will be paid, so they are relying on a lender’s creditworthiness rather than yours.
It’s not easy to build trust quickly between buyers and suppliers, especially when you trade internationally, but in today’s globally connected world it is essential to have good trade relationships. Letters of credit build mutual trust, allow suppliers to extend more credit to buyers and instill faith in a supplier’s ability to fulfil a contract.
The recipient of a letter of credit is placing trust in the finance provider that has issued it, rather than the buyer, which is useful for young companies, with a less than solid trading history, who may otherwise struggle to negotiate satisfactory credit terms. And the flipside is that if you are buying goods from overseas, a letter of credit can give you an added layer of security if the supplier fails to deliver the goods as specified.
Letters of credit offer an extra level of security when forging supplier relationships, in the UK or overseas. Some of the solutions we have provided include:
. TYPES OF LETTERS OF CREDIT
Types of Letters of Credit:
A revocable letter of credit allows for amendments, modifications and cancellation of the terms outlined in the letter of credit at any time and without the consent of the exporter or beneficiary. Because this places the exporter at risk, revocable letters of credit are not generally accepted.
An irrevocable letter of credit requires the consent of the issuing bank, the beneficiary and applicant before any amendment, modification or cancellation to the original terms can be made. This type of letter of credit is commonly used and
preferred by the exporter or beneficiary because payment is always assured, provided the documents submitted comply with the terms of the letter of credit. Irrevocable letters of credit can be both confirmed and unconfirmed (See below).
An irrevocable letter of credit may also be transferable. With a transferable letter of credit, the exporter can transfer all or part of his rights to another party. Transferable letters of credit are often used when the exporter is the importer’s agent or a middleman between supplier and importer, and not the actual supplier of merchandise. With a transferable letter of credit, the exporter uses the credit standing of the issuing bank and avoids having to borrow or use his own funds to buy goods from a supplier. Hence, it is a viable pre-export financing vehicle. Before transfer can be made, the exporter must contact, in writing, the bank handling the disbursement of funds – the transferring bank. Transferable letters of credit can only be transferred based on the terms and conditions specified in the original credit, with certain exceptions. Therefore, it may be difficult to achieve flexibility and confidentiality with this finance method. The transferring bank, whether it has confirmed the letter of credit or not, is only obligated to effect the transfer to the extent and in the manner expressly specified in the letter of credit. Transferable letters of credit involve specific risks. When a bank opens a transferable letter of credit for a buyer, neither party can be certain of who will be the ultimate supplier. Both parties must rely upon the importer’s assessment of the exporter’s reputation and ability to perform. To reduce overall risk and prevent the shipment of substandard goods, an independent certificate of inspection can be required in the documentation. For simplicity’s sake, many banks prefer single transfer and discourage multiple transfers, but will do multiple transfers if conditions are right. Partial transfers can also be made to one or several suppliers if the terms of the original letter of credit allow for partial shipments. The processing of this type of letter of credit can become complicated and tricky, requiring logistics coordination and the highest level of precision. Incomplete and/or ambiguous information on the transferable letter of credit almost always leads to problems. Furthermore, the beneficiary of the transferable letter of credit must be available throughout the entire negotiation process to assist the transferring bank.
A confirmed letter of credit is when a second guarantee is added to the document by another bank. The advising bank, the branch or the correspondent through which the issuing bank routes the letter of credit, adds its undertaking and commitment to pay to the letter of credit. This confirmation means that the seller/beneficiary may also look to the credit worthiness of the confirming bank for payment assurance.
An unconfirmed letter of credit is when the document bears the guarantee of the
issuing bank alone. The advising bank merely informs the exporter of the terms and conditions of the letter of credit, without adding its obligation to pay. The exporter assumes the payment risk of the issuing bank, which is typically located in a foreign country.
Back-to-back letters of credit are two individual letters of credit that together offer an alternative to a transferable letter of credit. The back-to-back letter of credit allows exporters (sellers or middlemen) who do not qualify for unsecured bank credit to use a letter of credit as security for a second letter of credit in favor of a supplier. In other words, if a foreign buyer will issue a letter of credit to an exporter, certain banks and trade finance companies will issue independent letters of credit to the exporter’s suppliers so that the required goods can be purchased. Even if the initial letter of credit is not successfully completed, the second remains valid, and the issuing bank is obligated to pay under its terms. Although back-to-back letters of credit provide small and medium exporters virtually unlimited working capital to finance their sales and complete more export transactions, many banks are reluctant to take on this type of arrangement. Because back-to-back letters of credit involve two separate transactions, it is likely that several participating banks will be involved and the risk of confusion and dispute is high. To protect itself, a bank generally will require that the exporter present all relevant documents that are part of the first letter of credit before issuing the second letter of credit. The second document is worded to conform precisely to the original and dated to expire at some date prior to the first, ensuring that the seller has sufficient time to present documents within the time limits of the first.
Unlike a commercial letter of credit, which is basically a payment mechanism, a standby letter of credit is a form of a bank guarantee. It may be used as necessary to cover nonpayment of a financial obligation. A standby letter of credit normally is intended to be drawn on only in the event of nonpayment. The standby letter of credit is issued by the bank and held by the seller, who in turn provides the customer open account terms. If payment is made according to the seller’s terms, the letter of credit is never drawn on. However, if the customer is unable to pay, the seller presents a draft, and all other documents as required, to the bank for payment. The standby letter of credit typically expires within 12 months.
A cash advance against a letter of credit works like back-to-back letters of credit, with the exception that the bank or financing company will issue cash to the suppliers instead of another letter of credit.
Revolving letter of credit lets the customer make any number of draws within a certain limit during a specific time period.
traveler’s letter of credit guarantees the issuing banks will honor drafts made at certain foreign banks.
Advantages 0f the Letter of Credit for the
“seller-exporter” and the “buyer-importer”
Advantages for the “Seller-Exporter”
Advantages for the “Buyer-Importer”
Letters of Credits use “Incoterms” which are abbreviations of International Commercial Terms that are key elements of international contracts of sale. In a trade transaction there are generally three parties involved: the Seller, the Buyer and the Transporting Company moving the goods from the seller to the buyer. The Incoterms explain the distribution of function, costs, risks and title to the goods relating to the transfer of goods from seller to buyer
A bank guarantee and a letter of credit are similar in many ways but they’re two different things. Letters of credit ensure that a transaction proceeds as planned, while bank guarantees reduce the loss if the transaction doesn’t go as planned.
A letter of credit is an obligation taken on by a bank to make a payment once certain criterion are met. Once these terms are completed and confirmed, the bank will transfer the funds. The letter of credit ensures the payment will be made as long as the services are performed.
A bank guarantee, like a letter of credit, guarantees a sum of money to a beneficiary. Unlike a letter of credit, the sum is only paid if the opposing party does not fulfil the stipulated obligations under the contract. This can be used to essentially insure a buyer or seller from loss or damage due to non-performance by the other party in a contract.
For example, an American wholesaler receives an order from a Canadian company. The wholesaler has no way of knowing whether the buyer can fulfil his payment obligations, and requests that a letter of credit be provided in their contract. The purchasing company applies for a letter of credit at a bank where it already has funds or a line of credit (LOC). After the goods have been shipped, the bank would pay the wholesaler its due as long as the terms of the sales contract are met such as delivery before a certain time or confirmation from the buyer that the goods were received undamaged. The letter of credit substitutes the bank’s credit for that of its client, ensuring correct and timely payment.
Bank guarantees insure both parties in a contractual agreement from credit risk. A construction company and its cement supplier may enter into a new contract to build a mall. Both parties may have to issue bank guarantees to prove their financial stance and capability. In a case where the supplier fails to deliver cement within a specified time, the construction company would notify the bank which then pays the company the agreed amount specified in the bank guarantee.
While letters of credit are used mostly in international trade agreements, bank guarantees are often used in real estate contracts and infrastructure projects.