Letters of Credit Overview
Letters of Credit are one of the most common methods of trade funding because they are versatile and secure, and can be used for almost any international trade transaction. A Letter of Credit is a financial instrument that represents the commitment of a bank on behalf of an importer that guarantees payment will be made to the beneficiary (exporter) provided the terms and conditions specified in the Letter of Credit have been met. Conditions which specified in Letters of Credit are typically evidenced by the presentation of specified documents.
Since they are credit instruments, issuing banks rely on the credit worthiness of importers when issuing Letters of Credit. The importer pays the issuing bank a fee to render this service. Letters of Credit are useful when there is insufficient credit information about a foreign buyer or the foreign buyer’s credit is unacceptable to the seller/exporter, but the exporter is comfortable with the creditworthiness of the issuing institution.
Letters of Credit also serve to protect the importer since the documents required to trigger payment provide evidence that goods have been shipped as agreed. However, documentary discrepancies in Letters of Credit could potentially negate payment to the exporter, documents must be prepared by trained professionals.
Using Letters of Credit
- Letters of Credit are a highly recommended method of funding imports, exports, and foreign trade. Letters of Credit are especially beneficial for high-risk situations, for transactions with new or less-established trade relationships and for transactions where the exporter is satisfied with the creditworthiness of the issuing bank.
- When Letters of Credit are used to finance trade, the transaction risk is fairly balanced between exporter and importer, assuming that all terms and conditions specified in the Letter of Credit are performed.
- Payment in Letter of Credit transactions is only made after the goods are shipped by the exporter. A variety of payment, financing and risk mitigation options are available to both the importer and exporter with Letters of Credit.
- Letters of Credit are a tremendously popular and effective method of financing international trade. They are, however, labor intensive and are a relatively expensive method of financing international transactions.
Key Features of Letters of Credit
- Letters of Credit, which are also known as documentary credit, are contractual agreements where the issuing bank, who is acting on behalf of the importer, promises to pay the beneficiary or exporter provided conditions specified in the Letter of Credit have been satisfied.
- The issuing bank will typically use intermediary banks to facilitate the transaction and make payment to the exporter.
- The Letter of Credit contract is a separate contract from the contract for the transaction on which it is based. Thus banks who issue letters of credit are not concerned with the quality of the underlying merchandise or whether either party fulfills the terms of the sales contract, only if they fulfill the letter of credit terms.
- The issuing bank’s obligation to pay is solely conditioned upon the seller’s compliance with the terms and conditions specified in the Letter of Credit.
- In Letter of Credit transactions, banks are only concerned with documents, not goods.
Special Letters of Credit
Letters of credit can take many forms. When they are made transferable, the payment obligation under the original letter of credit can be transferred to one or more second beneficiaries. With a revolving letter of credit, the issuing bank restores the credit to its original amount each time it is drawn down. A standby letter of credit is not intended to serve as the means of payment for goods but can be drawn in the event of a contractual default, including the failure of an importer to pay invoices promptly when due. Similarly, standby letters of credit are often posted by exporters in favor of an importer to pay invoices when due. Standby letters of credit are often posted by exporters in favor of importers because they can serve as bid bonds, performance bonds, and advance payment guarantees. In addition, standby letters of credit are often used as counter guarantees against the provision of down payments and progress payments on the part of foreign buyers.
Letter of Credit Process
- The importer arranges for the issuing bank to open an LC in favor of the exporter.
- The issuing bank transmits the LC to the nominated bank, which forwards it to the exporter.
- The exporter forwards the goods and documents to a freight forwarder.
- The freight forwarder dispatches the goods and either the dispatcher or the exporter submits documents to the nominated bank.
- The nominated bank checks documents for compliance with the LC and collects payment from the issuing bank for the exporter.
- The importer’s account at the issuing bank is debited.
- The issuing bank releases documents to the importer to claim the goods from the carrier and to clear them at customs.
Tips for Exporters For Letters of Credit
- Exporters should consult with their bank before the importer applies for a Letter of Credit
- Exporters must consider whether a confirmed Letter of Credit is necessary
- Importers and exporters should negotiate and agree upon detailed terms and conditions to be incorporated into the Letter of Credit
- Exporters must determine if all of the terms of the Letter of Credit can be met within the prescribed time limits
- Exporters must ensure that all documents are consistent with the requirements of the Letter of Credit
- Exporters must be very cautious in watching for discrepancies that may delay or prevent payment
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