Introduction to Letters of Credit | 2022 Guide

Letters of Credit | TFG Ultimate Guide to LCs

Trade Finance Global / Introduction to Letters of Credit | 2022 Guide

Letters of Credit

Welcome to TFG’s Letters of Credit hub. Find out how we can help you access Letters of Credit to increase your imports and exports to guarantee the payment and delivery of goods. Or, discover the latest research, information and insights on Letters of Credit here.

Diagram: Letter of Credit

The normal LC process flow can be diagrammatically represented as follows:

A diagram depicting the normal flow of a letter of credit

What is a Letter of Credit (LC)?

A Letter of Credit is a contractual payment undertaking issued by a financial institution on behalf of a buyer of goods for the benefit of a seller, covering the amount specified in the credit, payment of which is conditional on the seller fulfilling the credit’s documentary requirements within a specific timeframe.

The primary aim of this instrument is to provide increased assurance to both the buyer and seller of the fulfilment of each party’s obligations in a commercial trade – namely the seller’s obligation to deliver the goods as agreed with the buyer, and the buyer’s obligation to pay for those goods within the specified timeframe.

Some variations to the main Letter of Credit include revolving, escalating, de-escalating, transferrable, back-to-back, as well as red and green clause letters of credit.

An issuer will use its customer’s funds to make the payment.

A Letter of Credit (or LC) is a commonly used trade finance instrument used to ensure that the payment of goods and services will be fulfilled between a buyer and a seller. The rules of a Letter of Credit are issued and defined by the International Chamber of Commerce through their Uniform Customs & Practice for Documentary Credits (UCP 600), used by producers and traders worldwide. Both parties use an intermediary, namely a bank or financier, to issue a Letter of Credit and legally guarantee that the goods or services received will be paid for.

 

Standby Letters of Credit, Demand Guarantees and Bonds

These instruments can be classified as an independent payment undertaking, i.e. an undertaking issued by one party in support of another party’s obligations under an underlying agreement, where the issuing party’s obligations are independent of those of the supported party.

These instruments are typically required within a contractual framework with the objective of providing greater certainty and security as to a party’s fulfilment of its contractual obligations. In effect, a financial institution intervenes assuming the position of the party they are supporting, thereby replacing that party’s ability to perform with their own, providing increased comfort to the contractual party benefiting from the undertaking.

The most common requirements for the issuance of these instruments arise from the need to support bids on projects or contracts, to guarantee the performance of contractual obligations and to ensure the protection of advance payments made under an agreement. In Trade Finance terminology, the instruments issued by financial institutions to cover the aforementioned purposes are, respectively, bid, performance and advance payment bonds. When structured either as demand guarantees or stand-by letters of credit, no shipping documents are needed and only a demand is presented.

How can we help?

The TFG team works with the key decision-makers at 270+ banks, funds and alternative lenders globally, assisting companies in accessing Letters of Credit.

Our international team are here to help you scale up to take advantage of trade opportunities. We have a team of sector specialists, from fuel experts to automotive gurus.

Often the financing solution that is required can be complicated, and our job is to help you find the appropriate trade finance solutions for your business.

Read more about Trade Finance Global here, and how we can help you with your Letter of Credit queries.

.

Want to learn more about Letters of Credit?

Look no further. We’ve put together our feature Letters of Credit insights, research and articles, and you can catch the latest thought leadership from the TFG, listen to podcasts and digest the latest news from the LC community right here.

From the Editor – Trade Finance Insights

ICC briefing addresses the topic of reducing discrepancy rates ICC briefing addresses the topic of reducing discrepancy rates In the latest of its ongoing series of technical advisory briefings released on 27 June 2022, the International Chamber of Commerce (ICC) Banking Commission addressed the subject of ‘Reducing Discrepancy Rates under Documentary Credits’ (TAB-3).
Getting it right - Malaysia's highest court restores trial court decision in UCP 600 case Getting it right: Malaysia’s highest court restores trial court decision in UCP 600 case Further to the decision made in the Court of Appeal Malaysia (appellate jurisdiction) between Punjab National Bank (PNB) and Malayan Banking Berhad (Maybank), Maybank has successfully obtained leave from the Federal Court of Malaysia Putrajaya to file an appeal against the decision made in the Court of Appeal Malaysia
Incompatibility of D rules with Letters of Credit Incompatibility of D rules with Letters of Credit In the D rules delivery does not occur until a named destination place. How it gets there, what origin port or place it left and when it left are all irrelevant. This puts the D rules completely at odds with the typical LC that requires a port of shipment, port of destination and a latest shipment date.

Videos – Letters of Credit

Letter of Credit Podcasts




Letters of Credit (LCs) – Frequently Asked Questions

How do You Use a Letter of Credit?

Letters of Credit are issued and formatted under the guidelines of the Uniform Customs & Practice for Documentary Credits, or the UCP600, that is issued by the International Chamber of Commerce (ICC). Using one is fairly straightforward, both for businesses selling and those buying goods and services.

One of the parties, usually the importer, will contact a bank to serve as an intermediary and to guarantee to the seller that the goods will be paid for according to the agreement. All parties involved need to agree to the terms and sign the contract. This lowers the risk of doing business significantly, as Letters of Credit are legally binding documents that are acknowledged by 175 countries worldwide.

Check the Documents Carefully

Although the guidelines and the form of any Letter of Credit are largely the same, the content is not. It is crucial that both the buyer and the seller inspect the documents carefully and check for errors and mistakes that may end up in delays, further costs, or deferred payment. Even a minor oversight can be quite costly in this regard, and it is advisable to use several sets of eyes to check the documents.

Letter of Credit terms include:

  • Advising bank – accepts and then notifies the beneficiary of the LC
  • Confirming bank – financial institution that agrees to honour and payment the LC to the beneficiary and receives payment from the advising bank
  • Irrevocable – A non-amendable LC, unless agreed by all parties
  • Issuing bank / issuer – the party that issues the LC
  • Presentation – delivery of the LC documentation and any other required documents that are required by the beneficiary should payment be made / the LC honoured
  • Revocable – a type of LC that can be withdrawn, amended or cancelled by the issuing party at any time
  • Standby – the most common LC type whereby agreement to pay is made under certain conditions
Who should use a Letter of Credit?

Letters of Credit are useful to any business that trades in large volumes, both domestically, and cross-border. They are important to ensure the cash flow of a company and lowers the risk of default due to non-payment from the end customer.

Additionally, a LC can benefit companies that structure their business around e-Commerce or services.

When deciding whether or not to request a LC, some considerations might include:

  • The costs associated versus the risk of non-payment, as well as which party will incur these costs
  • Legal requirements and expertise required
  • Documentation needed (for proof of delivery, sending the goods across e.g. customs declaration and insurance documents)
  • The supplier / customers creditworthiness

Overseas Business

International traders or wholesale producers of goods are the primary users of Letters of Credit. These types of company need to be certain that they will not suffer losses from selling to overseas buyers that they are unfamiliar with.

In the unfortunate case that the recipient of the goods is unwilling or unable to pay the seller, the LC is activated, and under the terms of the agreement, the bank will be obliged to cover the missing payment. After the intermediary completes the payment, the bank will deal with the buyer according to the domestic law of the country where the buyer is located.

Online Business

Online, e-commerce and service businesses often use Letters of Credit for overseas contracts. For companies producing software, or other online services that demand the employment of significant resource, it is important to consider external finance to free up working capital.

Small and Medium Enterprises

Small or Medium Enterprises (SMEs) account for 99% of businesses. Letters of Credit can help alleviate some of the cash flow constraints stemming from delayed and long payment terms from end customers. Large international companies are often culprits for late payments to SMEs, which can often put small companies at financial strain, or even out of business.

What are the Benefits of Using a LC?

Risk and trust are one of the major challenges when it comes to trade, be that domestic or international. The specificity and legal weight of Letters of Credit are a big advantage, given that they are accepted and acknowledged by 175 countries, reduce the risk of doing business overseas, and provide transparent collaboration between unknown parties.

Finally, Letters of Credit provide better clarity on the transaction, as all of the goods or services supplied would be defined in detail. This provides additional comfort to the buyer as well as removing the possibility that the descriptions of the goods ordered are vastly different from what arrives.

Key advantages:

  • Avoids potential disputes overseas
  • Some form of guarantee to a seller / supplier that they will get paid
  • Flexibility and variability across different types of LCs
  • Secure payment method endorsed by most major markets
  • Risk of non-payment is taken by the banks rather than the buyer
  • Often required by national border / exchange control agencies
How Can a Letter of Credit help your business grow?

Using Letters of Credit can significantly advantage your business, regardless if you are a seller or buyer of goods and services. This trading tool is legally binding in almost all countries of the world, providing better transparency and creating trust in your business.

Using an LC, you can do business with any company or business around the world while being certain that all goods agreed upon will be received and that all payments will be fulfilled.

For any company, this secured access to the global market means lower prices and better services in a wider market. Additionally, it means that you can safely offer your goods and services to any buyer around the world, with little risk that the products you have provided will not be paid for.

What are the different types of Letters of Credit?

There are different types of LCs depending on the kind of business or transaction that it is needed. In most cases, these secondary features are used to increase security and make the operation easier, faster, and more transparent.

While there is a definite time and place of each type of LC, business should be aware that certain additions and clauses stipulated might increase the bank’s fee, or add some features that can cause future problems for one of the parties involved.

  1. Irrevocable

An Irrevocable Letter of Credit allows the buyer to cancel or amend the LC, provided that other parties agree. This can be used to trade additional goods that were not a part of the original LC inside the same shipment or to allow the exporter of products extra time to fulfil their obligation.

  1. Confirmed

A Confirmed Letter of Credit is used to further ensure the seller by adding more security. This addition stipulates that if the issuing bank from the buyer doesn’t pay the requested amount of money, the seller’s bank guarantees payment.

This article can be added if there is reduced trust in the buyer, or if the money requested is crucial to stable financial liquidity of the seller.

Most Letters of Credit will include this clause in the agreement, especially in international trade between partners that haven’t done business in the past.

  1. Transferable

A Transferable Letter of Credit is commonly used when there are intermediaries involved in the transaction, or when there are more than two parties included in the Letter of Credit. In this case, the LC can be transferred to other entities, provided that the original beneficiary agrees.

This type is usually employed by the seller’s bank, especially when the seller is an SME, as a way to reduce the risk of the transaction to the bank, usually decreasing the price of the trade in the process.

  1. Letter of Credit at Sight

This article of the Letter of Credit stipulates that all payments will be fulfilled as soon as there is documentation that the goods or services have been received by the buyer. This payment can be made by the buyer, or by the buyer’s issuing bank, giving the buyer some additional time to fulfil the debt.

Contrary to this type of LC, there is the Standby Letter of Credit that doesn’t have this clause, and that needs to be activated in the case that the buyer can’t fulfil the payment.

  1. Deferred or Usance Letter of Credit

A deferred or usance LC is used to allow deferred payment from the buyer for a specified time period. This slightly reduces the risk of unintentional non-payment and lowers the cost of an LC. Additionally, a Deferred Letter of Credit is more enticing for the buyer, making it more likely for them to accept buying goods or services.

  1. Red Clause

A Red Clause Letter of Credit obligates the buyer’s issuing bank to provide partial payment to the seller prior to shipping products or providing the service. It is usually used to secure a certain supplier and to expedite the shipping process, but it often makes the LC significantly more expensive.

Find out more about the different types of Letter of Credit in the next page of our LC guide, here.

Are there alternatives to using a Letter of Credit?

There are several situations where a business is either unable to get access to a letter of credit, perhaps due to a low credit score, or, because the supplier or customer does not want to use an LC to finance the transaction. Given that open account trade cover 80% of cross-border trade, businesses with good commercial relationships often won’t use LCs. Alternatives to LCs are often used to finance small purchases, perhaps those under $100k, given that they are significantly cheaper and faster to set up.

Revolving Vendor Accounts

In cases where a business has a good trading history, as well as paying its vendors and suppliers in time, revolving vendor accounts can be used to extend payment terms. Using these tools, a business can order supplies, materials, and services in advance on credit. Once all the necessary materials are ordered, a business can forward them to end users or customers, paying the supplier before the credit is due.

This type of account can be problematic however, as the seller may refuse to ship goods and services to a business that hasn’t paid their previous charge. Finally, some sellers will reject to enter this agreement, especially if abroad, as the entire risk of debt collection falls on the seller.

Purchase Order Financing

In this case, a third party, either a commercial bank or another entity can finance the advances or outstanding payables on any goods and services paid, assuming the risk of the sale contract not being fulfilled. This type of financing is usually made for a relatively short time period and it is not as uniform as a Letter of Credit.

Due to the fact that all risk is on the third party, this type of credit is usually more expensive and not applicable to sales of common goods. Read our PO finance guide here.

Invoice Factoring

This alternative to LC assumes that a third party, usually a commercial bank, will advance the seller for up to 80% of the total charge, assuming the risk of the customer or buyer paying the invoice in total once the goods arrive. Once the invoice is paid, the bank’s fee is withheld, and the rest of the funds are transferred to the seller’s account.

This tool is very useful to companies that suffer from diminished liquidity, but as the bank is taking more risk than when using a Letter of Credit, it is significantly more expensive than an LC. Trade Finance Global have put together a more extensive invoice factoring guide, which can be found here.

What are the Disadvantages of these Products?

The main disadvantage of using an LC compared to other methods is the relative cost of insurance, that may increase the overall cost of doing business. Letters of Credit should be used primarily on large shipments that may influence the liquidity and cash flow of the company, as well as when doing business with international buyers and sellers.

Additionally, an LC creates an issue for sellers, as the payment will be based on the documentation, and not the actual goods or services provided. Sellers need to be certain that the goods mentioned in the agreement are exactly as they are, with every minute detail included.

Finally, the disadvantage for the buyer is that the payment is connected to the documentation and not the actual provision of goods and services. Buyers need to ensure that all received products are exactly per specifications and have no flaws or damages before they create the necessary documentation that proves that they have received the goods.

What is the difference between a red clause and green clause letters of credit?

A red clause letter of credit is a variation of the traditional LC that contains a unique clause allowing the bank to make advance payments to the exporter before the exporter presents any shipping documents.

Similar to a red clause LC, a green clause LC is a variation on the traditional LC that allows a nominating bank to make an advance payment to the exporter. Experts often consider green clause LCs to be an extension of red clause LCs.

The key differences between red and green clause letters of credit are:
1) Advance percentage:
– With a red clause LC, the percentage of the total letter value available for an advance is generally around 20 – 25%.
– In contrast, with a green letter of credit, the percentage is far greater, often closer to 75 – 80% of the total value of the letter.

2) Security:
– Importers have much more security if using a green clause LC because of the stringent documentation requirements. If importing goods, the buyer is technically providing the advance against the documentation of title.
– Using a red clause LC, the buyer can take an advance before the producer has even made the goods.

Find out more about ed clause and green clause letters of credit here.

Download our free SME trade finance research


Contents

Get in touch with our Letters of Credit team



Access trade, receivables and supply chain finance

We assist companies to access trade and receivables finance through our relationships with 270+ banks, funds and alternative finance houses.
Get started

Download our free trade finance guide (including LCs)



Latest News

15Aug

TFG Weekly Trade Briefing, 15th August 2022

0 Comments

Your Monday morning coffee briefing from TFG: China hits record trade surplus in July… Read More →

12Aug

Standard Chartered and ADM launch $500mn sustainable export letter of credit programme

0 Comments

Standard Chartered and ADM announced the launch of the bank’s first green trade export letter of credit (LC) programme in… Read More →

11Aug

ICC briefing addresses the topic of reducing discrepancy rates

0 Comments

In the latest of its ongoing series of technical advisory briefings released on 27 June 2022, the International Chamber of… Read More →

08Aug

Getting it right: Malaysia’s highest court restores trial court decision in UCP 600 case

0 Comments

Further to the decision made in the Court of Appeal Malaysia (appellate jurisdiction) between Punjab National Bank (PNB) and Malayan… Read More →

02Aug

Podcast: The evolution of the UCP 600 and supplementing rules for documentary credits

0 Comments

TFG spoke to UCP 600 expert David Meynell, senior technical advisor for the ICC Banking Commission and digital rules advisor… Read More →

02Aug

Incompatibility of D rules with Letters of Credit

0 Comments

In the D rules delivery does not occur until a named destination place. How it gets there, what origin port… Read More →

25Jul

African trade finance and sustainability–a question of systemic liquidity and ESG standardisation

0 Comments

As global central banks hike rates to rein in inflation, and businesses battle with sourcing goods through choked supply chains… Read More →

24Jul

Red clause vs green clause letters of credit – A 2022 letter of credit guide

0 Comments

What is the difference between a red clause letter of credit and a green clause letter of credit? Read TFG’s… Read More →

19Jul

Letter of credit use amongst SMEs

0 Comments

Trade Finance Global surveyed firms throughout Europe to gain an understanding of SMEs’ trade finance usage norms and their propensity… Read More →

19Jul

Usance letters of credit – what are they? | 2022 TFG Usance LC Guide

0 Comments

When using an usance or deferred letter of credit, the issuing bank must make payment by a preset date. This… Read More →

19Jul

Debt vs. equity finance: how do European SMEs use third-party financing?

0 Comments

Trade Finance Global (TFG) surveyed firms throughout Europe to gain an understanding of SMEs’ trade finance usage norms and their… Read More →

19Jul

Is SME trade finance viable? A European outlook

0 Comments

Despite high inflation, record energy prices, and geopolitical uncertainty, demand for trade finance SMEs is on the rise…. Read More →

06Jul

VIDEO: TFG’s Mark Abrams featuring on the Trade Finance Distribution Initiative (TFDi)

0 Comments

The Trade Finance Distribution Initiative (TFDi) recently heard from Trade Finance Global’s (TFG) MD, Global Head of Trade & Receivables… Read More →

14Jun

Motivations and rationale for variation of Incoterms® rules

0 Comments

Certified Documentary Credit Specialist Ravi Jinugu explains the motivations and rationale for variation of Incoterms® rules…. Read More →

23May

As document checkers in trade head into retirement, how can banks retain their niche expertise?

0 Comments

For decades, trade document checkers at banks have mastered the crucial, time-consuming, and somewhat niche skill of manually reviewing complex… Read More →

17May

Trade Finance Global launches international trade finance series with Google

0 Comments

Trade Finance Global have partnered with Google (Market Finder) to launch a comprehensive trade finance series of guides…. Read More →

10May

Contour collaborates with TradeLens to transform trade finance workflows

0 Comments

Contour, the global digital trade finance network has today announced its collaboration with TradeLens, a blockchain-based supply chain platform that… Read More →

05May

Open sesame: trade finance in the metaverse

0 Comments

The metaverse could spell a watershed moment in human economic history. It will reinforce the concept of global human culture,… Read More →

03May

Implementing the ICC uniform rules for digital trade transactions (URDTT)

0 Comments

This article looks at the URDTT as it is applied to the first known commercial application: the eDTT Workspace…. Read More →

21Apr

Documentary Credit: Deconstructing a complex instrument

0 Comments

When searching for a definition of documentary credit, the Uniform Customs and Practice for Documentary Credits (UCP 600) is the… Read More →

14Mar

DAP, DPU and DDP Incoterms® 2020: What exactly is delivery and where does it occur?

0 Comments

The current Incoterms 2020 rules, like those in previous versions before them, are entirely devoid of any clue to assist… Read More →

14Mar

PODCAST: ‘Open by default’ – Finastra’s Iain MacLennan on partnerships, digitalisation, and helping SMEs triumph in uncertain times

0 Comments

In our latest podcast, TFG’s Deepesh Patel spoke to Finastra’s Iain MacLennan on fintech collaboration vs competition, the challenge of… Read More →

14Mar

Carriage Paid To (CPT), Carriage and Insurance Paid To (CIP): Are they compatible with Letters of Credit?

0 Comments

In CPT/CIP, the seller’s obligation is to deliver the goods to its own carrier on the agreed date or within… Read More →

11Mar

Central Bank of Egypt orders banks to quit documentary collections and replace with letters of credit

0 Comments

This article looks at the Central Bank of Egypt’s decision to stop accepting documentary collections for imported goods, and substitute… Read More →

09Mar

Do FCA transactions and Letters of Credit play nicely together?

0 Comments

Assuming we are looking at the normal type of Letters of Credit with the latest shipment date, port/airport of loading,… Read More →

04Mar

Letters of credit explained: How can they help your trading business grow, and how do you apply for one?

0 Comments

Letters of credit are one of the most commonly used trade finance instruments, and they are a great way to… Read More →

28Feb

Banks pull Russian commodity trade finance lines amid Ukraine invasion

0 Comments

Several public and private banks and financial institutions have imposed trade and commodity finance restrictions on Russia amid the escalating… Read More →

28Feb

Going nuclear: SWIFT ban to hamper Russian trade

0 Comments

The US and its Western allies have ramped up harsh economic sanctions against Russia, as it continues to attack Ukraine… Read More →

25Feb

Delivery of Full Container Loads (FCL) under Delivery at Paid (DAP)/ Delivery Duty Paid (DDP)

0 Comments

Delivery of the goods is “not unloaded” by the seller at the destination place, typically at either the CY (container… Read More →

18Feb

The role of ECAs in the global economic recovery and green transition – The view from SACE

0 Comments

In this article, SACE’s Irene Gambelli discusses the support provided by Italy’s export credit agency to SMEs during and after… Read More →

About the Author

Trade Finance Global (TFG) assists companies with raising debt finance. While we can access many traditional forms of finance, we specialise in alternative finance and complex funding solutions related to international trade. We help companies to raise finance in ways that is sometimes out of reach for mainstream lenders.

Back to Top