LCs are useful to any business that trades in large volumes, both domestically and across borders. They are important to ensure the cashflow of a company and lower the risk of default due to non-payment from the end customer.

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

When deciding whether or not to request an LC, companies should consider:

• The costs associated with an LC, and which party will incur them, versus the risk of non-payment
• Legal requirements and expertise required
• Documentation needed (for proof of delivery and sending the goods, e.g. customs declaration and insurance documents)
• The supplier/customer’s creditworthiness

Overseas business

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

If 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 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 LCs for overseas contracts. For companies producing software or other online services that demand the employment of significant resources, it is important to consider external finance to free up working capital.

SMEs

Small and medium-sized 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 at fault for late payments to SMEs, which can often put small companies at financial strain, or even out of business.

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 LCs are a big advantage: LCs are accepted and acknowledged by 175 countries, reduce the risk of doing business overseas, and provide transparent collaboration between unknown parties.

Letters of Credit provide better clarity on the transaction, as all of the goods or services supplied are defined in detail. This provides additional security to the buyer and removes the possibility that the descriptions of the goods ordered are vastly different from what arrives.

Key advantages:

• Avoids potential disputes over quality and attributes of goods
• Guarantee to a seller/supplier that they will get paid
• Flexibility and variability
• Secure payment method endorsed by most major markets
• Risk of non-payment is borne by the bank, not the seller
• Often required by national border/exchange control agencies

Using Letters of Credit can significantly help your business, whether you are a seller or buyer. This trading tool is legally binding in almost all jurisdictions, providing better transparency and creating trust in your business.

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

If you’re looking to finance business abroad or want to use a Letter of Credit to access financing, TFG can help.

TFG assists companies to access trade and receivables finance through our relationships with 300+ banks, funds, and alternative finance houses.

We assist specialist companies to scale their trade volumes, by matching them with appropriate financing structures – based on geographies, products, sector and trade cycles. Contact us here to find out more.

There are several different types of LCs, with different features depending on the kind of business or transaction. 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, businesses should be aware that certain additions and clauses stipulated might increase the bank’s fee or create additional hurdles if the transaction doesn’t go smoothly.

1. Irrevocable

An Irrevocable Letter of Credit only allows the buyer to cancel or amend the LC if all other parties agree. For example, this can be used to trade additional goods that were not a part of the original LC inside the same shipment or allow the exporter extra time to fulfil their obligations.

2. Confirmed

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

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

Most LCs will include this clause in the agreement, especially in international trade between partners that haven’t done business with each other before.

3. 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 LC. In this case, the LC can be transferred to other entities with the agreement of the original beneficiary.

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 lowering the price of the trade in the process.

4. Letter of Credit at Sight

This article of the LC 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.

Instead, Standby Letters of Credit do not include this clause, but are only activated if the buyer can’t fulfil the payment.

5. 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 LC is more enticing for the buyer, making it more likely for them to accept buying goods or services.

6. 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. The name derives from the fact that traditionally, when this clause was included in a letter of credit, it was printed in red ink to draw attention to it and make sure all parties knew what they were agreeing to.

Find out more about the different types of LC in our LC guide, here.

There are several situations where a business is either unable to get access to a letter of credit, for example due to a low credit score or because the supplier does not want to use a LC to finance the transaction. Given that open account trade covers 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 (those under $100,000), 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.

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

Purchase Order Financing

In this case, a third party, usually a commercial bank, finances the advances or outstanding payables on any goods and services, 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 Purchase Order finance guide here to find out more.

Invoice Factoring

This alternative to LCs involves a third party, usually a commercial bank, advancing 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 have 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.

The main disadvantage of using a LC compared to other methods is the relative cost of insurance, which 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, a LC could create an issue for sellers if the goods are not as described, 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, and that the buyer has clarity over what they are purchasing.

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.

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.

Similarly, 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 or green clause LC, the buyer can take an advance before the producer has even made the goods.

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

Key Standards

The ICC Uniform Customs and Practice for Documentary Credits (UCP 600) establishes the global standards for the utilisation of letters of credit in international trade. Additionally, the Swift network, particularly its Category 7—Documentary Credits standards, serves as the primary technical framework for handling LC, making Swift the central infrastructure for exchanging LCs and related messages. Typically, the MT700 message is sent by the issuing bank to the advising bank to indicate the terms and conditions of a documentary credit which has been originated by the sender (issuing bank).

Legal Framework

LCs are subject to the ICC Uniform Customs & Practice for Documentary Credits (UCP 600). The legal requirements for using a LC can vary depending on the jurisdiction and the specific terms and conditions of the LC.

Sourced from ICC DSI