Introduction to Letters of Credit
Did you know, SMEs account for 99% of UK business, and 46% of them experience some form of cash flow problems? Most trade in the world is done internationally. In order to facilitate this, a business needs to have trade agreements with their partners and counterparts.
Trust is incredibly important when agreeing payment terms. Putting this on a scale, at the riskier end, trade can be done on open account terms – where the seller bears the risk of not being paid. A Letter of Credit, or LC is less risky, and in this video, we’ll explain why.
Here at Trade Finance Global, we help companies find debt funding in the market – with various financing structures to meet the business needs. We want to help you explain debt terms to your clients, and help grow your clients or help them recognize future cash flow challenges.
A Letter of Credit is relevant where there is an exporter and an importer; and there needs to be prepayment or a confirmation of payment in order for goods to be shipped.
A letter of credit is an instrument from a bank, which guarantees a buyer’s payment to a seller if certain criteria are met.
If the buyer can’t pay up, due to the agreed contract through the Letter of Credit, the bank will cover the remaining price.
Letters of Credit are fundamental components of international trade. They’re governed universally by a set of guidelines called the UCP 600, which are issued by the International Chamber of Commerce.
So what is a Letter of Credit?
An LC is a promise written on a legal document that comes from a bank with a promise to pay the holder if the holder fulfills certain obligations. Obligations include payment when the goods are shipped if certain criteria are met.
A Letter of Credit is usually used when the buyer and seller do not know each other well and this is why it is used so frequently in international trade.
Letters of Credit are incredibly specific and a close attention to detail is required. If there is a misspelling in the contract, for example, the name of the goods is incorrectly spelt, there may be non-payment until a new, corrected LC is issued and accepted.
Advantages of Letters of Credit
For the buyer, they are certain to receive the goods as stipulated in the letter of credit, and they do not need to pay for the goods upfront. For the seller, they’re somewhat protected against non-payment from the buyer.
There are lots of different types of LCs, and I’ll cover most of them today. Often people get confused between commercial letters of credit, which acts as the primary payment mechanism for a transaction, and a standby letter of credit, the secondary payment mechanism, a fail safe guarantee.
Depending on the perspective of the buyer or the seller, there are also import Letters of Credit, set up by the importer or buyer of goods or services, and export Letters of Credit, which are set up by the exporter or seller.
How does a Letter of Credit work?
On behalf of a buyer, the issuing bank promises payment to a seller or beneficiary
An advising bank may act on behalf of the seller. The advising bank will receive payment, normally when they’ve been presented of specified documents representing the supply of goods.
Why are Letters of Credit used?
- Safe – Letters of Credit are usually legally binding and so all parties need to agree to cancel them;
- Clarity – The goods defined in an LC are specific and well defined so the details of a transaction are generally very transparent;
- Risk reduction – Exporter or payment to the seller is guaranteed providing the terms of the LC are met;
- Allows Safe Trading – Letters of Credit are a focus of international trade, and allow companies to trade safely in unfamiliar markets with unfamiliar suppliers;
- Efficiency – Letters of Credit can be raised electronically using an online trade banking service.
Different types of Letters of Credit
- The irrevocable letter of credit allows cancellation or amends to the letter of credit by the buyer, if the buyer’s bank, seller and/or sellers bank agree;
- A confirmed letter of credit is a second guarantee by the sellers bank. It’s adds additional security for the seller. It means that if the issuing bank from the buyer fails to make a payment, the seller’s bank agrees to guarantee payment.
- A transferable letter of credit can be passed from one ‘beneficiary’ to others. They’re commonly used when intermediaries are involved in a transaction, and others are supplying the seller in the transaction.
- Letter of credit at sight. These are payable as soon as the agreed documentation has been presented and verified;
- Deferred or usance letter of credit means that payment to the seller is delayed until an agreed period of time has passed;
- A red clause letter of credit permits the seller to receive partial payment from the issuing bank prior to shipping products or performing the services;
How is payment collected on Letters of Credit?
To receive payment, the beneficiary must present documentation of completion of their part in the transaction to the issuing bank and must present documents, such as:
- Bills of Exchange;
- Government documents
A LC transaction generally happens as follows
- An importer agrees to buy goods off an exporter – a purchase order (PO) is issued
- The importer will approach an issuing bank (trade financier) who will issue an LC if it fulfils their criteria (e.g. they are creditworthy)
- The exporter will work with a confirming bank who will request the LC documents to be shipped from the issuing bank of the importer
- The confirming bank will then check the LC and if the terms are correct, the exporter can then ship the goods
- The exporter then sends the relevant shipping documents to the confirming bank, who will then process the payment
- Once the confirming bank has examined the shipping documents in strict compliance against the LC terms from the issuing bank, they will forward these documents on to the issuing bank
- The importer pays the issuing bank
- The issuing bank then releases the shipping documents so that the importer can claim the goods that were shipped
- The issuing bank then transfers money to the confirming bank who will then transfer this money to the exporter
LCs are flexible and versatile instruments (we will talk about the different types of LC below). The LC is universally governed by a set of guidelines known as the Uniform Customs and Practice (UCP 600), which was first produced in the 1930s by the International Chamber of Commerce (ICC).