Usance Letters of Credit – What are they?
When Letters of Credit were first developed, there were a number of specific Letters of Credit that developed. This is a short guide about usance or deferred LCs.
Usance Letters of Credit (Usance or Deferred LCs)
A Usance or Deferred Letter of Credit is a term used often in trade finance. However, in order to understand a Usance Letter of Credit, it is first important to understand what a letter of credit is and why it is used.
In much international trade there is a naturally a lack of trust in cross jurisdictional transactions, and so mechanisms are used to mitigate this risk; one being termed a letter of credit. Letters of credit are then broken down into many different types, such as at Site Letters of Credit, Usance Letters of Credit, Standby Letters of Credit and many others.
Letters of credit are used to allow the facilitation of trade between buyers and sellers of goods worldwide. In order to facilitate trade, letters of credit are put in place by the buyer and seller. By having bank issued letters of credit in place; it allows both parties to trade with comfort. Goods will be released when certain conditions have been fulfilled and correspondingly payment will be made by the purchasing bank. The issue of when payment is made; is of utmost importance when looking at different types of instruments.
Usance Letter of Credit – How does it differ?
A Usance or a Deferred Letter of Credit; is also known as a time or term LC. LC is the short-handed name for discussing a Letter of Credit. Thus, it will be a letter of credit that is payable at a predetermined or future point following the conditions in the LC being fulfilled and the confirming documents being presented.
The simplest way to understand a Usance or Deferred Letter of Credit is to compare it to a Sight Letter of Credit; this is where funds are transferred to the supplier upon the conforming documents being submitted. Where a Usance Letter of Credit is used, there is a receipt of documents by the issuing bank and where these comply with the terms of the LC, the issuing bank accepts the draft and agrees to transmit funds for payment in compliance with LC at a later maturity date. Thus, the buyer is provided with a form of credit terms; as the purchasing party will take receipt of the product purchased but have the ability to make payment at a future date.
Why is a Usance Letter of Credit used?
A usance LC is used for the same reason that credit terms are provided. It allows the purchaser flexibility, increased working capital and the availability to sell through stock prior to payment. Paying for the goods is easier at a later date when compared to payment upon receipt; as there will usually have already been an element of payment collection at this point, from the ultimate purchaser.
When will a Usance Letter of Credit be used?
This financial instrument is most likely to be favoured where there is an element of trust between the buying and selling parties. It is important to understand what the eventual amount to be paid is set at and the interest rate on product. The Letter of Credit will set out the time to maturity and the actual payment date; so that both parties can use this as a reference. The tenor is typically set out as being a certain amount of days following the BL date or following sight. If it is “following sight”; then this will be from the date of the documents being received by the issuing bank.
Having a usance letter of credit allows the purchaser to deploy funds into other areas of the business until payment is made.
How does the seller have comfort?
The seller is able to trade in comfort as the payment is guaranteed by “promises” within the banking system; as the issuing bank will correspond with the advising bank and make sure that there is an understanding that there is sufficient capital or collateral buffers in order to make payment at the maturity date. Another option to the supplier is the ability to discount the Usance LC at a point, which is earlier than maturity. This will allow them an element of payment prior to the maturity date. Obviously, the credit worthiness of banks acting on behalf of the parties is of utmost importance when using these instruments.
Have you seen our Letter of Credit Guide?