What is a letter of credit?
Before we get into usance or deferred letters of credit, let’s first recap what a normal letter of credit is.
If you’re an importer or an exporter, you will probably want your goods and cash to be as safe as possible during a trade transaction.
To protect against non-payment or non-delivery, one of the best ways to reduce your risk in a trade transaction is to use a letter of credit.
Letters of credit are legally-binding financial instruments that are issued by banks or specialist trade finance institutions to ensure that payment is made for goods received.
So how does it work?
Let’s suppose that an importer wants to purchase goods from an exporter in a trade transaction. To secure the transaction using a letter of credit, the importer can apply for a letter of credit from an ‘issuing bank’ (so called because this is the bank that will issue the letter of credit).
Meanwhile, the exporter must get in touch with a ‘confirming bank’ – so called because this is the bank that will confirm the letter of credit on the seller’s behalf. (This bank is also known as the ‘advising bank’.)
When the terms set out in the letter of credit are met – such as receipt of goods or bills of lading – then the issuing bank is legally obliged to issue payment for the goods to the confirming bank.
Put simply, a letter of credit helps ensure that the seller will get paid, as long as the terms specified in the letter of credit are met.
This reduces the risk to the importer (the buyer), and increases security for the exporter (the seller) – and as a trading business, that’s exactly what you want.
What is a usance letter of credit?
Once a sale contract is agreed between a buyer and a seller, the buyer can request that a letter of credit be used to secure the transaction.
The buyer will nominate their bank of choice (the issuing bank) and the seller can nominate their own bank (the confirming bank).
The terms are negotiated between buyer and seller, including the delivery date and the description of goods being sold.
If using a deferred or usance letter of credit, this means that the payment will be made by the issuing bank at a preset date, and after the relevant documents are presented.
The date of payment is set either after the bills of lading are confirmed upon shipment, or when the issuing bank receives confirming documents, and is typically set at 90 days.
Once the seller ships the goods, they send confirmation of shipping with the letter of credit to their confirming bank, who will review the documents and send it to the buyer’s issuing bank.
Once the issuing bank and buyer have reviewed and confirmed the documentation, the issuing bank must pay the confirming bank within the time period set out in the letter of credit, while deducting a fee (or ‘advising charge’) for itself.
On the seller’s side, there is the option to negotiate payment discounting, which allows the seller to receive payment faster.
In such cases, the confirming bank will release the payment to the seller ahead of the deferred payment date, but will deduct a greater percentage fee for itself.
Why should SMEs use usance letters of credit?
Cross-border trade can be risky, but using a letter of credit can help facilitate trust in transactions, both during shipping and in the payment stage of the trade.
Letters of credit are widely recognised by banks worldwide, and using one should help you safely complete cross-border transactions.
If you are the buyer, using a letter of credit provides evidence that you can make payment to the seller, which increases trust between you and the seller.
Sellers are more likely to stick to the letter of credit’s terms and conditions, making it more likely that your business plan will run on time and the goods you purchase will be in the condition required for your business needs.
And if the seller doesn’t or can’t meet the conditions stipulated in your letter of credit, you won’t be legally obliged to issue a payment at all.
Using a deferred letter of credit makes cash flow management even easier, because it gives you more time to pay for the goods, and therefore more time to utilise those goods for sale, which frees up working capital.
If you are the seller, you will receive payment for your goods shipped as and when the terms specified in the letter of credit are met.
If the terms are met, then the buyer’s issuing bank is legally obliged to pay you even if the buyer changes the order, cancels the order, goes bankrupt, or refuses to pay.
By using a deferred letter of credit, you are sure to receive the payment by a certain date, so that you can plan your business with a more certain cash flow.
If your buyer offers long payment terms, or has previously made late payments, then this can be extremely useful for you from a security point of view.
Better still, the letter of credit itself can be used as collateral in the meantime, to finance working capital loans that can help cover production and shipping costs.
Sellers can also add the option of discounting, whereby they agree to receive a slightly lower payment for the transaction, albeit at an earlier date.
Things to watch out for when using letters of credit
When applying for a letter of credit, remember that your application can be rejected due to incorrect or incomplete documentation.
This could include submission of the wrong documents, typos and other errors, or ambiguity in your application.
You must also consider the difficulty of meeting the terms set out in the letter of credit from the counterparty’s point of view, if your application is to be successful.
Once an application has been approved, the seller should double-check that the quality and quantity of goods meet the requirements set out in the letters of credit before they ship.
Once the goods have arrived, the buyer should double-check the quality and quantity of goods, to ensure that they meet the requirements set out in the letter of credit, before submitting documentation to the banks for confirmation.
As noted above, banks are under no obligation to pay the seller until the right documents or other evidence is presented, and this process generally incurs administrative costs.
Confirmation and issuing banks normally charge commission and administrative costs for the letter of credit.
How can TFG help?
At Trade Finance Global (TFG), our advisers are experts in all things international trade, and we can help you find the perfect partner bank or financial institution to suit your financing needs.
TFG can advise you on what financing works best for your business, so that you can feel safe and assured during a trade transaction.
By working TFG, we can help you with all the documentation and procedural requirements, bringing added trust and security to your trade.
Get in touch with our team