Letters of credit (LCs) are one of the most versatile and secure instruments available to international traders. An LC is a commitment by a bank on behalf of the applicant (importer) that payment will be made to the beneficiary (exporter) provided that the terms and conditions stated in the LC have been met, as evidenced by the presentation of specified documents. Since LCs are credit instruments, the importer’s credit with their bank is used to obtain an LC. The importer pays their bank a fee to render this service. An LC is useful when reliable credit information about an importer is difficult to obtain or when the importer’s credit is unacceptable, but the exporter is satisfied with the creditworthiness of the importer’s bank. This method also protects the importer since the documents required to trigger payment provide evidence that goods have been shipped as agreed. However, because LCs have opportunities for discrepancies, which may negate payment to the exporter, documents should be prepared by trained professionals or outsourced.
Characteristics of a Letter of Credit
Applicability: Recommended for use in higher risk situations or new or less-established trade relationships when the exporter is satisfied with the creditworthiness of the importer’s bank.
Risk: Risk is spread between exporter and importer, provided that all terms and conditions as specified in the LC are adhered to.
Pros: (1) Payment made after shipment; (2) A variety of payment, financing, and risk mitigation options available to receive payment quickly after shipment.
Cons: (1) Labor intensive process; (2) Relatively expensive method in terms of transaction costs.
Key Points
• An LC, also referred to as a documentary credit, is a contractual agreement whereby the issuing bank (importer’s bank), acting on behalf of its customer (the applicant or importer), promises to make payment to the beneficiary or exporter against the receipt of “complying” stipulated shipping documents. The issuing bank will typically use intermediary banks to facilitate the transaction and make payment to the exporter.
• The LC is a separate contract from the sales contract on which it is based; therefore, the banks are not concerned with determining the quality of underlying goods or whether each party fulfills the terms of the sales contract.
• The bank’s obligation to pay is solely conditioned upon the compliance of the exporter’s documents with the terms and conditions of the LC. In LC transactions, banks deal in documents only, not goods.
• LCs can be arranged easily for one-time transactions between the exporter and importer or used for an ongoing series of transactions.
• Unless the conditions of the LC state otherwise, it is always irrevocable, which means the document may not be changed or cancelled unless the importer, banks, and exporter agree.
Confirmed Letter of Credit
The exporter can obtain a greater degree of protection when an LC issued by a foreign bank (the importer’s issuing bank) is confirmed by a second bank (this bank is typically the advising bank, which then becomes the confirming bank). The exporter can do so by asking the importer to have the issuing bank authorize a bank in the exporter’s country to add its confirmation to an LC. Confirmation means that the second bank adds its engagement to pay the exporter to that of the foreign bank. In other words, once the exporter presents the required shipping documents that strictly comply with the terms and conditions of the LC, the confirming bank will pay the exporter prior to receiving reimbursement by the issuing bank. If an LC is not confirmed, payment is made to the exporter only after the shipping documents are presented to the issuing bank. In this case, the exporter is subject to the payment risk of the foreign bank and the political risk of the importing country.
When to Consider Using Confirmed Letters of Credit
Exporters should consider using confirmed LCs if they are concerned about the credit standing of the foreign bank or when they are operating in a high-risk market, where political upheaval, economic collapse, devaluation or exchange controls could put the payment at risk. Exporters should also consider using confirmed LCs when importers ask for extended payment terms. Besides reducing risks, confirmation facilitates financing if the exporter desires payment prior to the due date.
Illustrative Letter of Credit Transaction
1. The importer applies for an LC to a local bank, which evaluates the importer’s creditworthiness.
2. The importer’s bank opens an LC in favor of the exporter.
3. The importer’s bank transmits the LC to the exporter’s bank for forwarding to the exporter.
4. The exporter forwards the goods and documents to a freight forwarder.
5. The freight forwarder dispatches the goods and either it or the exporter presents the documents required by the LC to the exporter’s bank.
6. The exporter’s bank checks documents for compliance with the LC and collects payment from the importer’s bank for the exporter.
7. The importer’s bank debits the payment for the goods from the importer’s account.
8. The importer’s bank releases documents to the importer to claim the goods from the carrier and to clear them at customs.
Key Letter of Credit Terminology
Below is terminology that helps understand who the key participants are in an LC transaction:
• Applicant: Importer (foreign buyer)
• Beneficiary: Exporter (seller)
• Issuing Bank: Importer’s bank which opens the LC in favor of the exporter.
• Nominated Bank: Exporter’s bank that facilitates the eventual payment from the importer’s bank.
• Advising Bank: Exporter’s bank that informs of the opening of the LC and verifies its authenticity.
• Confirming Bank: Exporter’s bank that adds its own guarantee to pay if the importer’s bank fails to do so.
• Exporter’s Banks: Generally, the exporter will ask that their own bank be used by the importer’s bank as
(1) advising bank and
(2) confirming bank.
The advising bank is normally also given the nominated bank’s role.
Special Letters of Credit
LCs can take many forms. When an LC is made transferable, the payment obligation under the original LC can be transferred to one or more “second beneficiaries.” With a revolving LC, the issuing bank restores the credit to its original amount each time it is drawn down. A standby LC is an LC that is not intended to serve as the means of payment for goods but can be drawn in the event of a contractual default, including the failure of an importer to pay invoices when due. Standby LCs are often posted by exporters in favor of importers as well because they can serve as bid bonds, performance bonds, and advance payment guarantees.
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