Letter of Credit
A standard, commercial letter of credit (LC) is a document issued mostly by a financial institution, used primarily in trade finance, which usually provides an irrevocable payment undertaking.
The letter of credit can also be payment for a transaction, meaning that redeeming the letter of credit pays an exporter. Letters of credit are used primarily in international trade transactions of significant value, for deals between a supplier in one country and a customer in another. In such cases, the International Chamber of Commerce Uniform Customs and Practice for Documentary Credits applies (UCP 600 being the latest version). They are also used in the land development process to ensure that approved public facilities (streets, sidewalks, storm water ponds, etc.) will be built. The parties to a letter of credit are usually a beneficiary who is to receive the money, the issuing bank of whom the applicant is a client, and the advising bank of whom the beneficiary is a client. Almost all letters of credit are irrevocable, i.e., cannot be amended or canceled without prior agreement of the beneficiary, the issuing bank and the confirming bank, if any. Typically, the documents a beneficiary has to present in order to receive payment include a commercial invoice, bill of lading, and documents proving the shipment was insured against loss or damage in transit.
Letters of credit (LC) deal in documents, not goods. An LC can be irrevocable or revocable. An irrevocable LC cannot be changed unless both buyer and seller agree. With a revocable LC, changes can be made without the consent of the beneficiary.
A sight LC means that payment is made immediately to the beneficiary/seller/exporter upon presentation of the correct documents in the required time frame. A time or date LC will specify when payment will be made at a future date and upon presentation of the required documents.
Negotiation means the giving of value for draft(s) and/or document(s) by the bank authorized to negotiate, viz the nominated bank. Mere examination of the documents and forwarding the same to the letter of credit issuing bank for reimbursement, without giving of value / agreed to give, does not constitute a negotiation.
After a contract is concluded between buyer and seller, buyer's bank supplies a letter of credit to seller.
Seller consigns the goods to a carrier in exchange for a bill of lading.
Seller present bill of lading for payment from buyer's bank. Buyer's bank exchanges bill of lading for payment from the buyer.
Buyer provides bill of lading to carrier and takes delivery of goods.
How Letters of Credit Work
Letters of credit are common in international trade because the bank acts as an uninterested party between buyer and seller. For example, importers and exporters might use letters of credit to protect themselves. In addition, communication can be difficult across thousands of miles and different time zones. A letter of credit spells out the details so that everybody's on the same page.
Why would I use a Letter of Credit?
Letters of credit are very useful for cash flow purposes. Often, suppliers ask for deposits upfront prior to the goods being manufactured. A letter of credit will often replace the need for placing a deposit with your supplier. Further, if letters of credit are allowed to be negotiated then some suppliers will grant credit terms such as 90 days from bill of lading, which is very useful for cash flow purposes.
Letters of credit is one of the most common methods of payment in international trade and are very useful when dealing with new suppliers. Although not a 100% guarantee that you will get exactly what you ordered, if structured correctly, letters of credit will ensure that suppliers have to meet all the terms of the document and you are more likely to get the quality and quantity of the goods your ordered in a timely manner.
Additionally, suppliers tend to like letters of credit as they can often transfer letters of credit to pay for their raw materials or indeed in some countries they can use these letters of credit as collateral to obtain business to business finance from their bank.
However, letter of credit facilities can be expensive and, because it is a specialist area, it is difficult to evaluate costs. Letters of Credit can seem bureaucratic and tedious but accuracy in print and translation are essential. A minor mistake could be costly.
International Trade Payment methods
Advance payment (most secure for seller)
Where the buyer parts with money first and waits for the seller to forward the goods
Documentary Credit (more secure for seller as well as buyer)
Subject to ICC's UCP 600, where the bank gives an undertaking (on behalf of buyer and at the request of applicant) to pay the shipper (beneficiary) the value of the goods shipped if certain documents are submitted and if the stipulated terms and conditions are strictly complied with.
Here the buyer can be confident that the goods he is expecting only will be received since it will be evidenced in the form of certain documents called for meeting the specified terms and conditions while the supplier can be confident that if he meets the stipulations his payment for the shipment is guaranteed by bank, who is independent of the parties to the contract.
Documentary collection (more secure for buyer and to a certain extent to seller)
Also called "Cash Against Documents". Subject to ICC's URC 525, sight and usance, for delivery of shipping documents against payment or acceptances of draft, where shipment happens first, then the title documents are sent to the [collecting bank] buyer's bank by seller's bank [remitting bank], for delivering documents against collection of payment/acceptance
Direct payment (most secure for buyer)
Where the supplier ships the goods and waits for the buyer to remit the bill proceeds, on open account terms.