Letter of Credit

Letter of Credit (L/C) in International Trade

Introduction to Letter of Credit

• Definition: A Letter of Credit (L/C) is a financial document issued by a bank on behalf of a buyer (importer). It guarantees payment to the seller (exporter) provided that the seller meets specific terms and conditions outlined in the L/C.
• Purpose: L/Cs are primarily used in international trade to ensure secure payments between buyers and sellers who may not know each other or operate in different legal and economic systems.
• Key Feature: Banks deal in documents, not goods. This is a crucial principle of L/Cs. Banks are concerned with whether the documents presented by the seller comply with the L/C terms, not with the actual quality or condition of the goods shipped.
  • Example: If an L/C requires a "Bill of Lading" and a "Commercial Invoice," the bank will only check if these documents are present and match the L/C requirements. They will not inspect the shipment of goods itself.

Key Principle of Letter of Credit

• Core Concept: Strict Compliance. Payment under an L/C is based on the compliance of documents presented by the seller with the terms and conditions stated in the L/C. This is often referred to as "documentary credit."
  • Explanation: Even a minor discrepancy in the documents can lead to payment refusal by the bank. This emphasizes the importance of accuracy and adherence to the L/C terms.
• Role of Banks: Intermediaries and Verifiers. Banks act as neutral intermediaries between the buyer and seller. They verify documents against the L/C terms and facilitate payment if compliance is met.
  • Explanation: Banks reduce the risk for both parties. The seller is assured of payment if documents are in order, and the buyer is assured that payment is only made when the seller has provided the required documentation, typically indicating shipment of goods.

ICC Definition of L/C

• Definition by the International Chamber of Commerce (ICC): "An arrangement, however named or described, whereby a bank (the issuing bank) acting at the request and on the instructions of a customer (the applicant or buyer) or on its own behalf, i. is to make a payment to or to the order of a third party (the beneficiary or seller), or is to accept and pay draft(s) drawn by the beneficiary, or ii. authorizes another bank (the nominated bank) to effect such payment, or to accept and pay such draft(s), or iii. authorizes another bank (the nominated bank) to negotiate,

  against stipulated documents, provided that the terms and conditions of the credit are complied with and that all stipulated documents are presented."

• Key Components (Parties involved):

  • Issuing Bank: The buyer's bank that issues the L/C on behalf of the buyer.
  • Applicant (Buyer or Importer): The party requesting the L/C.
  • Beneficiary (Seller or Exporter): The party who will receive payment under the L/C, provided they comply with the terms.

Process of Letter of Credit

• Step-by-Step Process:
  1. Buyer requests L/C from Issuing Bank: The buyer (applicant) applies to their bank (issuing bank) to open an L/C in favor of the seller (beneficiary). The application specifies all the terms and conditions, including required documents, payment terms, and goods description.
  2. Advising Bank informs Seller: The issuing bank sends the L/C to the seller's bank (advising bank) in the seller's country. The advising bank verifies the authenticity of the L/C and forwards it to the seller.
  3. Seller ships goods and submits documents: Once the seller receives the L/C and is satisfied with the terms, they ship the goods. After shipment, the seller prepares and submits the required documents (e.g., Bill of Lading, Commercial Invoice, Packing List) to the advising bank.
  4. Banks verify documents and process payments: The advising bank checks if the documents comply with the L/C terms. If compliant, the advising bank forwards the documents to the issuing bank. The issuing bank also verifies the documents. If they are compliant, the issuing bank makes payment to the advising bank (for the seller), as per the L/C terms (e.g., sight payment or usance payment). The advising bank then pays the seller.

Advantages of L/C

• For Exporters (Sellers):
  • Ensures Payment: L/C provides a guarantee of payment from a reputable bank, significantly reducing the risk of non-payment by the buyer, especially in international transactions where buyer's creditworthiness might be uncertain.
  • Reduces Risk: Protects against buyer's insolvency, payment delays, and political risks in the buyer's country (depending on the type of L/C and confirmations).
• For Importers (Buyers):
  • Payment only upon Document Compliance: The importer is assured that payment will only be released when the seller presents documents that strictly comply with the L/C terms. This ensures that the goods are likely shipped as agreed.
  • Benefit: Gives control to the importer as payment is contingent on the seller fulfilling documentary obligations.
• For Banks:
  • Secure Intermediary Role: Banks earn fees and commissions for their services in issuing, advising, confirming, and processing L/Cs. It's a relatively secure business as they deal with documents and have established procedures.

Disadvantages of L/C

• Challenges:
  • Labor-intensive: Processing L/Cs involves significant paperwork and detailed document checking, making it a labor-intensive process for both banks and traders.
  • High Transaction Costs: L/Cs involve various bank charges (issuing fees, advising fees, confirmation fees, etc.), which can be relatively high, especially for smaller transactions, increasing the overall cost of trade.
  • Risk of Discrepancies: Even minor errors in documents can lead to delays or non-payment, requiring careful document preparation and review.
• Mitigation:
  • Use of Digital Platforms: Adoption of digital platforms for L/C processing can reduce paperwork, speed up processes, and lower costs.
  • Training: Proper training for staff involved in L/C transactions (both in companies and banks) can minimize errors and improve efficiency.

Types of Letters of Credit

• Revocable LC: Can be modified or revoked by the issuing bank at any time without prior notice to the beneficiary. Rarely used because it provides very little security to the seller.
• Irrevocable LC: Cannot be amended or cancelled without the agreement of all parties involved (issuing bank, confirming bank if any, and beneficiary). Most common type as it offers security to the seller.
• Confirmed LC: An irrevocable L/C where a second bank (confirming bank), usually in the seller's country, adds its guarantee of payment in addition to the issuing bank's commitment. Reduces risk further for the seller, especially when dealing with banks in politically or economically unstable regions.
• Sight LC (At Sight L/C): Payment is made to the seller immediately upon presentation of complying documents to the nominated bank. Fastest payment method for the seller after document submission.
• Usance LC (Deferred Payment L/C): Payment is made at a predetermined future date after presentation of complying documents (e.g., 30, 60, 90 days from Bill of Lading date). Gives buyer credit period before payment is due.
• Back-to-Back LC: Issued based on another (primary) L/C. Commonly used by middlemen or traders. The primary L/C serves as security for issuing the back-to-back L/C to the actual supplier.
• Transferable LC: Allows the original beneficiary (first beneficiary) to transfer their rights to draw under the L/C to another party (second beneficiary). Useful for intermediaries who don't supply the goods themselves.
• Standby LC: Operates more like a bank guarantee. It is usually only drawn upon if the buyer fails to fulfill their obligations (e.g., payment). If the buyer pays on time, the standby L/C expires unused.

Parties Involved in a Letter of Credit

• Key Participants:
  1. Applicant or Opener (Importer/Buyer): The party who applies for the L/C to be issued.
  2. Issuing Bank (Buyer's Bank): The bank that issues the L/C on behalf of the applicant.
  3. Beneficiary (Exporter/Seller): The party in whose favor the L/C is issued and who will receive payment upon complying presentation.
  4. Advising Bank (Seller's Bank): The bank in the seller's country that advises the L/C to the beneficiary and verifies its authenticity.
  5. Confirming Bank (Optional): A bank (usually in the seller's country) that adds its confirmation to an irrevocable L/C, guaranteeing payment in addition to the issuing bank.
  6. Negotiating Bank (Optional): A bank that is authorized to negotiate documents under the L/C. This bank may purchase the documents from the beneficiary before payment is due (especially in Usance L/Cs).
  7. Reimbursing Bank (Optional): A bank authorized by the issuing bank to reimburse the confirming or negotiating bank after payment has been made to the beneficiary.
  8. Second Beneficiary (in Transferable LC): The party to whom the rights of the original beneficiary are transferred.

Risks in L/C Transactions

• Types of Risks:
  • Financial health of importer (Applicant Risk): Risk that the importer may become insolvent and unable to reimburse the issuing bank.
  • Quality of goods (Trade Risk): L/C only deals with documents, not goods. There's a risk that the goods shipped may not be of the expected quality or quantity, even if the documents are compliant. Mitigated by pre-shipment inspection clauses in L/C.
  • Country-specific political and economic risks (Country Risk): Risks arising from political instability, government regulations, or economic downturn in either the importer's or exporter's country, which could affect payment or performance under the L/C.
  • Foreign exchange fluctuations (Currency Risk): If the L/C is in a foreign currency, exchange rate fluctuations between the time of L/C issuance and payment can affect the actual value received or paid.

Conditions for Issuing Import L/C

• Circumstances when Import L/C is issued:
  • Domestic Import: Although primarily for international trade, L/Cs can sometimes be used for large domestic purchases where payment security is needed.
  • Merchandise Trade: Most commonly used for the import of goods or merchandise.
  • Third-country Import for Export Execution: When goods are imported from one country to be used in manufacturing products that will be exported to another country. L/C can facilitate these complex trade flows.

Fees and Charges Associated with L/C

• Issuing Bank Charges:
  • Opening Charges:
    • Commitment Fee: Charged for the bank's commitment to issue the L/C, often a percentage of the L/C value, and may be upfront or periodically.
    • Usance Fee (Deferred Payment Fee): Charged for Usance L/Cs, reflecting the credit period extended to the buyer.
  • Retirement Charges (Payment Charges): Fees for processing the payment when documents are found compliant.
• Advising Bank Charges: Fee for advising the L/C to the beneficiary and verifying its authenticity. Usually a flat fee.
• Confirming Bank Charges: Additional guarantee fee for adding confirmation to an irrevocable L/C. Usually a percentage of the L/C value and depends on the risk assessment of the issuing bank and country.
• Reimbursing Bank Charges: Settlement charge for handling the reimbursement process between banks.
• Foreign Obligations: Indemnification might be required from the applicant to cover any legal or regulatory requirements in foreign countries related to the L/C.

Summary:

• L/C ensures secure trade transactions: Provides a mechanism for secure payment in international trade, reducing risks for both buyers and sellers.
• Involves multiple stakeholders: A complex instrument involving various banks and parties, each playing a specific role in the process.
• Balances risks and benefits for exporters and importers: Offers payment security for exporters and document compliance assurance for importers, while involving costs and complexities.

Final Note:

Letter of Credit remains a critical tool in modern international trade, especially for transactions involving new trading partners, larger values, or higher risk environments, despite the rise of other payment methods and digital solutions. It provides a structured and secure framework for global commerce.