Letters of credit basics can help you go a long way toward starting the first international deal. Banks issue them on behalf of the purchaser of those goods or services. The letters of credit will state the maximum amount that the bank will pay to the seller. It also states other specific conditions terms and conditions the seller must meet.
Letters of credit are undertakings by the issuing bank on behalf of the applicant to the beneficiary through the advising that it will hour their claim provided they present documents confirming compliance to the terms and conditions. It is one of the most used trade finance products today.
The purpose of letters of credit are twofold: they assure the seller of payment for their transaction, and they also protect the buyer in case the seller does not deliver on their end of the bargain. Letters of credit are commonly used in international transactions, as there is always some risk involved when doing business across borders. If you are looking to use letters of credit in your next business deal, it is important to understand the ins and outs of this system. Let’s take a closer look at how letters of credit work!
Parties to Letters of credit (LC)and their roles :
-Applicant:
The company that initiates the letters of credit. This is also the importer of the goods. The term applicant comes from the fact they apply to the bank for the LC.
-Issuing Bank:
This is usually the banker to the applicant. The Issuing Bank has lines of credit for the applicant to issue letters of credit. Needless to say, the lines of credit need to go through a thorough credit analysis at the bank. It is this bank that initiates the issuance of LC on behalf of the applicant.
-Advising Bank:
This is the bank that advises (i.e., informs) the seller about the issuance of LC at the behest of the Issuing Bank. The term advising means informing the beneficiary that an LC has been received. This bank is usually located in the country of the beneficiary.
-Confirming Bank:
A confirming bank is optional, but if used, it strengthens the creditworthiness of the letter of credit. The confirming bank adds its guarantee to payment under LC terms, increasing its payment probability. This is important when the issuing bank has a low credit rating. Confirming Banks usually have a good credit rating. Some Global confirming banks include Citibank, Deutsche Bank, and HSBC.
-Beneficiary:
The company that will supply goods as per the sale contract is also usually the exporter of said goods. It is important to note that the applicant and beneficiary have engagements before LC issuance. Once the beneficiary gets the notification, they will commence production of goods for export.
-Negotiating Bank:
When dealing with usance L/Cs, the beneficiary will get payment later. This can be 90 days from the date of shipment, for example. In this case, when documents are presented to the bank, payment will only be received at the maturity date. If the LC states that it is available by negotiation, the beneficiary will go to the bank (i.e., the negotiating bank) and negotiate a discount on the spot rate in order to receive their money earlier.
What are a few advantages to using letters of credit in your business dealings?
-It protects the buyer in case the seller does not deliver on their end of the bargain. This can help prevent costly disputes down the road.
-It assures the seller that they receive a payment if they comply with the terms and conditions in the LC.
-It has international recognition, leading to wide acceptability.
-Sellers can easily monetize them once they perform and receive confirmation document acceptance by the issuing bank.
What are a few disadvantages to using letters of credit?
-The process can be quite complicated, so it may take longer than usual to get everything set up.
– Letters of credit can be expensive, so they may not be suitable for small transactions.
– The seller must meet the terms of the letter of credit to be eligible for payment. This can sometimes be difficult if the goods, leading to discrepancies.
-Letters of credit do not offer protection in cases of fraud if documents presented conform to terms and conditions. Actually, L/C’s are separate from underlying contracts and fraudsters can use them. We shall cover fraud through L/C’s separately.
What are the types of letters of credit?
-Usance LC:
Usance L/C’s are those that provide for payment sometime after the delivery of goods. You will see terms such as ‘Payment at 90 days from that date of shipment’. They are popular with buyers since they allow them time to receive the goods and trade before the due date. The flip side is that the seller will be out of pocket during this period.
-Sight LC:
This type of letter of credit is for immediate payment upon presentation and acceptance by the issuing bank. It is ideal when the LC is used to mitigate the basic risks of nonpayment by the buyer and nonperformance by the seller.
-Revocable LC:
This is an ordinary sight or usance LC with a clause that allows banks to cancel it before its due date. If this happens, then you will receive no money whatsoever under this kind of letter of credit arrangement, although some countries may have laws regarding revocation periods during which cancellation cannot occur once presented to banks. They are unpopular and rarely do you find a beneficiary that would accept them.
-Irrevocable Letter Of Credit:
The opposite of revocable letters of credit. Under irrevocable, no party can withdraw or amend the L/C’s unless there is acceptance by all parties. This provides certainty to everyone in the transaction.
-Restricted LC:
This type of letter of credit directs where export documents will be sent for payment, acceptance, or negotiation. Most LC’s bearing confirming of 1st class bank will be restricted to that bank.
-Revolving LC:
The applicant can utilize the approved limit of credit to issue letters of credit up to an unlimited amount. There are no amendments or negotiations with banks each time they make a transaction through this product, as it’s all done automatically. Once one LC is utilized and payment has come, the entire limit becomes available. It is useful, especially since the trade is for the same commodity and the parties have developed trust in each other.
-Back to Back LC:
This is where one LC acts as a master to another one. If you receive an L/C to supply machinery at the cost of $10,000, you will need to source it from somewhere. You will approach the bank and ask them to open an L/C for $8,000 to procure the machinery. The bank will use the Master L/C of $10,000 as security to open an $8,000 LC (slave LC). The relationship between these L/C’s is referred to as Back to Back because the terms and conditions mirror each other majorly.
-Transferable LC:
This LC allows a trader to transfer part of it to a second beneficiary who will supply goods. Its usage is mainly for traders who secure a large deal and have to use other companies to fulfill the order.
-Green Clause L/C’s:
A Green clause letter of credit is an excellent way to secure funds before shipment or presentation. The issuing bank can make advances on your behalf, to the beneficiary. This type of L/C is applicable where the buyer needs to finance the exporter for a certain motivation. This can be a regular supply of goods, exclusive supply, or discount price.
There is a greater risk of the beneficiary of none performance since they have received payment. Under the green clause, the applicant usually has great confidence in the beneficiary’s performance capability.
-Standby LC:
A standby letter of credit is a guarantee by a bank that it will pay the beneficiary upon presentation of specific documents, such as an invoice or performance bond. The guarantor in this case is usually the buyer. Usage of this type of LC is where the buyer does not have pre-existing credit with the seller’s bank or when there are time constraints on getting traditional financing from banks.
What are letters of credit payment terms?
The terminologies in payment terms and types on L/C’s keep repeating themselves. You will find this as repetition, but it isn’t.
-Sight:
These payment terms are when the beneficiary receives a fixed amount of money upon presentation of documents that comply with the terms and conditions of the L/c.
-Usance:
This is where payments will be received either on the maturity date. When the issuing bank ascertains that the documents are complying, it will accept the documents. Usually, the buyer and seller agree on the payment term before the issuance of LC.
-Mixed payment:
This is when the issuing bank designs an L/c in such a way that part of the money is payable at sight and the balance on a usance basis. An LC for machinery import can be in such a way that payments will be coming as follows, 20% at Sight, 60% payment upon commissioning, and finally 20% payment 180 days after commissioning.
-About Clause:
This is a technical term that applies when the price or quantity can vary. For example, the prices of Petroleum keep changing. In LC, the word [ABOUT] will be placed in the description of goods or prices. This means that claims under the LC can be anywhere between -10 % and +10%. About clause is necessary when the final price is determined by a certain formula that will be just before shipment.
How do Letters of credit work?
-It starts with buyers and sellers negotiating and signing a commercial contract. The contract contains detailed information on the underlying transaction and the responsibilities of each party.
-Buyer then applies for a letter of credit from his/her bank.
-Issuing bank (the buyer’s bank) vets the application and, if it is approved, opens the LC in favor of the beneficiary (usually the seller). The terms and conditions of the LC must be met before payment can be made to the beneficiary.
-Advising bank upon receipt of LC notifies the applicant.
-Applicant checks and confirms that the LC is as per negotiated terms. They then proceed and perform. If they are commodity traders, for example, they proceed to do everything needed to ship.
-They will then get all documents in the LC and present the same to negotiating bank.
– The negotiating (sometimes referred to as accepting bank)bank then checks the documents. If they are compliant, they proceed to negotiate them (provide value to the beneficiary ) or accept them for Usance LCs.
-Negotiating bank then sends the documents to the Issuing bank who checks the documents as well.
-If they find documents to be in order, they will then send a notification to the negotiating bank. If the LC provides for sight payment, then they must reimburse the negotiating immediately. However, for usance LCs the process is different. They will send a notification of acceptance. Whereupon, at maturity they will make payment by collecting money from the applicant.
What is Usance Payment at Sight?
This is a special arrangement where the LC payment terms are both as to sight and usance. It is different from the mixed payment discussed above. You can refer to Usance Payment at Sight as UPAS as well. The essence of UPAS is to ensure that the beneficiary gets their payment at sight. While at the same time ensuring that the beneficiary will only make payment at the maturity.
This is achieved by bringing in confirming bank. UPAS L/Cs explicitly authorize the confirming bank to pay the beneficiary at sight by creating a loan in their books. Once LC has been accepted by virtue of checking and confirming compliance, the confirming bank pays the beneficiary.
Interest charges are payable by either the buyer or the seller.
Advantages of UPAS
- The beneficiary gets their money at sight meaning that they are able to offer sharp prices to applicants.
- The applicant enjoys credit terms until maturity
- The issuing bank will have non-funded exposure in their books
- Interest charges are normally sharp/lower than the market.
In conclusion, letters of credit are an important financial instrument in international trade. Importers, exporters use them, and their banks to ensure the timely delivery of goods before releasing payment. Letters of Credit have many advantages but also some disadvantages which you must weigh when deciding if one will work for your company’s needs. There are different types of L/Cs and each has its own unique features along with pros and cons. It is worth considering each of their features before choosing the type of financing mechanism for your business operations. If you need help understanding how letters of credit operate or what they might do for your company, please subscribe to our blog today!
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