Letter of credit / documentary credit

With a letter of credit — you can trade in new international markets with confidence.

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What is a letter of credit?

A letter of credit (LC or L/C) is essentially a letter, from a bank, that guarantees a buyer will pay a seller — within a specified time frame.

This payment is guaranteed, as long as the seller meets certain pre-defined conditions — such as presenting proof of shipment.

Should the buyer be unable to make payment, a letter of credit, mandates that the issuing bank covers the balance. Conversely, should a seller not honor the terms of the deal — payment is not made and the buyer is protected.

Letters of credit are similar to bank guarantees (BGs), with the difference being that bank guarantees are used for a variety of different situations — while letters of credit are mainly used for import/export.

A letter of credit is also known as a documentary credit (DC or D/C) and is a form of trade finance.

Letter of credit — considerations

Letters of credit (L/Cs) are integral to international trade. Trading globally involves a lot of unique factors and risks — that are not seen in domestic trade. Countries have different laws, it can take weeks for goods to be shipped, there’s risk of non-payment or non-delivery, and parties often do not know each other personally.

A letter of credit can help address some of these issues. It offers a guarantee to the seller (exporter) that they will get paid, and the buyer (importer) can be sure that money is not released until goods have been shipped or delivered.

There are a number of different types of letters of credit obtainable. Depending on the circumstances — one may be more appropriate than the other.

Letters of credit are issued by the importer’s bank. They are negotiable instruments — where the issuing bank pays the beneficiary. Letters of credit can be transferable, in which case the beneficiary may assign the right to ‘draw’ funds — to a third party.

Before a bank issues a letter of credit — it may require collateral. This collateral is typically cash, deposited in a designated bank account — although other forms of collateral may be acceptable. When using an import financing facility — collateral may not be needed.

Banks will charge for issuing a letter of credit — making it a matter of weighing up costs against security benefits. Due to these costs, it is not economical to use letters of credit for smaller purchases or orders.

Alternative arrangements to documentary credits include documentary collection, credit insurance, factoring and cash in advance terms. These options are generally utilized after a buyer and seller have developed a stronger relationship.

The International Chamber of Commerce (ICC) has a set of international trade rules for LCs.

How do letters of credit work?

Whether your company is importing or exporting — letters of credit work in a similar way.

Should your business be looking to import products from overseas, to manage risk, your foreign supplier may require you to pay with a letter of credit — as soon as shipment has been made.

Accordingly, you would need to approach a bank and apply for the documentary credit. You will either be required to have the full funds at hand, or alternatively you may arrange an import loan — with the bank.

If you meet the banks financing criteria, they would issue you with a letter of credit. This L/C will guarantee payment to the overseas supplier — as long as they meet certain conditions. These conditions include them proving that shipment has been made. This proof would come in the form of a variety of shipping documents — with details such as dates, destinations, quantity, quality etc.

Once your bank obtains proof of shipment, depending on the arrangement, they may release funds immediately or wait until goods have been delivered to you.

Once your bank pays the supplier — you will need to make repayment. If you already had the cash at hand, you would simply transfer the monies over to your bank. Alternatively you may have borrowed the funds, as such you would begin making repayments as per your agreement.

As a form of export finance, letter of credit discounting allows the exporter to be paid in advance of fully meeting their contractual obligations. The discount represents the fees the exporter’s bank earns — for advancing funds.

Types of letter of credit

Irrevocable

An irrevocable letter of credit cannot be altered or revoked — unless all parties agree. Irrevocable letters of credit are more secure than revocable ones.

Revocable

A revocable letter of credit can be altered or revoked by the issuing bank, at any time — for whatever reason.

Confirmed

With a confirmed letter of credit, payment is guaranteed by both the issuing (importer’s) bank and the confirming (exporter’s) bank. Thus providing more security than an unconfirmed one.

Unconfirmed

Under an unconfirmed letter of credit — only the issuing bank guarantees payment.

Transferable

Transferable letters of credit may be passed from one beneficiary (the payee) to another.

Standby

A standby letter of credit (SBLC or SBL/C) further assures a supplier that a buyer will be able to pay. Sellers do not expect to draw on this letter of credit — as it is secondary or on standby to the primary LC.

Revolving

A revolving letter of credit may cover multiple transactions between the same buyer and supplier.

Back-to-back

Back-to-back letters of credit can be used when an intermediary is involved in the process. For example, a broker or when a seller must purchase goods from another supplier — before fulfilling a buyer’s order.

Benefits of a letter of credit

  • Allows companies to safely trade internationally
  • Seller is guaranteed payment in full and on time — as long as it meets obligations
  • Seller can get pre-shipment finance — against a L/C
  • Buyer gets a guarantee that the seller will fulfill contract terms
  • They can be tailored to suit all parties
  • Helps both importer and exporter manage cash flow

Limitations of a letter of credit

  • Adds to the cost of doing business
  • Time-consuming administrative processes
  • Must keep to strict terms of arrangement — any deviation can result in non-delivery or non-payment
  • Other risks e.g. political or currency fluctuation

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