A Letter of Credit (L/C) is identified in the sources as a method of payment used in international trade. It is described as a written obligation and a formal document issued by a bank on behalf of a customer. The fundamental purpose of an L/C is to ensure that the importer makes payment to the exporter once proof of shipment is received.
The sources highlight that banks involved in an L/C arrangement act as a trustworthy third party or intermediary between the buyer and the seller. A letter of credit is an arrangement whereby a bank helps its customer (the importer) to obtain credit from its suppliers (the exporter). When a bank opens an L/C in favour of its customer for specific purchases, the bank undertakes the responsibility to honour the obligation of its customer, should the customer fail to do so. This involves the importer’s bank (also referred to as the “issuing bank”) issuing an L/C by making a written commitment on behalf of the importer to pay the exporter when the importer’s bank receives shipping documents confirming that the exporter has shipped the products to the importer.
Purpose and Usefulness
The L/C is particularly useful when reliable credit information about a foreign buyer is difficult to obtain. In such situations, the exporter may not fully trust the importer’s ability or willingness to pay directly. However, if the exporter is satisfied with the creditworthiness of the buyer’s foreign bank (the issuing bank), the L/C provides a mechanism to proceed with the transaction with greater assurance. The exporter benefits from the L/C because it may trust the importer’s bank more than the importer itself to make payment. This trust is based on the bank’s commitment to pay, which is conditional upon the exporter presenting the stipulated documents.
Furthermore, the L/C arrangement also protects the buyer (importer) since no payment obligation arises until the goods have been shipped or delivered as promised. Payment is contingent upon the presentation of documents that prove the shipment has occurred according to the agreed terms.
Parties Involved
Several parties are typically involved in a Letter of Credit arrangement:
- Applicant: This is the customer who requests the LC, usually the importer. The importer applies to their bank for the letter of credit.
- Beneficiary: This is the party in whose favour the LC is issued, usually the exporter. The LC guarantees payment to the beneficiary.
- Issuing Bank: This is the importer’s bank that issues the L/C. It makes the written commitment to pay the exporter. The issuing bank substitutes its creditworthiness for that of the unknown importer.
- Advising Bank: This bank is generally located in the country of the exporter. It is responsible for the transfer of documents to the issuing bank on behalf of the exporter. It notifies the exporter that the L/C has been received.
- Confirming Bank: This bank provides an additional guarantee to the undertaking of the issuing bank. It comes into the picture when the exporter is not satisfied with the assurance provided solely by the issuing bank.
- Negotiating Bank: This bank negotiates the documents related to the L/C submitted by the exporter. It makes payments to the exporter, subject to the completeness of the documents, and claims reimbursement under the credit.
- Reimbursing Bank: This is the bank where the paying account is set up by the issuing bank. The reimbursing bank honours the claim that settles the negotiation, acceptance, or payment coming through the negotiating bank.
- Second Beneficiary: This is a party who can represent the original beneficiary in their absence.
- Carrier: Although not listed in the primary parties, the carrier is essential as they issue the bill of lading, a key document in the process.
- Money Market Investor: May become involved if a banker’s acceptance, created under the LC, is sold at a discount in the money market.
The Typical Process
The process of a typical foreign trade transaction involving an L/C is detailed in the sources. It often begins with the importer placing an order and requesting shipment under a letter of credit. The importer then applies to their bank for the letter of credit, providing the bank with the terms of the sale. The importer’s bank (the issuing bank) then issues the L/C, which is sent via the importer’s bank to the exporter’s bank (the advising bank).
Once the advising bank receives the L/C, it will notify the exporter. Based on this assurance from the bank, the exporter ships the goods. Along with the shipment, the exporter obtains crucial shipping documents from the carrier, such as the bill of lading, as well as prepares documents like the commercial invoice.
The exporter then presents these shipping documents, often along with a time draft, to their bank. The exporter’s bank sends these documents to the issuing bank. The issuing bank examines the documents to ensure they comply strictly with the terms and conditions stipulated in the L/C. A critical requirement is that the description of the merchandise in the commercial invoice must correspond exactly to that contained in the L/C.
If the documents are found to be in order and comply with the LC terms, the issuing bank honours its commitment and makes payment to the exporter (or the exporter’s bank). The buyer (importer) pays their bank for this service. The documentary credit procedure involved with an L/C is depicted in Exhibit 19.3 and Exhibit 20.1.
Key Documents
Several key documents are involved in shipments facilitated by a Letter of Credit:
- Letter of Credit (L/C): The central document containing the bank’s commitment and the terms of the transaction.
- Bill of Lading (B/L) / Airway Bill: This document is provided by the carrier. It serves as a receipt for the shipment, a summary of freight charges, and most importantly, it conveys title to the merchandise. An ocean bill of lading is used for boat shipments, and an airway bill for air shipments. The B/L usually includes details like merchandise description, identification marks, ports, names of exporter and importer, freight status, and shipment date.
- Commercial Invoice: This is the exporter’s description of the merchandise being sold. It typically includes the names and addresses of the exporter and importer, the date, terms of payment, price (including potential freight, handling, insurance), quantity, weight, packaging, and other details. The description must exactly match the L/C.
- Draft (or Bill of Exchange): A written order from the exporter instructing the importer (or the importer’s bank) to pay a specified amount. Drafts are generally included in the documents required by an L/C.
- Other Documents: Depending on the L/C terms, other documents such as packing lists, certificates of origin, and insurance certificates may also be required. An original copy of the letter of credit is mandatory if credit has been availed under the letter of credit for post-shipment credit.
Types of Letters of Credit
The sources describe various types of Letters of Credit:
- Revocable Letter of Credit: Can be modified or revoked by the issuing bank without notice. It is rarely practiced in modern-day international trade.
- Irrevocable Letter of Credit: Cannot be revoked or modified without the consent of the issuing bank, the beneficiary, and the confirming bank (if applicable). It is considered a safer option for the exporter as it assures payment if documents comply. LCs used in international trade are typically irrevocable, meaning they cannot be cancelled or amended without the exporter’s consent.
- Confirmed Letter of Credit: An arrangement where another bank (the confirming bank) adds its guarantee to the LC. This provides added assurance to the exporter but increases the cost of the LC.
- LC at Sight: Requires the issuing bank to make payment immediately upon presentation of complying documents (at sight or on demand).
- Usance Letter of Credit (Deferred LC, Time or Term LC): Payable at a predetermined or future point in time, subject to conditions and presentation of documents.
- Back to Back LC: Made up of two distinct LCs, one from the buyer’s bank to an intermediary (broker) and another from the intermediary’s bank to the seller.
- Transferable Letter of Credit: Used when a middleman is involved, allowing the first beneficiary to request the bank to transfer the entire payment or part thereof to a second beneficiary. The first beneficiary is typically the middleman or a company selling another’s products.
- Standby Letter of Credit: Similar to a bank guarantee, it is more popular in the US. The exporter can obtain payment from the bank even if the applicant fails to perform as per the underlying agreement. On an international scale, standby L/Cs are often used with government-related contracts and serve as bid bonds, performance bonds, or advance payment guarantees.
- Freely Negotiable Letter of Credit: Allows any bank willing to pay, accept, incur deferred payment undertaking, or negotiate the LC to become a nominated bank. The LC indicates it is not restricted to a specific bank or can be negotiated at any bank.
- Revolving Letter of Credit: An LC where the amount mentioned gets reinstated after payment, reducing the need to create a new LC. It is used for shipments with a diverse set of goods or repeated shipments of the same goods within a specific period.
International L/Cs are usually issued in accordance with the provisions contained in “Uniform Customs and Practice for Documentary Credits” (UCP), published by the International Chamber of Commerce.
LCs as a Source of Financing
Letters of Credit are described not only as an important payment method but also as a source of financing in international trade.
- Exporter Financing: When a Usance or Time LC is used, payment is deferred to a future date. This arrangement means the exporter provides financing to the importer until the importer (or the importer’s bank) makes the payment.
- Importer Bank Financing: When an importer obtains an L/C, their bank is obligated to make payments due under the L/C, even if the importer does not have sufficient funds in their account. In such a case, the bank is effectively extending credit to the importer. The bank’s willingness to do this depends on its trust in the importer’s creditworthiness.
- Banker’s Acceptances: A banker’s acceptance (B/A) is a bill of exchange or time draft that is issued by a firm and guaranteed by a bank. B/As often arise from transactions initiated with an L/C. After the exporter presents a time draft and shipping documents, and the importer’s bank accepts it, it becomes a B/A. The exporter can hold the B/A until maturity or sell it at a discount to the importer’s bank or in the money market to get immediate funds. B/As are a short-term source of trade financing, typically with maturities ranging from 30 to 180 days. A time draft can become a negotiable money market instrument called a banker’s acceptance.
- Forfaiting: While forfaiting is a method of medium-term trade financing, it can involve an overseas buyer opening a “letter of credit” or other negotiable instruments in favour of the exporter to finance the import of goods on deferred payment terms.
Comparison with Other Methods
The sources compare LCs with other payment methods:
- Drafts: Drafts are often included in L/C documents. However, a draft can also be used without an L/C. Using a draft without an L/C provides less protection to the exporter because no bank is obligated to make the payment on the importer’s behalf. Sources state that Drafts are generally less expensive than letters of credit, implying LCs are more costly due to the bank guarantee involved.
- Open Account: Open Account is another payment method in international trade. Unlike an L/C, Open Account is an informal agreement based on significant trust and prior experience between the exporter and importer [Sources on Open Account from previous conversation]. Under Open Account, the exporter ships goods with an invoice and expects payment later [Sources on Open Account]. With an L/C, the bank’s creditworthiness is substituted for the importer’s, offering greater assurance to the exporter compared to an Open Account transaction, which relies solely on the buyer’s promise to pay [Sources on Open Account]. Consignment sale is presented as a variation of open account.
Other international trade finance techniques mentioned alongside LCs include Accounts Receivable Financing, Factoring, Forfaiting, Banker’s Acceptances, and Countertrade.
Costs
The buyer (importer) pays its bank to render this service (issuing the LC). The cost of the LC can escalate, for example, when a confirmed letter of credit is used.
Reliability and Potential Issues
L/Cs are generally a reliable payment method, particularly in international trade. The sources suggest that situations where a bank backs out of an irrevocable L/C obligation are rare in industrialized countries. However, a scenario is presented where a Russian bank failed to honour an irrevocable L/C, illustrating that while rare, such issues can create a crisis in trade relations. The question is also posed whether traditional payment methods for international trade, including LCs, can fully insulate a business when strained relations arise between countries.
In summary, the Letter of Credit is a cornerstone of international trade finance, offering a formalized, bank-backed payment guarantee that significantly reduces the risk of non-payment for the exporter, while also protecting the importer by conditioning payment on proof of shipment. Its complexity involves multiple parties and documents, and while generally reliable, its effectiveness can be influenced by the specific type of LC, the financial health of the involved banks, and broader geopolitical factors. It stands as a more secure, albeit generally more expensive, alternative to simpler methods like Open Account or drafts without bank guarantees.