Trade Finance Terms: Letters of Credit
In a recent blog we shared a glossary of commodities trading terms, aiming to de-mystify the many terms that are commonly used in the industry. Some of these benefit from a little more explanation so we decided to dive deeper and share some further blogs with you.
What is a letter of credit?
Letters of credit can also be known as documentary credits and so can be given the abbreviation LC or DC. A letter of credit is a document issued by a bank that authorises the seller of a commodity to draw an agreed amount of money under specified terms. It guarantees that the payment from buyer to seller will be received on time and for the correct amount. If the buyer is unable to fulfil the agreement, the bank will then be required to cover the full amount of the purchase. As there are so many factors in international trade, there are multiple different letters of credit to account for different scenarios.
How it works
Letters of credit help mitigate sellers’ risk by ensuring that the seller is paid on time. It is a method of payment which discharges any legal obligation for the buyer to pay the seller by having the nominated bank to pay the seller directly. In this way, the seller is dependent on the bank as opposed to the buyer for receiving payment.
Once the issuing bank has assessed the buyer’s credit risk, assessing whether the buyer will in fact be able to pay for the good, then the letter of credit will be issued. The seller will then receive the letter of credit, review the terms to make sure that they match with the contract and, with all being well, will then arrange for the goods to be shipped. Having shipped the goods, the seller presents the requested documents to the nominated bank. The bank will only pay the seller the correct value of the goods when the seller provides the bank with these documents referred to as ‘negotiable instruments’. After checking to see whether these documents comply, the bank will then honour the terms of the letter of credit and pay the seller the correct value for the goods. If the documents do not comply however, the terms of the letter of credit are referred to as ‘discrepant’.
Once the negotiable instruments have been presented, the goods typically become under the control of the issuing bank. This gives the bank security and ensures that the buyer will repay the bank for paying the seller on their behalf. Banks also collect a fee for issuing letters of credit and they may also require a pledge of securities as collateral. The fee which the banks charge is often a percentage of the amount covered by the letter of credit. The majority of letters of credit are governed by the rules determined by the International Chamber of Commerce which are also known as ‘Uniform Customs and Practise for Documentary Credits’ (UCP).
Letters of credit first existed as paper documents only however became regularly issued by telegraph at the end of the 19th century. In the late 19th century, travellers would often carry a circular letter of credit on them having been issued to them by a relationship bank. This then allowed the beneficiary to withdraw cash from other banks along their travels. This sort of letter of credit however was eventually replaced by traveller’s checks and credit cards. The first set of UCP was overseen in 1933 by the International Chamber of Commerce and in 1973 banks began to switch to electronic data interchange which has resulted in the majority of letters of credit being issued in electronic form at present.
Types of Letter of Credit:
- Revocable/ Irrevocable Letter of Credit — Whether a letter of credit is irrevocable or revocable is determined by whether the buyer and issuing bank are able to amend and alter the Letter of credit without the seller’s permission. According to UCP 600, all letters of credit are irrevocable. In this way, the number of revocable letters of credit is becoming increasingly diminished. Any changes or amendments to the contract must be done through the buyer and issuing bank and approved by the seller.
- Confirmed/Unconfirmed Letter of Credit — A letter of credit is considered to be confirmed when a second bank confirms that it will honour a complying presentation at the request of the issuing bank. A complying presentation is a set of documents that meet with the requirements of the letter of credit and all of the rules relating to letters of credit.
- Deferred / Usance Letter of Credit — A credit that is not paid or assigned immediately after the presentation, but instead after an indicated period that is accepted by both buyer and seller.
- Standby Letters of Credit – The contract is a termed a standby agreement as the bank is only required to pay in the worst-case scenario. A standby letter of credit guarantees payment to a seller however the agreement must be followed exactly. If there were to be a delay in shipping for example, the bank has the right to refuse making the payment.
Why they’re used
Letters of credit have multiple advantages for both the buyer and the seller. The principal benefits for the seller include being able to calculate the payment date for the goods, a reduction in production risk if the buyer cancels or changes his order and the buyer not being able to refuse payment due to a complaint about the goods delivered. The principal benefits for the buyer include controlling the time period for the shipping of the goods and being able to reduce or avoid pre-payment.
Overall as trade dealings are often international, there are factors such as geography, distance, laws and customs which need to be taken into account. Letters of credit are very useful for instances when the buyer and seller may not know each other personally. For this reason, letters of credit help mitigate the risk for a seller providing goods to a buyer and are an extremely crucial aspect of international trade.
Author: Betty Rook