Royal Bank Pacific - Letter of credit

When we make a promise to someone we make sure to deliver it whether it is a service to be provided or a product to be delivered. But there is no assurance of its completion except a mutual understanding and one’s conscience to do what is promised.

Now imagine a scenario where money is involved. Things get a little more complicated when it is a matter of monetary transaction. One doesn’t simply make a deal on a verbal promise to pay. Something more concrete is required. 

There are many institutions dealing with money nowadays. The most common are the banks. Banks deal with a number of accounts, transfer of funds, deposit and withdrawal of cash, savings of its customers, loaning services etc. Can a bank make all these transactions on a verbal promise? Will you trust a bank with your money with no legal compliance? No, right?

so there are various legal documents required to carry out such transactions.  Imagine making a sale with a client and not being paid for it. To avoid such a contingency there is a document that assures you the payment for your sale. It becomes essential to make use of such a document when the parties to contract are not known to each other or are from different countries having different legal procedures. It is the Letter of Credit. 

Now what exactly is a letter of credit. It is a letter issued by the buyer’s bank to promise to pay to the seller in lieu of the purchase made by the buyer. It is a promise made by the bank of the buyer to make the payment on the behalf of the buyer in case the buyer is unable to pay.  

The bank or the financial institution acts as a middleman between the buyer and the seller and gives the assurance of making the payments on the compliance of certain obligations. The letter of credit works not only in the international trade but also domestic trade. There are certain terms and conditions that need to be complied with in order for the issuing bank (buyer’s bank) to be obliged to make the payment. These terms and conditions need to be complied with by both the parties to the contract ,i.e, the buyer as well as the seller, in accordance to its presence in the letter of credit. 

One thing to be understood before knowing about letter of credit is that the bank or the financial  institution liable to make the payment investigates the ‘documents’ and not ‘goods’ to abide by the contract.  

The letter of credit is widely used for various financial transactions as it proves to be beneficial for both the parties to contract. It benefits the seller as the risk of non-payment for the goods or services delivered is eliminated as the seller is assured by the bank to be paid in case of non-compliance by the buyer.  And it benefits the buyer as the chance of pre-payment can be reduced or avoided.

Usance letter of credit

Usance letter of credit is also referred to as deferred payment letter of credit. Under this payment method, payment is undertaken by the issuing bank, i.e, the buyer’s bank on a certain fixed date that is determined prior to entering the contract. The payment is done by the bank on a predetermined or a future date decided in advance.  This payment is also subject to the presentation of required documents and fulfilment of the terms and conditions mentioned in the letter of credit. 

Usance letter of credit is a form of credit borne by the buyer towards the seller. Though there is no risk of non-payment as the bank guarantees the payment to the seller but the buyer stands at an advantageous position wherein he can proceed to pay after getting the delivery and inspecting it thoroughly. 

How this works?

When two parties enter into a contract and make a trade deal through a letter of credit, the buyer’s bank issues a letter of credit to the seller that guarantees the payment to the seller. With letter of credit payment is to be done on the submission of the conforming documents, but under usance letter of credit the issuing bank receives a receipt for the goods delivered and may opt to pay the seller at a predetermined future date.

usance letter of credit

Using a usance letter of credit gives the purchaser an opportunity to utilize the funds towards other areas of the business till the time payment is made.

The seller is at comfort through this option because of the presence of the promise by the issuing bank to pay at a later date. While dealing in the letter of credit, one thing that is of utmost importance ,that is, to make sure of the credit worth of the bank or the financial institution involved. Making sure that the issuing bank has enough funds to fulfil the payment at the time of maturity is crucial for the seller. The seller, in case, wishes to be paid in advance, can also do so by discounting the letter of credit at a date before maturity. 

There can be two types of usance letter of credit based on the tenure for payment.

1. Payment within 90 days after the Bill of Lading is passed-

Under this method, the buyer is under an obligation to make the payment within 90 days of the passing of The Bill of Lading.

What is The Bill of Lading?

A bill of Lading is a document between the carrier (transporter) and the shipper of goods, that confirms the receipt of goods to be transported. It contains the details regarding the consignor’s name, consignee’s name, the date when the goods have been loaded, account numbers used to track the orders etc.

2. Payment within 30 days after sight-

Under this method the buyer is under an obligation to make the payment within 30 days of presenting the conforming documents by the seller. 

Usance letter of credit allows an option of bearing credit by the buyer as opposed to letter of sight which demands the buyer to make the payment immediately after the presentation of the documents.

Standby letter of credit

Letters of credit has been widely used in various trade finances, especially in the cases where the buyer and the seller are not known to each other, are living in different countries or have different laws to trade. One such letter of credit is Standby credit.

Now, generally when two parties come into a contract to purchase and sell a product, the seller promises to deliver the goods on the payment of a specified amount. At times this payment can be agreed to be paid at a later date on the fulfillment of certain terms and conditions. But it may so happen that even after being bound by a contract the purchaser refuses to make the payment or becomes unable to make the payment after the delivery of goods. To mitigate the loss that the seller may incur under the aforesaid circumstances, the parties may use a standby letter of credit.

Standby Letters of Credit

Under a standby letter of credit, the issuing bank (or the buyer’s bank) gives the assurance to make the payment even after the buyer has failed to do so.  

SBLC is a safety measure adopted by the beneficiary (Seller) to safeguard the risks associated with the business. Simply speaking, it is a guarantee made the bank on account of the buyer.

Advantages of using Standby Letter of credit:-

1. The seller can still be accounted to be paid in case he is not able to present the conforming documents.

2. The process is easier than any other documentary letter of credit.

3. The seller doesn’t bear any burden of proof whether the goods were actually delivered or not. 

Pre-requisites for obtaining the standby letter of credit-

1. One must have appropriate evidences to show that he has the ability to pay the loan.

2. Something must be presented to the bank as a collateral which will act as a security in case you are unable to pay.

3. Once the bank is completely satisfied of your ability to pay the loan, after inspecting the documents presented by you, the bank will provide you in writing within a week’s time. 

4. A fee needs to be paid for every year the Standby letter of credit remains in effect.

5. A fee of about 1-10% of the total monetary value of the letter of credit has to be paid.

Types of standby letter of credit.

There are 3 types of standby letter of credit.

1. Financial SBLC

2. Performance SBLC

3. Revolving SBLC

1. Financial SBLC- This is an irrevocable assurance made by the issuing bank to the seller in case the buyer fails to make the payment. 

2. Performance SBLC- This is an undertaking by the bank in the circumstance that the buyer has failed to make the payment. The bank promises to pay 50% of the value of the transaction when the buyer fails to make the payment.

3. Revolving SBLC- It is issued by the bank to enable long-term business  between an importer and an exporter and is used to cover multiple shipment contracts which may validate upto years.

Usance Letter of Credit - Knowing the types and the uses

A letter of credit is a term of payment that is mostly used for both international and long-distance commercial transactions. They seem to be indispensable for foreign transactions as they make sure the payments are received on time. Using these documentary letters of credit lets the seller considerably alleviate the risk of non-payment of the delivered goods by transferring the risk (on the buyer’s end) to that of the bank. One of the most crucial aspects of international trade is letters of credit due to separate laws in each country and the hassle of not knowing each other personally. 

As trade between two countries was impossible with the help of conventional payment methods, thanks to letters of credit, that now businesses can grow worldwide. Letter of credit was a letter written by the bank of the buyer to the seller’s bank resolving to pay the seller when the buyer defaults on the payment. 

Advantages of usance letter of credit for the seller

 The seller gets the obligation of the bank of the buyer to pay for the shipped goods

 Reduces the risk of production if the buyer changes or cancels his order

 The seller can know the exact date of payment for the goods

 The opportunity to receive financing during the period between shipment of goods and receiving the payment

 The buyer can’t refuse to pay due to any unnecessary complaints about the goods

Advantages of usance letter of credit for the buyer

 The bank will pay off the seller for the goods and services provided the latter shows the determined documents associated with the letter of credit

 The buyer demonstrates his solvency through a letter of credit

 The buyer controls the time period that is required for shipping of goods

 For issuing a usance letter of credit for delayed payment, the seller grants credit to the buyer

 Having a letter of credit lets the buyer to avert or reduce pre-payment

Usance letter of credit – How is it different?

Another name of usance letter of credit is deferred letter of credit or term LC. As the name suggests, a letter of credit is payable at a future provided the conditions in the letters of credit are fulfilled and all the documents are presented. 

If you have to understand usance letters of credit, you can compare it to Sight letter of credit where the funds are instantly transferred to the supplier as soon as the documents are given. In cases where usance LC is used, you’ll find a receipt of the documents by the issuing bank and where these abide by the terms of the LC, the issuing bank receives the draft and transmits funds for payments agreeing upon a future maturity date. The buyer is offered a form of credit terms as the buying party will take the documents of the product bought and also enjoy the ability to pay at a future date.

Usance Letter of credit – Why is it used?

The same reason for which credit terms are offered, a usance letter of credit is also offered for the same reason. The purchaser is given flexibility, better flow of working capital and availability to sell stocks before payment. In this case, payment for goods is easier when done on a later date as compared to payment on receipt as there would have been an element of payment collection from the actual purchaser.

Usance Letter of credit – When can it be used?

This usance letter of credit can be used only when there is a trust factor between the selling and buying parties. It is vital to understand the future amount that is to be paid and the interest rate that has been decided on the product. The usance letter of credit will set the maturity time and the date of payment so that both the parties can utilize that as a reference. The tenor is set as being specific few days following the BL date. When you have a usance letter of credit, the purchaser deploys funds into different areas of the business till the payment is done. 

Thanks to the usance letters of credit that the seller is able to trade in peace as the payment is guaranteed by promises within the banking system. 

Letters of Credit – Revealing its advantages and disadvantages

Exporting is always associated with several risks among which non-payment of foreign buyer is the most common one. To mitigate these payment risks, letters of credit are moderated by a bank in the form of a contract where the foreign buyer pays to their bank and the bank holds the amount unless the terms and conditions mentioned in the contract of sales are met. Letters of credit have always been the standard for handling risks though there are several other payment methods which are now in use for dealing with foreign transactions. Read on to know the advantages and disadvantages of letters of credit.

THE ADVANTAGES
 Safe expansion of your international business: The trade partners gain the ability to make further transactions with even unknown partners or set new trade relationships with foreign clients. Letters of credit help in business expansion regardless of geographical differences.
 Can be customized: Both the trade partners have the discretion of customizing a letter of credit. They can include terms and conditions that tailor to their requirements and then conclude with a common list of clauses. Letters of credit can also be personalized from one payment to another with the same trade partner.
 A buyer’s credit certificate: A letter of credit passes on the credit-worthiness from the buyer or the importer to the issuing bank. When the importer is backed by a reputable institution like a bank, he can carry on several transactions with ease.
 No credit risk on part of the seller: From the perspective of the exporter or seller, a letter of credit is a mark of safety in case the importer or buyer suddenly goes broke. As the credit-worthiness of the importer is passed on to the issuing bank, the bank becomes liable to pay the amount as per the letter of credit. Hence, an LC works as credit insulation.
 Seller gets money after term completion: The issuing bank becomes independent of the obligations of the trading partner and any consequential obligations through a letter of credit. The bank needs to check whether or not the documents given by the beneficiary satiate the terms specified in the letter.
 Timely payments & better cash flow: A letter of credit offers surety to the timing and amount of the clash flow of the exporter. The exporter can thereafter plan his financing needs ahead of time and also diminish his risk level.
 Sellers get pre-shipment financing: The exporter can easily access pre-shipment financing against an LC as this lets him bridge the financing gaps.

THE DISADVANTAGES
 Bank fee is an additional cost: A letter of credit unnecessarily increases the cost of business as the banks charge a fee for offering this kind of service. In case the parties wish to add extra features, the fees can increase steeply.
 Formalities are time-taking: The formalities and documentation that are required can be more in case of a letter of credit. This can even add to the total cost of running a business.
 Fraud risks increase: There are few complicated governing rules that bind a letter of credit and several infamous sellers and buyers can misuse them to take undue advantage of it. Moreover, an LC also poses a fraud risk to the importer. Disputes can arise in case the quality differs from what has been agreed upon.
 Risk of currency: A letter of credit has forex risk as there is a currency agreed-upon in the letter of credit. Since one of the parties might have a variation in currency, they can face a risk because of fluctuations in currency. However, this might even work in your favor.
 Expiry date: There is an expiry date to a letter of credit and hence the exporter will be bound by time to deliver the goods at any cost. Hurrying might lead to a mess.
 Default risk by issuing bank: As the credit-worthiness is transferred to the issuing bank, in case the bank defaults, the exporter still has a payment risk.

The exporter may avoid this when the issuing bank guarantees payment but this has a cost attached to it. Therefore, letters of credit are of utmost importance for securing international trade transactions. Seek help of them in order to insulate your payments.