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.

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. 

Letters of credit – Knowing the different types

Generally the international traders need help of financial intermediaries like banks for guaranteeing payments and also the assurance of delivering goods on time. Letters of credit usually accomplish their goal by playing the role of a substitute to the credit of the bank to that of the client mainly for facilitating trade. Such a letter is issued by a bank to guarantee full payment and timely payment to the seller. Under a circumstance where the buyer is not able to make such a payment, the bank will either cover the entire amount or the remaining amount on the buyer’s behalf. This letter is granted against a pledge of cash or securities as collateral. Banks also collect a fee which is a percentage of the total amount of letter of credit. 

Letter of Credit

Letters of Credit - Their importance

International trade comprise of factors like different laws, distance, various laws pertaining to the countries involved and the dearth of contact during the process of trade. Amidst all this, letters of credit are used as a dependable mechanism of payment. The letters of credit that are used during international transactions are supervised by the International Chamber of Commerce Uniform Customs and Practice for Documentary Credits. 

Key elements of Letters of Credit

 The issuing bank gives a payment undertaking

 On the buyer’s behalf who is also the applicant

 To pay off a beneficiary (mostly a seller) for a specific money amount

 On providing the exact documents that are proof of the goods supply

 Within a stipulated time period

 Documents should abide by the terms and conditions that are mentioned in the LC

 Documents also need to be shown at a definite place

A letter of credit – How does it work?

Due to the fact that a letter of credit is more of a negotiable payment mechanism, the issuing bank has to pay the beneficiary bank or the bank that has been mentioned by the beneficiary. In case the LC is transferable, the beneficiary might appoint yet another person, third party or corporate parent as an entity that has the right to draw the amount. 

As already mentioned above, banks will need a pledge of cash or securities as collateral for issuing a letter of credit. A percentage of the size of the LC will be collected as a fee for providing the service. There are different kinds of LCs available. Read on to know on them. 

Types of Letters of Credit

There are many variations to Letters of Credit and each are suited for a separate situation. Let’s take a look at the main types:

1. Revocable: This letter type can be amended or cancelled by either the issuing bank or the buyer any time without any prior notice. However in the current version of UCP 600, revocable LCs have been removed for transactions that are done under their jurisdiction. 

2. Irrevocable: On the other hand, this letter can’t be cancelled or revoked unless the three parties – the buyer, seller and the third party agree to the terms and conditions. 

3. Transferrable: If the beneficiary is an intermediary for the actual suppliers of services, the payment has to be transferred to the actual suppliers. 

4. Un-transferrable: An un-transferrable letter of credit doesn’t allow any transfer of payments to a third party as in such a case, the beneficiary is the recipient. 

5. Confirmed: Here the LC will be given a ‘confirmed’ status as the bank that confirms the exporters has added the liability to the issuing bank. The liability will be either assurance of payment or guarantee of payment. 

6. Unconfirmed: This letter of credit is guaranteed by the bank issuing the letter and this implies that there’s no sort of confirmation from the advisory bank of the exporter. However, in areas of sluggish economy or uncertainty in political conditions, payments could be at risk in such cases. 

The letters of credit are therefore used as a tool to diminish the risk that has substantially grown over the last decade. The letters of credit serve various purposes that are perfect for different functions. The credit professional, on receiving the LC, should review all items to insure what’s expected from the seller and understand all terms and conditions.