21 Jul Documentary letters of credit
A documentary letter of credit is an undertaking of the bank, which has opened a letter of credit on request of a buyer (applicant) to pay an amount to the seller (beneficiary) as specified in the letter of credit upon the provision of documents by the seller (beneficiary) that meet the conditions of the letter of credit and confirm the shipment of commodities (the provision of services) within the prescribed time frame.
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If you’re familiar with escrow services, the concept is similar: Banks act as “disinterested” third parties. The bank doesn’t take anybody’s side, and banks release funds only after certain conditions are met. Letters of credit are common in international trade, but they are also helpful for domestic transactions like construction projects.
- A manufacturer receives an order from a new customer overseas. The manufacturer has no way of knowing if this customer can (or will) pay for the goods after producing and shipping the products.
- To manage risk, the seller uses an agreement that requires the buyer to pay with a letter of credit as soon as shipment is made.
- To move forward, the buyer needs to apply for a letter of credit at a bank in their home country. The buyer may need to have funds on hand at that bank or get approval for financing from the bank.
- The bank will only release funds to the seller after the seller proves that the shipment happened. To do so, the seller typically provides documents showing how goods were shipped (with details like the exact dates, destination, and contents). In some ways, the buyer also enjoys protection under a letter of credit: Buyers might prefer to pay a bank with a big legal department rather than send the money directly to an unknown seller.
- If the buyer is concerned about a dishonest seller, there are additional options available for the buyer’s protection. For example, somebody can inspect the shipment before the payment is released.
Types of Letters of Credit
There can be numerous types of letters of credit. Each may or may not be funded. Some of the most common types of letters of credit include the following:
- Documentary letter of credit
- Standby letter of credit
- Secured letter of credit
- Revocable letter of credit
- Irrevocable letter of credit
- Revolving letter of credit
- Red clause letter of credit
- Green clause letter of credit
Letters of credit are used:
- if you are not certain about the solvency of your counterparty;
- if the counterparty is not certain about the proper performance of obligations by you (in terms of the quantity and quality of commodities or services);
- if you need a payment respite or trade credit;
- if you need a downpayment (advance payment) for the valuables to be supplied;
- if the counterparty insists on a settlement through letters of credit.
Advantages of Letters of Credit For The Seller:
- elimination of the credit risk, the receipt of an undertaking from a bank (banks) to pay for commodities supplied or services provided , if the seller lacks adequate information about the financial standing of the buyer or the credit relationship;
- elimination of the risk of receipt of a counterfeit undertaking or an undertaking issued by a non-existing bank;
- elimination of the risk of non-payment / late payment / partial payment for goods supplied / services provided;
- maximum reduction in the time interval between the shipment of the commodity (the provision of services) and the receipt of proceeds;
- elimination of the risk of order abandonment (change in conditions) by the buyer without the consent (permission) of the seller;
- possibility to get short-term funding;
- possibility to increase supply volumes, to promote commodities (services) in new markets, to gain competitive advantages.
Advantages of Letters of Credit For The Buyer:
- a letter of credit can be opened at the buyer’s own expense or using a bank loan by pledging other collateral to secure performance of its obligations (a lien on assets or a deposit, etc.);
- the buyer may withhold payment pending documentary confirmation that the goods meet the quality requirements and have been delivered in full to their specified destination (the payment is made after the goods are have been delivered and documents provided);
- the buyer specifies a list of documents against which payment will be made;
- the buyer limits the time frames for the provision of documents and goods delivery.
Importers and exporters regularly use letters of credit to protect themselves. Working with an overseas buyer can be risky because you don’t really know who you’re working with.
A buyer may be honest and have good intentions, but business troubles or political unrest can delay payment or put a buyer out of business.
Also, communication is difficult across thousands of miles, different time zones, and different languages. A letter of credit spells out the details so that everybody is on the same page. Instead of assuming that things will work a certain way, everybody agrees on the process up front.
Letter of Credit Lingo
To better understand letters of credit, it helps to know the terminology.
Applicant: The party who requests the letter of credit. This is the person or organization that will pay the beneficiary. The applicant is often (but not always) an importer or buyer who uses the letter of credit to make a purchase.
Beneficiary: The party who receives payment. This is usually a seller or exporter who has requested that the applicant use a letter of credit (because the beneficiary wants more security).
Issuing bank: The bank that creates or issues the letter of credit at the applicant’s request. It is typically a bank where the applicant already does business (in the applicant’s home country, where the applicant has an account or a line of credit).
Negotiating bank: The bank that works with the beneficiary. This bank is often located in the beneficiary’s home country, and it may be a bank where the beneficiary is already a customer. The beneficiary submits documents to the negotiating bank, and the negotiating bank acts as a liaison between the beneficiary and the other banks involved.
Confirming bank: A bank that “guarantees” payment to the beneficiary as long as the requirements in the letter of credit are satisfied. The issuing bank already guarantees payment, but the beneficiary may prefer a guarantee from a bank in their home country (with which they are more familiar). This may be the same bank as the negotiating bank.
Advising bank: The bank that receives the letter of credit from the issuing bank and notifies the beneficiary that the letter is available. This bank is also known as the notifying bank, and may be the same bank as the negotiating bank and the confirming bank.
Intermediary: A company that connects buyers and sellers, and which sometimes uses letters of credit to facilitate transactions. Intermediaries often use back-to-back letters of credit (or transferable letters of credit).
Freight forwarder: A company that assists with international shipping. Freight forwarders often provide the documents exporters need to provide in order to get paid.
Shipper: The company that transports goods from place to place.
Legal counsel: A firm that advises applicants and beneficiaries on how to use letters of credit. It’s essential to get help from an expert who is familiar with these transactions.