Letters of credit (LCs) or sometimes known as documentary LCs are financial instruments. It is an instrument from a bank which guarantees a buyer’s payment to a seller if certain criteria are met. There are fundamental components of Letters of Credit for International Trade and as such Letters of Credit law are governed universally by a set of guidelines called the UCP 600 which was first produced in the 1930s by the International Chamber of Commerce (ICC).
More often than not they are issued by banks or specialist trade finance service providers offering LCs. Payment is made to the trade/commerce firm on behalf of the buyer if the terms specified in the LC are fulfilled.
Fundamentally, a letter of credit requires an importer and an exporter and their corresponding issuing bank as well as the receiving/confirming/advising bank. It is relevant where there is an exporter and an importer and there needs to be prepayment or a confirmation of payment in order for goods to be shipped. For this type of trade finance, the financiers and their creditworthiness are crucial. Letters of Credit are incredibly specific and close attention to detail is required. For example, if there is a misspelling in the contract such as the name of the goods or company name is spelt incorrectly, this could cause a non-payment and will remain so until a new, corrected LC is issued and accepted.
We can delve deeper and outline the Letters of Credit advantages and disadvantages however for now we will focus on Letters of Credit advantages
What Is A Commercial Letter Of Credit?
A commercial letter of credit (or sometimes referred to as import/export letters of credit) is one of the oldest and most standard forms of payment for transactions in international trade. Global importers and exporters can often feel uncomfortable producing and shipping goods without any assurance of payment especially if this the first time the parties have dealt with each other. Both importers and exporters can come to an agreement that helps protect both interests whether it is to receive money or goods in exchange. Commercial letters of credit are an agreement in which the importers bank guarantees to pay the exporters bank at the time goods/services are delivered.
Commercial letters of credit act as the primary payment mechanism for a transaction, whereby a standby letter of credit (SBLC) act as the secondary payment mechanism, i.e. a fail-safe guarantee. Some of the benefits of using Letters of Credit but not limited to are safety, risk reduction, efficiency, transparency and above all allows for safe trading.
There are different types of Letters of Credit which we won’t go into detail however here is a brief list of the types of LCs often used; Irrevocable Letter of Credit, Confirmed Letter of Credit, Transferable Letter of Credit, Letter of Credit at Sight, Deferred Letter of Credit, Red Clause Letter of Credit.
How Do LC’s Differ From SBLC’s?
A Standby Letter of Credit is different from a Letter of Credit. Commercial letters of credit differs from Standby letters of credit (SBLC) as they are primarily used in straightforward transactions. Eg; LC’s are used in primary instrument of payment whereas SBLC’s are used as a secondary back up method of payment.
The major difference between a Commercial LC and a Standby Letter of Credit is that a Commercial Letter of Credit (for Import or Export) is a payment method for a trade transaction whereas an SBLC supports the payment of a debt, which debt may or may not be trade related. Using an SBLC for trading such as in Import/Export transactions can be useful in so much that the SBLC is paid when called on after conditions have not been fulfilled. However, a Letter of Credit is the guarantee of payment when certain specifications are met and documents received from the selling party.
Trade finance instruments such as a commercial letter of credit is the bridge in building trust in a transaction due to the nature of international dealings, distance, lack of familiarity with another party and legal differences.
Trade Finance; Letter Of Credit For Importers
Importers may need to delay payments of manufactured products until their batch of goods have been distributed and sold. This is common in supply chains when a business is dependent on a number of processes happening to keep cash flow/liquidity on their accounts. Importers may choose to use a commercial letter of credit to show their credit worthiness to the exporter. Also, they can ensure payment for the provision of goods against invoices or other documentation within a specified time frame. Without a commercial letter of credit, exporters generally ask for substantial deposits or other payment guarantees.
Importers can also choose to use documentary letters of credit (DLC) whilst trading internationally. This means they are protected by financial loss if goods are not produced according to the documented specifications.
Trade Finance Instruments For Exporters
Commercial letters of credit represent a reasonable compromise that protects the exporters of missed payment for the shipment of goods. An LC can be used to demonstrate that goods won’t be released until they are paid for. They can provide importers with a guarantee that they will get the goods if the exporter is paid. Exporters can agree to terms according to the documentary requirements that in turn protect importers’ interests.
Unsecured Letters Of Credit
Most letters of credit for trade are secured against collateral. Prestige has teamed up with an organisation who can offer unsecured letters of credit. This means businesses do not have to tie up valuable collateral to open a letter of credit. Below is a general overview of the Letters of Credit Process and how it should work:
Importer wishes to purchase goods off the exporter and upon agreement, a purchase order (PO) or invoice is issued.
The importer then approaches an issuing bank and/or trade financier who will issue an LC whilst the exporter assigns a confirming/receiving bank who will request the LC documents to be shipped from the issuing bank of the importer.
Once received, the confirming/receiving bank will check the LC and if the terms are correct, the exporter will be given the green light to ship the goods.
The exporter then sends the relevant shipping documents to the confirming/receiving bank, who in turn will process the payment
Once the confirming/receiving bank has examined the shipping documents in strict compliance against the LC terms from the issuing bank, they will forward these documents onto the issuing bank.
The importer then pays the issuing bank who in turn release the shipping documents so that the importer can claim the goods that were shipped.
The issuing bank then transfers money to the confirming bank who will then transfer this money to the exporter. Transaction is complete.
What Is A Standby Letter Of Credit?
A Standby Letter of Credit (‘SBLC’) is a guarantee that is made by a bank on behalf of a client, which ensures payment will be made should the client default on their payment obligations. It is a payment of last resort from the bank which is not meant to be called upon. Simply put, it is a guarantee of payment which will be issued by a bank on the behalf of a client. If used for commercial trading purpose the SBLC is used as a “payment of last resort” due to the circumstances under which it is called upon. The SBLC prevents contracts going unfulfilled if a business declares bankruptcy or cannot otherwise meet financial obligations.
Please note also that there are SBLC’s for lease and SBLC’s for sale. With that comes a massive difference in price. One needs to seriously consider what is the purpose of the instrument they require and whether or not they need to purchase an SBLC or would a leased one do the job sufficiently?
Furthermore, the presence of an SBLC is usually seen as a sign of good faith as it provides proof of the buyer’s credit quality and the ability to make payment.
MG Capital Fund has teamed up with one of the world’s largest issuers of Letters of Credit. The process is very simple and quick. If you are in need of an SBLC for performance, please fill out the enquiry form to learn more.