A letter of credit is a financial tool used widely in international trade to facilitate payments between importers and exporters. This article will explore what letters of credit are at their core, why they matter so much in global commerce, the typical process involved, the various types used, their key benefits and disadvantages, some illustrative examples, typical costs, and how businesses should approach getting set up with letters of credit. Whether you are an entrepreneur looking to export goods overseas or an established multinational firm importing raw materials from abroad, understanding letters of credit is indispensable in navigating the world of international trade today.
What is a Letter of Credit (LC)
A letter of credit is a document that helps companies do business with and trust each other, especially when buying and selling goods internationally. It is a promise by a bank that it will pay the seller of goods when certain conditions are met. Using a letter of credit can give both buyers and sellers confidence that they will get paid.
How Letters of Credit Work
A letter of credit involves three parties – the applicant, the beneficiary, and the issuing bank. Here is the typical process:
- A buyer (the applicant) asks their bank to issue a letter of credit. The buyer specifies the amount they want the bank to promise to pay, along with other terms.
- If the bank approves, it issues a letter of credit to the seller (the beneficiary). This letter promises that the bank will pay the seller a certain amount when certain conditions are met, like when the goods are shipped.
- The seller reviews the letter of credit to make sure all the details are correct. If they approve it, they ship the goods to the buyer.
- The seller presents documents like invoices and delivery receipts to the bank to prove they have met the letter of credit’s conditions.
- After reviewing the documents, the bank pays the seller the amount promised in the letter of credit.
- The issuing bank collects this money back from the buyer, who initially requested the letter of credit.
This process allows international trading to proceed smoothly because the bank’s promise reduces the seller’s risk of not getting paid. The buyer can also feel confident knowing that they will only have to pay the bank after receiving the goods from the seller.
Negotiable Instruments Act, 1881 History, Types, Features
When Letters of Credit Are Used
Letters of credit are commonly used in international trade transactions when the buyer and seller do not know each other well. They provide assurance of payment to sellers, especially when goods have to be shipped before payment is made.
Specifically, letters of credit are often used when:
- The buyer and seller are in different countries: Cross-border business partners often prefer letters of credit because they make the transactions less risky.
- The deal involves custom-made products: Sellers are more willing to manufacture goods specially for buyers if letters of credit ensure they will get paid.
- The buyer makes very large orders: When there are huge sums of money involved, sellers protect themselves with letters of credit.
- The goods take a long time to produce: Sellers can use letters of credit when manufacturing and shipping goods will take weeks or months before payment would normally happen.
Overall, letters of credit provide a way for international companies to do business with more trust and less financial uncertainty on both sides.
The Details in a Letter of Credit
When a bank issues a letter of credit, it contains very specific terms that must be followed carefully by both the seller and the buyer. It includes details like:
- Amount of money promised: The letter states the amount the bank agrees to pay the beneficiary if the terms are met. This amount covers the value of the goods themselves plus extras like freight costs.
- Expiration date: The promise made in the letter of credit will end after a specific date, requiring the transaction to proceed on schedule.
- Documents required: To receive payment from the bank, the letter lists documents the seller must present like commercial invoices or packing lists to prove they shipped the goods properly.
- Timeframes: The letter sets deadlines for submitting documents or shipment and delivery of the goods. Meeting these timeframes is required.
- Goods description: The products being sold are described in detail, including quantity, type, quality standards, packing method, etc.
Closely following the requirements described in the letter of credit ensures the process goes smoothly for both the seller and buyer while keeping the issuing bank comfortable guaranteeing the payment.
Benefits of Using Letters of Credit
Using letters of credit for international transactions provides several key benefits, like:
For Sellers
- Guaranteed payment from reputable banks, reducing risk
- Ability to extend credit without thorough credit investigations of every buyer
- Confidence to start production planning and invest in customized orders
For Buyers
- Assurance that sellers will fulfill orders before getting paid
- Lower cost compared to some other forms of payment guarantees
- Ability to negotiate better deals by providing payment guarantees
Using letters of credit also benefits importers and exporters by allowing trade to happen securely on credit terms rather than requiring risky advance payments. Overall, international trade depends enormously on the guarantees provided by letters of credit to proceed smoothly.
With some insight into what letters of credit are and how they enable trust between distant business partners, it’s easier to appreciate the vital role they play in global commerce today.
Types of Letters of Credit
There are several different types of letters of credit that serve various purposes in international trade. Here are four of the main types:
- Commercial Letters of Credit
A standard commercial letter of credit is the most common kind. It promises payment when a seller meets its conditions related to a shipment of goods. It provides assurances for both the buyer and seller in a transaction.
- Standby Letters of Credit
A standby letter of credit promises payment not in relation to goods, but if the applicant fails to fulfill a contractual obligation. For example, it could cover a construction company failing to finish work on a project. It provides a backstop guarantee.
- Revolving Letters of Credit
A revolving letter allows for partial shipments of goods over the terms of a longer contract. As shipments occur, the letter value replenishes back to its original amount to fund future shipments. It avoids needing new letters for each part of an ongoing purchase agreement.
- Back-to-Back Letters
A back-to-back letter acts as a go-between for intermediaries in a trade transaction. For example, the ultimate buyer’s bank issues one to an intermediary trader, who then has their bank issue another one to the producer. It simplifies logistics.
In addition, some other varieties include transferable letters of credit, red clause letters, and green clause letters. There are also many mixes and variations used for specialized trade finance situations. But these four examples represent the most common types of letters of credit in international commerce.
International Organization for Standardization (ISO)
Example Letters of Credit Transactions
To better understand letters of credits, let’s walk through two examples:
Example 1
Farm Co, a producer of agricultural products based in Thailand, gets an order from Grocer Co, a food importer based in the United States. The sales contract is for $1 million worth of palm oil to be delivered within 60 days.
To finalize this international trade agreement, Grocer Co has its bank issue a letter of credit for $1 million in favor of Farm Co. The letter of credit states that Farm Co must ship the palm oil to arrive at the port in Los Angeles no later than 60 days from today. Upon presenting accurate shipment documentation proving the palm oil has shipped on time, Farm Co’s bank will be authorized to collect $1 million from Grocer Co’s bank.
In this case, both parties reduce their risk significantly by utilizing a letter of credit. Grocer Co ensures that they will only have to pay if Farm Co delivers the goods on time. And Farm Co can feel confident shipping the product knowing they’re guaranteed payment via the letter of credit as long as they meet the 60-day shipment deadline.
Example 2
Tech Device Co, a consumer electronics manufacturer in China, gets a large order from Retail Store Inc in Germany for the latest tablets. The 10-year sales agreement is for €100 million in tablets to be delivered in monthly installments.
Rather than Retail Store Inc sending payment every month upon receiving each tablet shipment, their bank issues a rolling letter of credit that automatically renews each month for the amount of that month’s scheduled shipment. As long as Tech Device Co presents documentation proving that month’s shipment has been sent, their bank is automatically authorized to collect payment from Retail Store Inc’s bank. This arrangement will continue monthly for 10 years to fulfill the entire sales agreement.
This structure benefits both parties by formalizing the documentation, shipping terms, and installment payments, while also minimizing the back-and-forth communications between the buyer and seller.
Advantages and Disadvantages of a Letter of Credit
Using letters of credit for international trade offers some notable advantages, but also has some disadvantages to consider:
Advantages
- Reduced payment risk: The biggest benefit is the guarantee of payment to sellers once they meet the letter of credit conditions. This supports sales that might not happen without that assurance.
- Buyers don’t pay until goods shipped: Buyers can ensure they receive goods before being obligated to pay via the letter of credit terms, unlike advance payments.
- Allows credit transactions: By substituting bank guarantees for full advance payment, letters of credit enable orders, production planning, and sales done on credit terms between businesses.
Disadvantages
- Added complexity: Meeting all requirements of letters of credit adds an administrative burden versus basic purchase orders and invoices. There are more document checks and potential discrepancies.
- Bank fees: Issuing banks charge fees linked to the letter of credit, typically 1-3% of the amount. These raise transaction costs.
- Tied up collateral: Importers asking their banks to issue letters of credit often must keep the full amount on deposit until the transaction completes. This locks up capital.
- Risk of fraud: While rare, there are instances of fraudulent letters of credit being circulated to extract payments illegally from banks. Checks help mitigate this.
Overall there is no question that for major international sales of goods, especially between less familiar business partners, letters of credit remain a key facilitator of trade. But they do add some layers of complexity and cost.
How to Apply for a Letter of Credit
Applying for a letter of credit involves a few key steps for the buyer or applicant. Here is an overview of the typical application process:
- Contact Your Bank
Reach out to your commercial bank or trade finance specialist at your bank to discuss your need for a letter of credit. Be prepared to explain details like the seller, purchase agreement terms, shipment plans, and currency/amounts needed.
- Fill Application Forms
Your bank will have you formally apply by completing standard letter of credit application forms. This captures all the letter’s key details including beneficiary, dates, authorized amounts, expiration term, required documents from the seller, and descriptions of the goods or transaction.
- Get Credit Approval
The bank will conduct due diligence by reviewing your company’s financial statements and creditworthiness to approve issuing the letter of credit on your behalf. This protects their interests. They determine amounts and collateral requirements.
- Accept Terms
If approved, you’ll receive final letter of credit terms spelling out specifics like fees, collateral holdings, and legal obligations you take on as the applicant if the letter is drawn upon by the beneficiary. You sign agreements accepting these.
- Bank Issues Letter
Finally, after your signed application is approved internally, the bank will formally issue the physical letter of credit and send it directly via courier or banking channels to the recipient (usually the exporter or seller).
That completes the process. As the applicant, you will also be involved should the beneficiary draw funds against the letter of credit by having to review and sign off on payments made from your accounts under its terms. Using an experienced trade finance banker simplifies getting letters of credit in place.
How Much a Letter of Credit Costs
The cost of a Letter of Credit (LC) varies depending on the transaction size, bank involved, and risk factors, but typically falls within 0.75% to 1.5% of the total value. The buyer often bears this cost but, depending on the agreement, they can share it with the seller or negotiate alternative fee structures. Remember, while initial fees may seem steep, they’re often outweighed by the risk mitigation and trade facilitation benefits LCs offer.
Conclusion
Letters of credit remain an indispensable tool for facilitating international trade between businesses that may not know or trust each other. By having banks guarantee payments to sellers once shipment terms are met, letters of credit create the trust needed to enable cross-border transactions. From agricultural goods to consumer electronics, billions of dollars in products are shipped globally each year relying on the security of letters of credit. While they do add complexity and costs, these drawbacks pale in comparison to the alternative of making risky advance payments. For the foreseeable future, letters of credit will continue serving a critical role supporting commerce worldwide.
FAQs
Q: What is the main purpose of a letter of credit?
Ans: The main purpose is to guarantee payment to exporters/sellers and thus support international trade transactions between parties that may not know each other well. This substituted bank guarantee gives sellers confidence in getting paid.
Q: Who are the parties involved in letters of credit?
Ans: Typically there is the applicant (buyer of goods), the issuing bank, the beneficiary (the seller/exporter being paid), and the advising bank that coordinates transmitting the letter.
Q: What are typical costs for letters of credit?
Ans: Costs usually range from 0.75%-1.5% of the total value of the letter of credit. There can be additional transaction fees charged by various banks assisting with coordinating the letters of credit.
Q: Can letters of credit be risky or cause issues?
Ans: While very rare, there are occasional fraud issues with fake or invalid letters of credit being used to try to extract illegal payments. Banks vet letters carefully to avoid this. There can also be discrepancies between parties regarding meeting terms that need resolution. Proper documentation by all parties minimizes problems.
Q: Do online sellers/buyers use letters of credit?
Ans: Generally not – letters of credit are used for substantial corporate transactions selling and buying goods internationally in the thousands to millions of dollars range. SMEs and online retailers/consumers typically do not utilize letters of credit for purchases.
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