In simple terms, is a conditioned payment instrument, a letter of credit is an undertaking by a bank to make a payment to a named beneficiary within a specified time, against the presentation of documents which comply strictly with the terms of the letter of credit.
Its main advantage is providing security to both the exporter and the importer, but the security offered, however, comes at a price and must be weighed against the additional costs resulting from bank charges. The exporter must understand the conditional nature of the letter of credit and the that payment will not be made unless the terms of the credit are met precisely.
A letter of credit is opened by an importer (applicant), to ensure that the documentation requested reflects and proves that the seller has performed under the requirements of the underlying sales contract, by the exporter by making them conditions of the letter of credit (N.B.)
The sales contract is not an inherent part of the Letter of Credit, although the Letter of Credit may contain a reference to such contract). For the exporter a letter of credit, apart from cash in advance, is the most secure method of payment in international trade as long as the terms of the credit are met. The following diagram shows those involved in a Letter of Credit transaction:
How it works
Imagine that a business called Acme Electronics from time to time imports computers from a business called Beijing Computers, which banks with the Shanghai Business Bank. Acme holds an account at Commonwealth Financial. Acme wants to buy $500,000 worth of merchandise from Beijing Computers, who agree to sell the goods and give Acme 60 days to pay for them, on the condition that they are provided with a 90-day LC for the full amount. The steps to get the letter of credit would be as follows:
Acme goes to Commonwealth Financial and requests a $500,000 letter of credit, with Beijing Computers as the beneficiary.
Commonwealth Financial can issue an LC either on approval of a standard loan underwriting process or by Acme funding it directly with a deposit of $500,000 plus fees between 1% and 8%.
Commonwealth Financial sends a copy of the LC to Shanghai Business Bank, which notifies Beijing Computers that payment is ready and they can ship the merchandise Acme ordered with full assurance of payment.
On presentation of the stipulated documents in the letter of credit and compliance with the terms and conditions of the letter of credit, Commonwealth Financial transfers the $500,000 to Shanghai Business Bank, which then credits the account of Beijing Computers by that amount.
Note that banks deal only with documents under the letter of credit and not the underlying transaction.
If the stipulated documents are presented and the terms and conditions of the letter of credit are met, then the issuing bank is obligated to pay under the letter of credit, even if the underlying transaction is not fulfilled.
Types of Letter of Credit
A revocable letter of credit can be amended or cancelled at any time by the importer without the exporter’s agreement (unless documents have been taken up by the nominated bank). Little protection is offered to the exporter with a revocable credit and they are rarely seen.
An irrevocable letter of credit can neither be amended nor cancelled without the agreement of all parties to the credit. Under UCP500 all letters of credit are deemed to be irrevocable unless
otherwise stated. Here, the importer’s bank gives a binding undertaking to the supplier provided all the terms and conditions of the credit are fulfilled.
An unconfirmed letter of credit is forwarded by the advising bank directly to the exporter without adding its own undertaking to make payment or accept responsibility for payment at a future date, but confirming its authenticity.
A confirmed letter of credit is one in which the advising bank, on the instructions of the issuing bank, has added a confirmation that payment will be made as long as compliant documents are presented. This commitment holds even if the issuing bank or the buyer fails to make payment.
The added security to the exporter of confirmation needs to be considered in the context of the standing of the issuing bank and the current political and economic state of the importer’s country. A bank will make an additional charge for confirming a letter of credit.
Confirmation costs will vary according to the country involved, but for many countries considered a high risk will be between 2%-8%. There also may be countries issuing letters of credit which banks do not wish to confirm - they may already have enough exposure in that market or not wish to expose themselves to that particular risk at all.
Standby Letters of Credit
A standby letter of credit is used as support where an alternative, less secure, method of payment has been agreed. They are also used in the United States of America in place of bank guarantees. Should the exporter fail to receive payment from the importer he may claim under the standby letter of credit. Certain documents are likely to be required to obtain payment including: the standby letter of credit itself; a sight draft for the amount due; a copy of the unpaid invoice; proof of dispatch and a signed declaration from the beneficiary stating that payment has not been received by the due date and therefore reimbursement is claimed by letter of credit. The International Chamber of Commerce publishes rules for operating standby letters of credit - ISP98 International Standby Practices.
Revolving Letter of Credit
The revolving credit is used for regular shipments of the same commodity to the same importer. It can revolve in relation to time or value. If the credit
is time revolving once utilized it is re-instated for further regular shipments until the credit is fully drawn. If the credit revolves in relation to value once utilized and paid the value can be reinstated for further drawings. The credit must state that it is a revolving letter of credit and it may revolve either automatically or subject to certain provisions.
Revolving letters of credit are useful to avoid the need for repetitious arrangements for opening or amending letters of credit.
Transferable Letter of Credit
A transferable letter of credit is one in which the exporter has the right to request the paying, or negotiating bank to make either part, or all, of the credit value available to one or more third parties. This type of credit is useful for those acting as middlemen especially where there is a need to finance purchases from third party suppliers.
Back-to-Back Letter of Credit
A back-to-back letter of credit can be used as an alternative to the transferable letter of credit.
Rather than transferring the original letter of credit to the supplier, once the letter of credit is received by the exporter from the opening bank, that letter of credit is used as security to establish a second letter of credit drawn on the exporter in favor of his importer. Many banks are reluctant to issue back-to-back letters of credit due to the level of risk to which they are exposed, whereas a transferable credit will not expose them to higher risk than under the original credit.
Uniform Customs and Practice for Documentary Credits (UCP)
Most letters of credit are subject to UCP 500, which are the universally recognized set of rules governing the use of the documentary credits in international trade. UCP were originally formulated in 1933 by the International Chamber of Commerce (ICC) and last updated in 1993 (ICC publication 500). All definitions and general documentary requirements referred to in this briefing are in accordance with UCP500 unless otherwise stated (it should be remembered that in some instances this may differ from national law). SITPRO would only recommend using letters of credit which are subject to UCP500.
It is important to negotiate, at contractual stage if possible, which party will bear bank charges. It is worth remembering that on a small transaction these may be totally out of proportion and if these costs are not included in the pricing any profit may be completely eroded.