Letters of Credit, Bank Guarantees, and Financial Instruments
Importers and exporters normally require intermediaries such as banks or alternative financiers to guarantee payment and also the delivery of goods. Therefore trade finance structures are used to support these relationships.
Letters of Credit (or LC) are commonly used trade finance instruments to ensure that the payment of goods and services will be fulfilled between a buyer and a seller. The rules of a Letter of Credit are issued and defined by the International Chamber of Commerce through their Uniform Customs & Practice for Documentary Credits (UCP 600).
Relationships between buyers and sellers are based largely on trust. Regardless of whether you are a buyer, seller, or end user of a product or service, being certain about the intentions of the other parties, and having security that they will honour their part of the deal is critical when trading overseas. It is often easier to have a relationship with your supplier if you are trading domestically (within the same region), but what if your supplier is less well known, perhaps based overseas? Although around 80% of global trade occurs on open account terms (buy now, pay later), suppliers now often ask for full payment up front. For businesses, access to credit lines which not only provide some form of guarantee and peace of mind that your goods will be protected, but also the offer of flexible payment terms, can be achieved through a Letter of Credit.
Letters of Credit are issued and formatted under the guidelines of the Uniform Customs & Practice for Documentary Credits, or the UCP600, that is issued by the International Chamber of Commerce (ICC). Using one is fairly straightforward, both for businesses selling and those buying goods and services.
One of the parties, usually the importer, will contact a bank to serve as an intermediary and to guarantee to the seller that the goods will be paid for according to the agreement. All parties involved need to agree to the terms and sign the contract. This lowers the risk of doing business significantly, as Letters of Credit are legally binding documents that are acknowledged by 175 countries worldwide.
It is necessary to check the Documents Carefully.
Although the guidelines and the form of any Letter of Credit are largely the same, the content is not. It is crucial that both the buyer and the seller inspect the documents carefully and check for errors and mistakes that may end up in delays, further costs, or deferred payment. Even a minor oversight can be quite costly in this regard, and it is advisable to use several sets of eyes to check the documents.
Letter of Credit terms include:
Advising bank – accepts and then notifies the beneficiary of the LC.
Confirming bank – financial institution that agrees to honour and make payment of the LC to the beneficiary and receives payment from the advising bank.
Irrevocable – A non-amendable LC, unless agreed by all parties.
Issuing bank / issuer – the party that issues the LC
Presentation – delivery of the LC documentation and any other required documents that are required by the beneficiary should payment be made / the LC honoured.
Revocable – a type of LC that can be withdrawn, amended or cancelled by the issuing party at any time.
Standby – the most common LC type whereby agreement to pay is made under certain conditions.
Who should use a Letter of Credit?
Letters of Credit are useful to any business that trades in large volumes, both domestically, and cross-border. They are important to ensure the cash flow of a company and lowers the risk of default due to non-payment from the end customer.
Additionally, a LC can benefit companies that structure their business around e-Commerce or services.
When deciding whether or not to request a LC, some considerations might include:
- The costs associated versus the risk of non-payment, as well as which party will incur these costs.
- Legal requirements and expertise required.
- Documentation needed (for proof of delivery, sending the goods across e.g. customs declaration and insurance documents).
- The supplier / customer's creditworthiness.
International traders or wholesale producers of goods are the primary users of Letters of Credit. These types of companies need to be certain that they will not suffer losses from selling to overseas buyers that they are unfamiliar with.
In the unfortunate case that the recipient of the goods is unwilling or unable to pay the seller, the LC is activated, and under the terms of the agreement, the bank will be obliged to cover the missing payment. After the intermediary completes the payment, the bank will deal with the buyer according to the domestic law of the country where the buyer is located.
Online, e-commerce and service businesses often use Letters of Credit for overseas contracts. For companies producing software, or other online services that demand the employment of significant resource, it is important to consider external finance to free up working capital.
Small and Medium Enterprises
Small or Medium Enterprises (SMEs) account for 80% of businesses across the globe. Letters of Credit can help alleviate some of the cash flow constraints stemming from delayed and long payment terms from end customers. Large international companies are often culprits for late payments to SMEs, which can often put small companies at financial strain, or even out of business.
Types of Letters of Credit
There are different types of LCs depending on the kind of business or transaction that it is needed. In most cases, these secondary features are used to increase security and make the operation easier, faster, and more transparent.
While there is a definite time and place of each type of LC, business should be aware that certain additions and clauses stipulated might increase the bank’s fee, or add some features that can cause future problems for one of the parties involved.
An Irrevocable Letter of Credit allows the buyer to cancel or amend the LC, provided that other parties agree. This can be used to trade additional goods that were not a part of the original LC inside the same shipment or to allow the exporter of products extra time to fulfil their obligation.
A Confirmed Letter of Credit is used to further ensure the seller by adding more security. This addition stipulates that if the issuing bank from the buyer does not pay the requested amount of money, the seller’s bank guarantees payment.
This article can be added if there is reduced trust in the buyer, or if the money requested is crucial to stable financial liquidity of the seller.
Most Letters of Credit will include this clause in the agreement, especially in international trade between partners that have not done business in the past.
A Transferable Letter of Credit is commonly used when there are intermediaries involved in the transaction, or when there are more than two parties included in the Letter of Credit. In this case, the LC can be transferred to other entities, provided that the original beneficiary agrees.
This type is usually employed by the seller’s bank, especially when the seller is an SME, as a way to reduce the risk of the transaction to the bank, usually decreasing the price of the trade in the process.
Letter of Credit at Sight
This article of the Letter of Credit stipulates that all payments will be fulfilled as soon as there is documentation that the goods or services have been received by the buyer. This payment can be made by the buyer, or by the buyer’s issuing bank, giving the buyer some additional time to fulfil the debt.
Contrary to this type of LC, there is the Standby Letter of Credit that does not have this clause, and that needs to be activated in the case that the buyer cannot fulfil the payment.
Deferred or Usance Letter of Credit
This type of LC is used to allow deferred payment from the buyer for a specified time period. This slightly reduces the risk of unintentional non-payment and lowers the cost of an LC. Additionally, a Deferred Letter of Credit is more enticing for the buyer, making it more likely for them to accept buying goods or services.
A Red Clause Letter of Credit obligates the buyer’s issuing bank to provide partial payment to the seller prior to shipping products or providing the service. It is usually used to secure a certain supplier and to expedite the shipping process, but it often makes the LC significantly more expensive.