An introduction to the use of Letters of Credit

(A number of companies provide training on the use of Letters of Credit, they can be found  through an internet search)

Many companies, but trading companies in particular, which wish to benefit from Brexit driven importing and exporting opportunities are likely to require Letters of Credit to finance certain transactions.

Many transactions could include the shipping of goods or commodities from one country to another. In these circumstances the seller is likely to demand payment prior to the shipment of the cargo, while the buyer will not want to pay for the cargo until it arrives or preferably some time after it has arrived.

The parties can reduce various financial risks by using Letters of Credit. In principal, if the correct Letter of Credit is used, it can guarantee that the seller will receive payment for the cargo, while the buyer know that he will not be required to pay for the goods until have arrived.

Over the years, Letters of Credit have been developed which are designed to eliminate the risks, although there will always be minimal risks. But as outlined below those risks can be eliminated through insurance or banking procedures. 

There are several different types of letters of credit which are available. It is important to use a Letter of Credit which meets your requirements.

This article explains what letters of credit are and how they work. Some Letters of Credit are not suitable for some transactions. You must decide in advance which type of Letter of Credit will  meet your requirements. There are commonly agreed international rules that govern most letters of credit. Wise users make it their business to understand those rules.

What is a Letter of Credit?

A letter of credit is a guarantee from a bank that the named seller will receive a specified payment which will be due from a named buyer. In effect the bank, which issues the Letter of Credit, guarantees that the named seller will receive an agreed amount of money at a specified time. In return for the above guaranteed payment, the bank will require that Letter of Credit terms are in fully implemented. As an example, the bank must receive all the documents, which are detailed in the Letter of Credit, before it will pay the seller.

Why do businessmen and companies use Letters of Credit?

Because sellers must be certain that they will be paid at a specified time for their goods and the buyer must be certain that they will receive the goods before they pay for them. Letters of credit are most commonly used when a buyer in one country purchases goods from a seller in another country. The letter of Credit will eliminate the risks and provide the security of both parties require.

What advantages does the seller gain by using a Letter of Credit?

By obtaining for the suitable Letter of Credit for the transaction, a seller is guaranteed by the bank that they will receive their money in full when it is due provide that they have met all the requirements specified in the Letter of Credit. 

What advantages do buyers get for using a Letter of Credit?

When a buyer uses a Letter of Credit he will be guaranteed by the bank that, subject to documentary proof being provided and the Letter of Credit’s terms being met, that seller will honour his delivery commitments.

Are there any other significant issues? 

Additional costs will be incurred if a Letter of Credit is used, because banks will carry the default risks and they will charge for their services and any loan interest. However, in international transactions most potential buyers and sellers prefer to use Letters of Credit so there is no disadvantages in using them except for the known cost of the Letter of Credit. 

If you’re an exporter you should be aware that you’ll only receive payment if you keep to the strict terms of the Letter of Credit. You’ll need to give documentary proof that you have supplied exactly what you contracted to supply. (Using a Letter of Credit can sometimes cause delays and other administrative problems).

When is it appropriate not to use a Letter of Credit?

If you are a buyer, a Letter of Credit is only essential if the seller demands it,  further it is often not used for small and or one off transactions . However, if you want to do the business a Letter of Credit is essential if the seller insists that it should be used. Also, some national exchange controls require the participants to use Letters of Credit.

Why should an exporter decide not to request a Letter of Credit?

If your country does not require you to use a Letter of Credit, the choice is yours:-

• If you demand that a Letter of Credit should be used, you could have a price disadvantage if your competitor proposed to supply similar goods without the use of a Letter of Credit.
• You may wish to do business and save money without a Letter of Credit, if you have a good trading record with the buyer.
• You may wish to do business without a Letter of Credit if you are exporting small quantities to a country which is stable and has a good reputation as an international partner.
• If it is normal practice for exporters not to use Letters of Credit when trading with that country or that commodity.
• You may wish to ignore Letters of Credit if credit insurance, export factoring or “cash in advance” terms are available.

There are different types of letter of credit below are the 5 most common types

They are all different and some are safer than others. 

• Irrevocable Letters of Credit
• Revocable Letters of Credit
• Unconfirmed Letters of Credit
• Confirmed Letters of Credit
• Transferable Letters of Credit

Other types of Letters of Credit include:

• Standby Letters of Credit
• Revolving Letters of Credit
• Back-to-Back Letters of Credit

Sometimes a letter of credit may combine two or more types, such as “Confirmed” and “Revocable Letters of Credit”. A “Confirmed and Irrevocable Letter of Credit” is the safest type.

What is the difference between irrevocable and revocable Letters of Credit?

A revocable letter of credit can be modified or cancelled by the bank that issued it at any time and for any reason.

An irrevocable letter of credit cannot be modified or cancelled unless all the parties involved agrees. 

What is the difference between confirmed and unconfirmed Letters of Credit?

When a buyer takes out a Letter of Credit they usually do so with their own bank, known as the issuing bank. The seller will usually want a bank in a major international country to check that the Letter of Credit is valid and require the Letter of Credit to be ‘confirmed’ by the bank that checks it. By confirming the Letter of Credit, the second bank agrees to guarantee payment even if the issuing bank fails to make it. Therefore, a confirmed Letter of Credit provides more security than an unconfirmed Letter of Credit. A confirmed Letter of Credit is more expensive but many consider it to be worthwhile.

What are Transferable Letters of Credit?

A transferable Letter of Credit is one that can be passed from one ‘beneficiary’ to another or others. They are commonly used when intermediaries are involved in a transaction in order that they may receive any agreed commissions.

What are Standby Letters of Credit?

A standby Letter of Credit is an assurance from a bank that a buyer is able to pay a seller. If the buyer fails to pay the seller, the seller will claim the sum due from the bank which issued the stand by Letter of Credit.

What are Revolving Letters of Credit?

A Revolving Letter of Credit is one Letter of Credit which can cover two or more transactions between the same buyer and seller.

What does “Uniform customs and practice for documentary credit” refer to?

“Uniform customs and practice for documentary credit” are a set of international rules for Letters of Credit which have been developed by the International Chamber of Commerce (ICC).

Most commercial Letters of Credit are regulated by these rules, which are referred to as “Uniform Customs and Practice for Documentary Credits” (UCP). The current version of the rules is UCP 600, came into effect on 1 July 2007.

The UCP standards give definitions of important terms that are used in Letters of Credit. When referring to letters of credit, banks and others involved in international trade will generally use the UCP definitions in key terms and phrases.

UCP also sets out general documentary requirements and standard practices for handling Letters of Credit.

The ICC publishes a number of guides on UCP 600. These are available  in publications about UCP 600 on the ICC Bookshop website.

The Benefits of using UCP 600 Letters of Credit

Because UCP 600 standards are internationally recognised it is advisable to use Letters of Credit which follow those rules, because many importers insist that sellers should them.

If a Letter of Credit is subject to UCP rules, the Letter of Credit confirm it within the document. The confirmation is likely to state the following or similar wording  “This Letter of Credit is subject to the latest version of “Uniform Customs and Practice for Documentary Credits published and updated by the International Chamber of Commerce”.

But caution is required because in some cases the procedures and or definitions which are used in the UCP standards may differ from the laws in some countries.

We recommend companies to provide detailed instructions to their employees as to how they should instruct the bank to issue any required Letters of Credit and to check the content of the Letters of Credit before they are activated. Should there be any uncertainties we would suggest that you should refer the uncertainties to your lawyers for clarification before the Letter of Credit/s is or are issued.

We also recommend that you should review your instructions on a regular basis in case there have been any modifications to the procedures. 

Good luck, and we wish you all the best when you enter into your international transactions.

 

Photo by Rinson Chory on Unsplash

Tags: brexit, export, letter of credit, shipping, trading