Letter of credit (LC) or documentary credit (DC), is a contractual agreement whereby the issuing bank (importer’s bank), acting on behalf of its customer (the importer or buyer), promises to make payment to the beneficiary or exporter against the receipt of “complying” stipulated documents.
Payment under Letter of Credit
Payment under a documentary letter of credit is based on documents, not on the terms of sale or the physical condition of the goods. The letter of credit specifies the documents that are required to be presented by the exporter, such as an ocean bill of lading (original and several copies), commercial invoice, draft, and an insurance policy. The letter of credit also contains an expiration date. Before payment, the bank responsible for making payment, verifies that all document conform to the letter of credit requirements. If not, the discrepancy must be resolved before payment can be made and before the expiration date.
To expedite the receipt of funds, wire transfers may be used. Exporters should consult with their international bankers about bank charges for such services.
Importance of Letter of Credit
Letter of credits (LCs) are one of the most versatile and secure instruments available in international trade payments. It protects the interests of both, the importer (buyer) as well as the exporter (seller). An LC is useful when reliable credit information about a foreign buyer is difficult to obtain or if the foreign buyer’s credit is unacceptable, but the exporter is satisfied with the creditworthiness of the importer’s bank. This method also protects the importer since the documents required to make payment provide evidence that goods have been shipped as agreed.
However, because LCs have opportunities for discrepancies, which may negate payment to the exporter, documents should be prepared by trained professionals or outsourced. Discrepant documents, may negate the bank’s payment obligation.
Characteristics of a Letter of Credit
- It is useful for higher-risk situations or new or less-established trade relationships between the exporter and the importer
- Risk is spread between exporter and importer
- Payment is made after shipment of goods
- A variety of payment, financing and risk mitigation options available
- Labor intensive process
- Relatively expensive method in terms of transaction costs
- The LC is a separate contract from the sales contract on which it is based; therefore, the banks are not concerned with the quality of the underlying goods.
- In LC transactions, banks deal in documents only, not goods.
- LC is irrevocable document, which means the document may not be changed or cancelled unless the importer, banks, and exporter agree.
Letter of Credit Transaction Process
- The exporter and importer agree on the terms of a sale
- The importer arranges for the issuing bank to open an LC in favor of the exporter.
- The issuing bank issues or transmits the LC to the nominated bank, which forwards it to the exporter.
- The exporter reviews carefully all conditions in the letter of credit.
- If the exporter cannot comply with one or more of the conditions, the importer is contacted to request issuing bank to make amendment in LC.
- If the exporter is agreed to LC terms, the exporter arranges with the freight forwarder to deliver the goods to the appropriate port or airport.
- When the goods are loaded, the freight forwarder completes the necessary documentation.
- The exporter (or the freight forwarder) presents the documents, as per letter of credit terms, to the nominated bank.
- The nominated bank checks documents for compliance with the LC and collects payment from the issuing bank for the exporter.
- The importer’s account at the issuing bank is debited.
- The issuing bank releases documents to the importer after receiving payment or acceptance of draft (bill of exchange)
- The importer claims the goods from the carrier and get clearance from customs.
Amendment in LC
A change made to a letter of credit after it has been issued is called an amendment. Banks also charge fees for this service. It should be specified in the amendment if the exporter or the buyer will pay these charges.
Parties involved in a Letter of Credit
The major parties involved in a letter of credit are discussed below. We can classify mainly eight main parties involved in a Letter of Credit.
Applicant of Letter of Credit
Applicant is one of the main parties involved in a Letter of Credit. Who is an applicant under Letter of credit?
Applicant is the party who opens Letter of Credit. Normally, buyer of goods is the Applicant who opens letter of credit. Letter of credit is opened as per his instruction and necessary payment is arranged to open Letter of credit with his bank. The applicant arranges to open letter of credit with his bank as per the terms and conditions of Purchase order and business contract between buyer and seller. So Applicant is one of the major parties involved in a Letter of credit.
LC Issuing Bank
Issuing Bank is one of the other main parties involved in an LC. Who is an Issuing Bank under Letter of credit?
Issuing Bank is the bank who opens letter of credit. Letter of credit is created by issuing bank who takes responsibility to pay amount on receipt of documents from supplier of goods (beneficiary under LC).
Beneficiary is one of the main parties under letter of credit. Beneficiary of Letter of credit gets the benefit under Letter of credit. Beneficiary is the party under letter of credit who receives amount under letter of credit. The LC is opened on Beneficiary party’s favor. Beneficiary party under letter of credit submits all required documents with is bank in accordance with the terms and conditions under LC.
Advising bank is another party involved under LC. Advising bank, as a part of letter of credit takes responsibility to communicate with necessary parties under letter of credit and other required authorities. The advising bank is the party who sends documents under Letter of Credit to opening bank.
Confirming bank is one of the other parties involved in Letter of Credit. Confirming bank as a party of letter of credit confirms and guarantee to undertake the responsibility of payment or negotiation acceptance under the credit.
Negotiating bank is one of the main parties involved under Letter of Credit.
Negotiating Bank, who negotiates documents delivered to bank by beneficiary of LC. Negotiating bank is the bank who verifies documents and confirms the terms and conditions under LC on behalf of beneficiary to avoid discrepancies
Reimbursing Bank is one of the parties involved in an LC. Reimbursing bank is the party who authorized to honor the the reimbursement claim of negotiation/ payment/ acceptance.
Advantages and disadvantages of Letter of Credit to Importers
Advantages of Letter of Credit to Importers
- While accepting a LC, the supplier guarantees to meet the terms and conditions of letter of credit with documentary proof. This is one of the major advantages of LC to an importer/buyer. This assurance provides security to buyer for future business plan.
- Since buyer is the holder of Letter of credit, Bank acts on behalf of buyer. Opening bank remits amount only after satisfaction of all terms and conditions of letter of credit with documentary proof. This arrangement protects importer and minimize time, as bank acts on behalf of him.
- A letter of credit transaction reduces the risk of non performance by the supplier, as the supplier prefers LC than other transactions due to various reasons which protect him than the buyer. This is an advantage for the buyer on fulfillment of meeting commitments on shipments.
- Another advantage of letter of credit to a buyer/importer is that the exporter/seller receives payment of exported goods only after shipment and meeting of all necessary requirements under LC terms and conditions with presentation of documentary proof including evidence of shipment.
- Unlike other shipments, a shipment under Letter of credit is treated with most care to meet delivery schedule and other required parameters by the exporter. The documents receive by buyer promptly and quickly with complete sets. Unless meeting delivery schedule and prompt documentation, the supplier does not get his payment from opening bank. This is one of the major advantages of LC for an importer is concerned.
- An importer/buyer is concerned; he can plan his payment schedule properly by anticipating the requirements under letter of credit. This arrangement makes importer for easier planning.
- Based on timely delivery schedule, buyer receives goods on time thereby he can execute his business plan smoothly and efficiently, in turn satisfying his clients promptly and effectively.
Disadvantages of Letter of Credit to Importers
- One of the major disadvantages of letter of credit is that LC is operated on the basis of documentation and not on the basis of physical verification of goods on its quality, quantity or other parameters. In other words, an LC issuing bank can effect payment to beneficiary of LC on the basis of documentation produced as per the terms and conditions of letter of credit. The parties under letter of credit do not have any right to physically verify the contents of goods. So, if the buyer needs to confirm and satisfy on the quality of goods he buys, he can appoint an inspection agency of international repute and instruct exporter to enclose certificate of such inspection by mentioning a condition in letter of credit.
- Once opened a confirmed and irrevocable letter of credit, the importer/buyer already tied up with the said business credit line and can not change in between. Due to various reasons, especially on selling price variation, if buyer needs to stop his export order he can not do so.
- Compared to other payment mode of transactions, cost of operating letter of credit procedures and formalities are more, which may be an additional expenses to an importer especially on amendment, negotiation etc.
- Currency fluctuation is another disadvantage of Letter of credit. Normally buyer/importer places purchase orders once in a year and opens letter of credit accordingly. The exchange rate may differ at the time of effecting payment. So, if any loss due to fluctuations in foreign currency contracted under letter of credit, need to be beard by him. This is also one of the major demerits of LC.
Advantages and disadvantages of Letter of Credit to Exporters
Advantages of Letter of Credit to Exporters
- One of the best methods of international trade is Letter of Credit (LC), as buyer’s bank guarantees payment to seller through seller’s bank on presentation of required documents as per LC.
- Letter of credit is favorable for exporter to minimize credit risk. In import and export, the geographical distance between importer and exporter is very far; hence ascertaining credit worthiness of buyer is a major threat., such risk can be avoided.
- Buyer can not deny payment by raising dispute on quality of goods, as letter of credit terms and conditions are based on documentation. This is a major advantage of Letter of Credit in terms of seller point of view.
- LC provides a security to exporter which is another advantage of a letter of credit. Based on such security, the exporter can preplan his further business activities to strengthen his business world.
- In a letter of credit, any dispute in transaction can be settled easily, as LC terms and conditions are under the guidelines of uniform customs and practice of documentary credit.
- In a letter of credit, all required documents have been mentioned well before shipment and there is no confusion or misunderstanding to the importer (buyer) to inform supplier to act in between.
- An exporter can avail pre shipment finance from banks or other financial institutions.
- Another advantage under a Letter of Credit transaction is that the exporter receives money on time.
- A confirmed LC, the exporter need not worry on cancellation of his export order, changes in said order, importer or importer’s country risk.
- Meeting delivery schedule by proper production plan is one of the major advantages under a letter of credit terms of business.
Disadvantages of Letter of Credit to Exporter
- While accepting a letter of credit, the exporter guarantees to meet the requirements of buyer as mutually agreed as per the terms and conditions mentioned in letter of credit. So the liability of meeting all required parameters are with supplier failing which bank may not accept documents under such transaction. Bank may debit certain charges against the discrepancy of documents also if proper documentary proof has not been submitted along with other shipping documents. So, if the exporter does not follow strictly with the terms and conditions of letter of credit with 100% compliance of documentation, the payment will not be effected by bank.
- Under letter of credit opening procedures, there are certain bank charges and other costs. If buyer insists seller to pay such costs, the said charges will be additional expenses for the supplier.
- If exporter is aware that the credit worthiness of buyer is favorable and sound, he does not need to open a letter of credit to transact with such buyers. However, he agrees on opening LC based on the requirements of buyer to enjoy the advantage of opening LC by buyer. In such cases, meeting of all terms and conditions under letter of credit is the major responsibility of exporter. Apart from meeting additional documentation procedures, exporter needs to spend additional expenses also.
- As I have mentioned in other articles in the same website, an exporter must verify the authenticity of opening bank. The Letter of Credit opening bank should be a prime banker. I have experienced many cases of fraudulent LC opening bank who were not a prime banker who does not have proper ‘stand’ to follow the guidelines of uniform customs and practice of documentary credit. So the strength and stability of LC issuing bank is a prime factor while discussing about the demerits of Letter of Credit.
- Policy of a country may effect the business transaction between countries. If a cold ware is being continued between two countries, due to political reason, the trade bilateral agreement between such countries may become void, resulting to effect the guidelines of uniform customs and practice of documentary credit. This is another demerit of LC for a seller.
A best caliber of personnel is required to monitor and navigate the process of letter of credit to provide no room for even minute discrepancy of documents.
- Compared to other modes of payment, the expenses for opening, negotiating and other procedures of letter of credit is high. This is another disadvantage of Letter of credit for an exporter. This is another disadvantage of letter of credit for an exporter
- Currency fluctuation is another disadvantage of Letter of credit. Normally buyer/importer places purchase orders once in a year and opens letter of credit accordingly. The exchange rate may differ at the time of shipping goods, from the time of opening LC. The exporter receives payment after shipment. So, if any loss due to fluctuations in foreign currency contracted under letter of credit, need to be beard by him. This is also one of the major demerits of LC.
- Currency fluctuations may also effect on price variation to procure raw materials for the buyer/exporter, resulting hike of cost of production in turn the exporter/seller can not hike the selling price, as the purchase order agreement already signed by accepting letter of credit for whole shipments under one LC. So currency fluctuation also is a threat under letter of credit which is treated as other disadvantages of letter of credit.