Letters of Credit – It can often be challenging for smaller companies to participate in international trade for the first time. There is a host of regulations to weave around and setting up both the terms of the trade and ensuring timely payment are the key to success. There are various methods of making payments like open account, advance payment, documentary credit, etc. These offer varying degrees of security to buyers and sellers. However, the most method used by new buyers/sellers is the use of Letters of Credit.
A Letter of Credit is essentially a guarantee issued by the buyer’s bank (issuing bank) for the seller (beneficiary), guaranteeing payment to him once a trade is successfully completed. The rules of Letters of Credit are governed by the International Chamber of Commerce via the Uniform Customs and Practice for Documentary Credits. Letters of Credit usually contain the terms of the trade as part of the text of the document and the fulfillment of the trade is gauged by the documentary evidence alone.
Types of Letters of Credit
Letters of Credit are used both domestically and in international trade. Their need is determined solely by the comfort that the buyer and seller have on each other. Old trading partners across continents may not need Letters of Credit if they trust each other while two companies within miles of each other but trading for the first time might opt for one.
Most Letters of Credit issued currently are irrevocable, meaning they can’t be altered or canceled once issued without the consent of the beneficiary. This makes them one of the most secure methods of receiving payment for the beneficiary. Also, some beneficiaries may require a Letter of Credit to be further confirmed by another bank which has the effect of another large or trusted bank guaranteeing the Letter of Credit issued by a foreign bank.
Finally, there are sight Letters of Credit and usance Letters of Credit. The difference between them is only the usance period which is the time difference between the documentary evidence being submitted and the day when payment is due. This is the mechanism through which the seller can offer some credit period to the buyer to inspect the goods, sell them and make collections. For a sight Letter of Credit, the usance period is zero, and it must be paid immediately once the issuing bank receives the documents.
A sample Letter of Credit
As far as banks are concerned, they only go by the supporting documents to conclude that a successful trade has been made. Once a bank receives documents under a Letter of Credit and the documents are perceived to be in order, they are obligated to make the payment immediately or face reputational damage and regulatory action. The underlying documents usually include invoices, certificates of origin, transport / documents like a bill of lading or airway bills, insurance certificates, inspection certificates, etc.
Letters of Credit offer a reliable and time wasted method for companies to make payments to their suppliers locally or across the globe. The inbuilt feature of a Letter of Credit allowing for extending credit to the buyer is an added attraction for some companies. The involvement of banks acting as guarantors and document handlers significantly increases the strength of the underlying trade and can put both the buyer and seller at ease regarding their transactions.