Corporate TreasuryFinancial Supply ChainLetters of Credit/Open AccountThe Specifics of Letters of Credit

The Specifics of Letters of Credit

In international trade, buyers and sellers are separated by long distance, they may not know each other and are governed by a number of different factors, such as trade and exchange control regulations, legal systems, political entities and currencies.

When commercial parties to the transactions are placed in such complicated and complex situations, they adopt a mechanism for settlement of trade that is mutually convenient, reliable and safe.

Seller wants Buyer wants
(i) Payment to be made by buyer as soon as shipment is made. (i) To pay only after receipt of goods.
(ii) Assurance that he will be paid by the buyer. (ii) Assurance that seller would ship goods ordered and deliver in time.
(iii) Payment in his own country and possible financial assistance. (iii) Financial assistance till he receives/sells goods.

Taking into consideration all the complexities of international trade and the requirements of both buyer and seller, one useful method of payment is by documentary credit or letter of credit (LC).

One definition of a documentary credit is: “An undertaking issued by a bank, on behalf of the buyer (the importer), to the seller (exporter), to pay for the goods and services, provided that the seller presents documents that comply with the terms and conditions of the letter of credit.”

There are three contractual relationships in the use of documentary credits:

  • Between the buyer and the seller.
  • Between the buyer and the bank that issues the letter of credit.
  • Between the seller and the bank that issues the letter of credit.

Parties To a Documentary Credit

Applicant: The buyer is responsible for providing precise and clear instructions for the issuance of credit and amendments thereafter. As he applies to the bank for the LC, he is referred to as the applicant.

Issuing bank: This is the bank that issues the LC. Before issuing the LC it must satisfy itself about the standing of the applicant making a request for the issuance of a letter of credit. Once the documents are presented it has to examine them to ascertain whether the documents presented are compliant and meet the requirements of the credit. If so, they have to provide the payment to the bank (negotiating bank) from whom the documents were received.

Advising bank: The issuing bank will route the LC through their correspondent bank (advising bank) in the exporter’s country. The advising bank’s responsibility is to establish apparent authenticity of the credit before advising it to the beneficiary.

Beneficiary: The exporter or seller is the beneficiary of an LC arrangement. On receipt of a properly worded, properly advised LC; the beneficiary has to ship the goods, prepare the documents as per terms of LC and submit them to his bank for negotiation.

Confirming bank: If the exporter does not have confidence in the standing of the issuing bank, he can demand a confirmed letter to credit. In which case, the issuing bank will request their correspondent bank (confirming bank) to add confirmation to the LC. This bank will satisfy itself about the standing of the issuing bank, (making a request for adding confirmation to the letter of credit), before agreeing to add confirmation. By adding confirmation, it steps into the shoes of the issuing bank and it becomes bound to pay, accept or negotiate the documents drawn under LC, provided that they comply with the terms and condition of the LC. For adding confirmation, this bank will recover commission.

Negotiating bank: Upon shipment of goods, the exporter prepares the documents as per the terms of the LC and submits these to his bank for payment. This bank is the negotiating bank. This bank must examine the documents to satisfy that they are drawn in compliance with the terms and conditions of the LC. If so, then this bank will make the payment to the beneficiary and will forward the documents to the issuing bank to get the payment. The payment made by the negotiating bank to the exporter is ‘with recourse’ (i.e. the bank reserves a right to recover the payment from exporter in case it fails to get the payment from the issuing bank for any reason). However, in case of a confirmed LC, the payment made is ‘without recourse’.

Reimbursing bank: In case the currency of the transaction is other than the currencies of the export and import countries there will be a delay in getting the payment (e.g. an exporter in India has received the LC issued by a bank in Dubai, which is denominated in US$). In this case the negotiating bank in India will send the documents to the issuing bank in Dubai and will instruct them to remit proceeds to a bank in US, with whom negotiating bank maintains a US$ account. To avoid this delay, the issuing bank, at the time of issuing the LC, will nominate a bank (their correspondents) in US as a reimbursing bank. In such a case, the negotiating bank will send all documents to the issuing bank but will simultaneously lodge a reimbursement claim with nominated bank in US. This will avoid the delay in getting the proceeds and the beneficiary stands to benefit.

The LC mechanism is explained in figure 1 below. This uses the following assumptions:
An exporter in India and an importer in Dubai enter into a trade contract for the supply of goods worth US$100. The method of payment agreed is by an LC issued by British Bank of Middle East (BBME), Dubai and confirmed by State Bank of India (SBI), India. The reimbursing bank is Citigroup, US. So, the various parties to this LC mechanism are as follows:

  • Applicant: Importer in Dubai.
  • Issuing bank: British Bank of Middle East (BBME), Dubai.
  • Advising bank and confirming bank: State Bank of India (SBI), India.
  • Beneficiary: Exporter in India.
  • Negotiating bank: State Bank of India (SBI), India.
  • Reimbursing bank: Citigroup, US.
Figure 1: Trade agreement between an Indian exporter and an importer in Dubai

The following steps take place in figure 1:

  1. Trade contract between exporter in India and Importer in Dubai.
  2. Importer submits an application to BBME, Dubai with a request to issue an LC in favor of exporter in India.
  3. BBME, Dubai checks the credibility of the importer and, if satisfied, issues an LC and forwards the same to SBI in India with a request to advise the same to exporter after adding confirmation.
  4. Simultaneously, BBME in Dubai tells Citigroup US that they have been nominated as the reimbursing bank and mentions this in the LC.
  5. SBI, India verifies the validity of the LC and also checks credibility of BBME, Dubai and if satisfied on both counts, forwards LC to exporter after adding its confirmation.
  6. Upon receipt of the LC, the exporter manufactures goods and hands them over to shipping company in India.
  7. The shipping company issues a Bill of Lading (BL) to the exporter.
  8. The shipping company arranges to ship goods to their counterparts in Dubai.
  9. In the meantime, the exporter prepares documents as per the terms of the LC and submits the same to his bank, SBI in India, for payment.
  10. This bank plays a role of negotiating bank. The bank checks documents to ensure that they comply to the terms of the LC and, if satisfied, makes payment upfront to the exporter.
  11. The documents are then forwarded to the issuing bank.
  12. At the same time, the negotiating bank claims payment from the reimbursing bank, in this case Citibank US.
  13. The reimbursing bank debits the account of the issuing bank.
  14. The reimbursing bank makes payment to the negotiating bank.
  15. The issuing bank checks the documents to ensure that they are as per the terms of the LC. If satisfied, it recovers payment from importer.
  16. The issuing bank hands over the documents to the importer.
  17. The importer hands over documents to the shipping company in Dubai.
  18. The shipping company in Dubai hands over the goods to the importer.

Types of Letters of Credit

Revocable letter of credit
A revocable LC is one that can be amended or cancelled at any time by the issuing bank without the notice or reference to the beneficiary. Consequently, revocable credit does not constitute a legally binding undertaking between the banks and the beneficiary as it can be modified or cancelled at any time without notice to the beneficiary.

Irrevocable letter of credit
An irrevocable LC constitutes a definite undertaking of the issuing bank, provided that the stipulated documents are presented to the nominated bank or to the issuing bank and that the terms and conditions of the credit are complied with.

Confirmed irrevocable letter of credit
A confirmation of an irrevocable credit by another bank (the confirming bank) upon the authorization or at the request of the issuing bank (add its confirmation to the LC) constitutes a definite undertaking of the confirming bank, in addition to that of the issuing bank. This is providing that the stipulated documents are presented to confirming bank or to any other nominated bank and meet the terms and conditions of the credit are complied with.

Transferable letter of credit
Here the LC can be transferred to a second beneficiary. The LC is only transferable if this is specifically stated when it is issued. The benefit of a transferable credit is that if the beneficiary is only an intermediary between the opener and the manufacturer and is interested in the margin/spread then he can make this without employing his own funds. Transferable credit can only be transferred once. The second beneficiary cannot transfer it again. However a part or fraction can be transferred provided it does not exceed the total quantity/value of the original LC and provided that partial shipment is allowed.

Revolving letter of credit
A revolving letter of credit is where the credit available to the beneficiary gets reinstated after being utilized once. The amount of the credit is renewed or reinstated from time to time without a specific amendment. This credit may be limited by the overall credit available or the time period in which such a credit may be utilized or both.

Credit available by instalments
A credit available by instalment is a credit requiring specific quantities to be shipped weekly or monthly and allowing part shipment.

Back-to-back letter of credit
A back-to-back credit is issued on the strength of a credit already required. It is in fact a secondary or counter credit of a primary credit and is issued for when a credit cannot be issued in a transferable form. A back-to-back credit is opened with another letter of credit as the security. It may be opened by the beneficiary when he does not wish to reveal the identity of the producer to the importer or when the importer does not want to open a transferable letter of credit. However, it should be ensured that the second credit terms and conditions are identical to these of the first credit. Differences that appear are mainly on the date of expiry and the amount. Also, the second credit must expire before the first credit and the amount of the second credit will have to be less than that of the first credit.

Anticipatory credit or red clause letter of credit
Under a red clause letter of credit, some part payment is made to the beneficiary before the shipment of goods and submission of documents stipulated in the credit. It is method of financing gets its name from the clause authorizing the advising bank, which is typed or printed in red. This enables the beneficiary to purchase required raw materials and goods, etc. for the exporter. This amount of advance is either to be repaid by the exporter/beneficiary or is adjusted from the negotiation amt of the bill. If the exporter/beneficiary fails to repay or fails to submit the documents for negotiation, the ultimate responsibility is of the LC opener to repay the monies so advanced.

Green clause letter of credit
This is an extension of red clause letter of credit in as much as, in addition to advance payment, it takes into account the grant of storage facilities at the part of shipment and its cost, including insurance charges, is met by opener. These LCs are very uncommon.

Deferred payment letter of credit
This letter of credit allows payment under the LC in installment to the beneficiary and each installment is covered by a separate draft. The issuing bank will accept the drafts when the documents are submitted in accordance with the terms and conditions of letter of credit. The exporter can also discount the drafts with his banker or the issuing bank if the drafts are drawn under the credit.

Standby letter of credit
Thisis not actually a letter of credit, but rather a guarantee for the performance of a contract and the realizable bank stating that the named party has not fulfilled the contract. It is basically a guarantee issued by a bank in a letter of credit format. Normally it calls for one or two documents, which can be issued by the beneficiary, to be presented against payment. Normally these may be a copy of invoice and a declaration by the beneficiary that the said invoice has not been paid. Standby letter of credits were introduced in the US by US banks because they were not allowed to issue on demand guarantees.

Value to Exporter

As the beneficiary of an LC, the exporter has the assurance that if he presents the documents in accordance with the terms and conditions of the LC, he will receive proceeds from the issuing bank.

The financial standing of the buyer is replaced by that of the issuing bank who undertakes to pay, accept or negotiate against presentation of the documents drawn in conformity to the LC terms. A confirmed and irrevocable LC places the onus on the nominated bank and provides the best security for the exporter.

Value to Importer

The importer will receive the documents that were specified by him and embodied in the LC by the issuing bank. He is assured that he will only be debited with the value of the LC providing that all of the LC instructions have been complied with. Therefore the importer is able to conserve capital, as he does not have to pay cash in advance.

The importer’s ability to do business abroad is increased as the LC assures the supplier of payment. Because of assurance of payment, he can negotiate a better price and terms and broaden his sources of supply.

It enables the importer to meet a supplier’s request for payment by way of the LC. He is not necessarily guaranteed that the documents will produce the goods that he contracted to purchase, although this risk can be reduced by stipulating the condition of pre-shipment inspection to be carried out by a recognized institution and their certificate to accompany the documents.

There used to be a good chance of dispute in transactions backed by LCs, as they contain various terms and conditions. Each party would take the meaning of terms to suit their own advantage. To eliminate/minimize chances of disputes, the International Chamber of Commerce published a set of guidelines titled, “Uniform Customs and Practices of Documentary collection” (UCPDC).

Comments are closed.

Subscribe to get your daily business insights

Whitepapers & Resources

2021 Transaction Banking Services Survey
Banking

2021 Transaction Banking Services Survey

2y
CGI Transaction Banking Survey 2020

CGI Transaction Banking Survey 2020

4y
TIS Sanction Screening Survey Report
Payments

TIS Sanction Screening Survey Report

5y
Enhancing your strategic position: Digitalization in Treasury
Payments

Enhancing your strategic position: Digitalization in Treasury

5y
Netting: An Immersive Guide to Global Reconciliation

Netting: An Immersive Guide to Global Reconciliation

5y