Letter of Credit
What is the Best Type of Letter of Credit for Your International Payments?
International trade has many elements to consider, including payment for goods. Among the variables to consider, buyers and sellers may not know each other well or have an established relationship yet. They may be under different laws in their respective countries. So there needs to be a way to mitigate payment risks involved. That is where a letter of credit comes into the picture. So,What Is a Letter of Credit?
A letter of credit, or “credit letter” is a letter from a bank guaranteeing that a buyer’s payment to a seller will be received on time and for the correct amount. If the buyer cannot make a payment on the purchase, the bank will be required to cover the total or remaining amount of the purchase.
Basically, an L/C helps eliminate the risk a seller has when providing goods to a buyer. It helps guarantee that the seller will be paid when presenting the documentation of the sale contract. If a buyer fails to pay a seller, the bank that issued a letter of credit must pay the seller as long as the seller meets all of the requirements in the letter.
The obligation for payment will shift from the buyer to the bank, who will pay the seller directly. The bank will pay the seller the goods’ value when the seller delivers the proper documentation representing the goods.
At that point, the goods are under the bank’s control (who paid the seller on their behalf) as a security against the buyer, until that buyer pays the bank.
Usually, the buyer will be charged a percentage of the amount covered as a fee for the letter of credit, and the bank will likely require collateral before issuing. Banks issue letters of credit when a business “applies” for one and the business has the assets or credit to get approved. Letters of credit can also protect buyers. If you pay somebody to provide a product or service and they fail to deliver, you might be able to get paid using a standby letter of credit. That payment can be a penalty to the company that could not perform, and it’s similar to a refund. With the money you receive, you can pay somebody else to provide the product or service needed.
SIDENOTE
A Letter of Credit (L/C) is also known as Documentary Credit (D/C)
The Flow of a Letter of Credit
What Are The Types of Letters of Credit and Which is Best for You?
There are a few different types of letters of credit with different uses. They each solve various issues and are sometimes used in foreign markets. Below are the most common.
Revocable vs Irrevocable
A Letter of Credit is irrevocable by default, meaning the instructions or terms cannot be amended, manipulated, canceled, or corrected without permission from the beneficiary and the confirming bank. By default, an L/C is irrevocable even if it is not indicated anywhere, so remember this is the default setting.
Revocable L/C’s are becoming obsolete. It means the L/C can be amended or canceled by the issuing bank at any time. Therefore, attention needs to be paid to this type of L/C. This could occasionally happen, possibly due to ignorance. However, banks generally do not confirm a revocable documentary credit, so beware.
Confirmed vs. Unconfirmed
An L/C is considered confirmed when the receiving bank guarantees or “confirms” that the L/C issued by the issuing bank is valid and that the issuing bank can honor its financial undertaking, and that the country of the issuing bank is not facing financial risk.
Silent Confirmation
It is when the advising bank adds a conditional guarantee of payment to the beneficiary without the knowledge of the issuing bank because, in some cases, the issuing bank may consider themselves creditworthy enough and do not see the need for a confirming bank.
Revolving
To avoid credit that has been partially utilised, a revolving credit may be used to restore the value of the credit.
These revolving credits can be in terms of:
⦁ Cumulative (any sum not utilized can be carried forward to the next month)
⦁ Non-cumulative (specific shipment each month)
⦁ Reinstated each time a shipment is made
This type of credit is proper when there are repetitive shipments between the same parties regularly.
Transferable
In this type of L/C, the seller is allowed to transfer the credit either fully or partially to one or more parties, provided the L/C clearly states that it is transferable.
Back to Back
A pair of L/Cs is issued for intermediaries, such as middlemen, brokers, or trading houses. In these cases, a transferable L/C may be unsuitable. The two credits are a Master credit (to the broker) and a Back to Back credit (to the supplier.) One is issued to benefit a seller who couldn’t provide the goods for any reason. Afterward, a second credit is opened for another seller to deliver the goods.
Standby Letter of Credit
This is a credit assurance from a bank that a buyer can pay a seller.. But, this credit is considered to be a secondary credit covering only default and if there is non-performance. Such credit is usually used to cover the risks that can occur in finalizing a contract between a buyer and seller.
Red Clause
It is a type of credit containing special Red Clauses (due to the color of the ink used in writing this clause), allowing the beneficiary to access the credit even before the shipment of goods and/or presentation of documents. A Clean Red Clause allows this access with the required documents but does not include the evidence of goods. In contrast, a Documentary Red Clause allows this access against the presentation of warehouse receipts along with the beneficiary’s undertaking to deliver the required documents upon shipment.
Green Clause
It is a type of credit containing special Green Clauses (due to the color of the ink used in writing this clause), allowing the beneficiary to access the credit even before the shipment of goods and/or presentation of documents. Using the Green Clause, the beneficiary can get advance payment by lodging the goods under storage in the bank’s name as security.
Letters of credit are complicated, and it’s easy to make an expensive mistake when using one.
Conclusion
A letter of credit is an arrangement entered into between banks on how the payments in an international commercial transaction can be settled while ensuring both the parties involved.
International trade puts rules for payment terms to protect your rights. Therefore, always choose the most suitable term for you after studying it in detail very well. Keep in mind that it’s possible to change the term with each shipment, but it depends on whom you work with?
If you have any inquiries, don’t hesitate to contact us.
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