Decoding Letters of Credit
What it is, Examples, and How does it Work
Letters of credit, or “LCs,” are common overseas trade financing.
The usual procedure for obtaining a credit letter involves the buyer requesting one from their bank (the “issuing bank”) on behalf of the seller (LC).
An advising bank in the seller’s nation receives the LC after sending it from the buyer’s bank.
You can start opening a credit letter by doing the following.
Letters of credit provide financial security for buyers and sellers in foreign business transactions, facilitating smoother product and service transfers.
A Letter of Credit, or “LC,” is a kind of financing commonly used in global trade that allows a bank to guarantee payment to a seller on behalf of a buyer.
The Uniform Commercial Code (UCC) governs the treatment of letters of credit in the United States. The bank representing the buyer acts as the issuing bank. It sends the LC to the bank representing the seller in the seller’s country. This bank acts as the advising bank and notifies the seller that the LC has arrived. This is the first step in opening a Letter of Credit, which safeguards both buyers and sellers in International transactions and facilitates the smooth flow of goods and services worldwide.
How Does a Letter of Credit Work?
Using a financial instrument called a Letter of Credit to guarantee payment between a buyer and a seller in a transaction is standard procedure when doing business worldwide.
Here’s how it works for a Letter of Credit issued by the seller’s bank to the acquiring bank.
- The terms of the transaction, including price, delivery date, and goods or services to be traded, have been agreed upon by both the buyer and the seller.
- The buyer requests a Letter of Credit from the bank, which ensures that the buyer will pay the seller for the goods or services.
- The bank will often want collateral or security from the buyer before issuing the Letter of Credit.
- The seller’s bank checks the letter at the buyer’s bank to ensure it satisfies the requirements of the commercial transaction.
When the seller sends the required paperwork to the bank and then ships the products to the buyer or provides the services to the customer, the invoices, bills, and other financial records are included.
- When everything is in order, the bank representing the seller will forward the documentation to the bank representing the buyer.
- The buyer’s bank reviews the paperwork, and if everything checks up, the buyer’s bank pays the vendor.
- The onus then shifts to the buyer to make any required bank repayments, which may include interest or other charges.
As a whole, a Letter of Credit can calm nerves during an overseas sale. This increases the likelihood that the transaction will be completed and reduces the danger of not being paid for.
How Much a Letter of Credit Costs
A letter of credit (LC) is a financial instrument widely used in international trade transactions to provide a secure method of payment between a buyer and a seller. It acts as a guarantee from a bank that the seller will receive payment for the goods or services they provide as long as they comply with the terms and conditions outlined in the LC. While the issuance of an LC offers several advantages, it is important to consider the costs associated with this service.
- LC Issuance Fee: Banks typically charge an upfront fee for issuing a letter of credit. The fee is usually a percentage of the total value of the LC, known as the face value. The percentage can vary depending on the transaction’s complexity, the parties’ creditworthiness, and the issuing bank’s policies. This fee covers the administrative costs incurred by the bank to review and process the LC application.
- Amendment Fees: During a transaction, it may become necessary to make changes to the terms and conditions of the LC. These changes could include modifications to the shipment dates, the quantity of goods, or the beneficiary’s details. Banks generally charge an amendment fee for each modification made to the LC. The fee amount can vary based on the complexity of the amendment and the bank’s policies.
- Confirmation Fee: In certain cases, the seller may require additional assurance of payment beyond the issuing bank’s commitment. To address this concern, another bank can confirm the LC, usually located in the seller’s country. The confirming bank becomes liable for the payment and the issuing bank. Confirming the LC provides the seller with an extra layer of security, but it comes at a cost. The confirming bank will charge a fee for taking on this risk.
- Advising Fee: When an LC is issued, it is often transmitted through a bank in the seller’s country, known as the advising bank. The advising bank verifies the authenticity of the LC and forwards it to the beneficiary (seller). The advising bank charges a fee for this service, which covers their administrative expenses and the liability they assume by transmitting the LC.
- Negotiation Fee: Once the beneficiary receives the LC, they may choose to obtain immediate payment from their bank before the actual payment is received from the issuing bank. This process is known as negotiation. The beneficiary’s bank charges a negotiation fee for providing this service. The fee is typically a percentage of the LC value or a flat fee based on the transaction amount.
- Acceptance Fee: In some cases, the beneficiary may request that the issuing bank accepts a time draft, also known as a usance LC. This means that the payment will be made at a future date determined by the terms of the LC. In such instances, the issuing bank may charge an acceptance fee for assuming the risk associated with the delayed payment.
- Handling Charges: Apart from the specific fees mentioned above, there may be additional charges may bed with the handling processing of the LC.ese charges can include document handling fees, courier charges for delivering the documents, and other miscellaneous administrative costs incurred by the banks involved in the LC transaction.
It’s important to note that the actual costs of a letter of credit can vary depending on the specific terms and conditions negotiated between the parties involved and the banks they choose to work with. Additionally, the fees mentioned above are partial and may differ from one bank to another. Therefore, it is advisable to consult with the issuing bank and carefully review the terms and conditions to understand the complete cost structure associated with a letter of credit.
Types of Letters of Credit
Several letters of credit (LCs) are commonly used in international trade transactions. Each type serves specific purposes and provides different levels of security and flexibility. Here are some of the most common types of LCs:
Revocable Letter of Credit:
The issuing bank can modify or cancel a revocable LC without prior notice to the beneficiary (seller). It provides little security for the seller since the terms can be changed or revoked anytime. As a result, revocable LCs are rarely used in international trade transactions.
Irrevocable Letter of Credit:
An irrevocable LC cannot be modified or canceled without all parties’ agreement. It provides a higher level of security for both the buyer and the seller. Under an irrevocable LC, the issuing bank is obligated to honor the payment to the seller as long as the terms and conditions of the LC are met.
a. Confirmed LC:
In a confirmed LC, a second bank (confirming bank) adds its confirmation to the LC, providing an additional guarantee of payment to the beneficiary. This type of LC is often used when there are concerns about the creditworthiness or country risk of the issuing bank.
b. Unconfirmed LC:
An unconfirmed LC is solely backed by the issuing bank’s commitment without any additional confirmation from another bank. The beneficiary relies on the issuing bank’s creditworthiness and reputation.
Standby Letter of Credit (SBLC):
Unlike commercial LCs used for payment in trade transactions, standby LCs are used as a form of financial guarantee or backup. They serve as a promise by the issuing bank to pay the beneficiary if the applicant (buyer) fails to fulfill their obligations. Standby LCs are commonly used in construction projects, real estate transactions, or as a guarantee for performance or payment.
Transferable Letter of Credit:
A transferable LC allows the beneficiary (first beneficiary) to transfer all or part of their rights to a third party, known as the second beneficiary. This type of LC is useful when the first beneficiary acts as an intermediary or middleman in a transaction and wishes to involve a supplier or subcontractor. The second beneficiary can then present the transferred LC to their bank for payment.
Back-to-Back Letter of Credit:
In a back-to-back LC, two separate LCs are issued by different banks. The buyer’s bank issues the first LC in favor of the intermediary (first beneficiary). The intermediary then uses this LC as collateral to obtain a second LC from their bank in favor of the actual supplier (second beneficiary). The back-to-back LC allows the intermediary to facilitate a transaction without using their own funds.
Red Clause Letter of Credit:
A red clause LC allows the beneficiary to obtain pre-shipment financing from their bank. The LC includes a clause specifying the maximum amount the bank can advance to the beneficiary before the shipment of goods. This type of LC is useful when the seller requires funds to cover production or purchase costs before the shipment is made.
Green Clause Letter of Credit:
Similar to a red clause LC, a green clause LC allows the beneficiary to receive both pre-shipment financing and warehousing facilities. The LC includes a clause that permits the beneficiary to store the goods in a warehouse before shipment. This is particularly useful for commodities that require storage or processing before export.
These are some of the commonly used types of letters of credit. It’s important to note that the specific terms and conditions of an LC can vary depending on the agreement between the parties involved and the issuing bank. Parties should carefully review and negotiate the terms to ensure they align with their specific requirements and preferences.
Example of a Letter of Credit
Citibank understands the challenges buyers face in Latin America, Africa, Eastern Europe, Asia, and the Middle East when obtaining international credit independently. To address this issue, Citibank offers a comprehensive solution in the form of letters of credit. These letters of credit play a crucial role in facilitating international trade by minimizing the risks associated with the buyer’s country and the issuing bank’s commercial credit.
By leveraging Citibank’s letters of credit, exporters can confidently engage in business with buyers from these regions, knowing their payment is secure. The letter of credit guarantees that the exporter will receive payment for their goods or services, regardless of any potential financial or political challenges the buyer faces.
One of the key advantages of utilizing Citibank’s letters of credit is the speed at which they are provided. Typically, within just two business days, Citibank issues the letter of credit, offering the exporter a swift and efficient payment guarantee. This promptness in delivering the letter of credit allows exporters to proceed confidently and focus on their core business operations.
Furthermore, Citibank’s extensive global network ensures the effectiveness of these letters of credit. With branches and correspondent banks across the globe, Citibank can confirm and honor the letters of credit, providing a reliable and trustworthy payment mechanism for exporters.
This service becomes especially valuable when dealing with clients in potentially unstable economic environments. The inherent risks and uncertainties associated with such markets can often make exporters hesitant to engage in business transactions. However, with Citibank’s letters of credit, exporters can navigate these challenges with peace of mind, knowing that a reputable financial institution guarantees payment.
In summary, Citibank’s letters of credit offer a robust solution for buyers in Latin America, Africa, Eastern Europe, Asia, and the Middle East who face difficulties obtaining international credit. These letters of credit minimize the risks associated with the buyer’s country and the issuing bank’s commercial credit and provide a swift and reliable payment guarantee. With Citibank’s extensive global network, exporters can confidently engage in business, even in potentially unstable economic environments.
How to Apply for a Letter of Credit
Applying for a Letter of Credit can be a critical step in facilitating secure and smooth international trade transactions. Whether you are a buyer or a seller, understanding the process of applying for a Letter of Credit is essential. Below is a detailed guide on how to apply for a Letter of Credit:
Determine the Need for a Letter of Credit:
First and foremost, assess whether a Letter of Credit is necessary for your specific trade transaction. Letters of Credit are commonly used when there is a lack of trust between the buyer and the seller or when the transaction involves significant financial risk. Factors such as the buyer’s creditworthiness, political or economic instability in the buyer’s country, or unfamiliarity between the parties involved may warrant a Letter of Credit.
Consult with Your Bank:
Contact your bank to discuss your intention to apply for a Letter of Credit. Your bank will guide you through the application process and provide the necessary information and documentation requirements. Working with a bank with experience in handling Letters of Credit is advisable to ensure a smooth and efficient process.
Provide Detailed Transaction Information:
Prepare all the relevant details about the trade transaction, including the buyer’s and seller’s names, addresses, contact information, and the nature of the goods or services being traded. Additionally, provide the desired amount and currency for the Letter of Credit, the shipment or delivery terms, and any specific conditions or requirements.
Complete the Letter of Credit Application:
Your bank will provide you with an application form for the Letter of Credit. Fill out the application accurately and completely, ensuring all required fields are properly addressed. Double-check the information provided to minimize the chances of errors or discrepancies.
Submit Supporting Documentation:
Along with the application form, you must provide supporting documentation to your bank. These documents may include but are not limited to:
- Proforma invoice or sales contract specifying the details of the transaction
- Shipping documents (e.g., bill of lading, airway bill, packing list)
- Insurance documents
- Inspection certificates (if applicable)
- Any additional documents required as per the terms of the transaction or as requested by the bank
Review and Verification:
Your bank will review the application form and supporting documents to ensure compliance with their internal policies and international trade regulations. They may also assess the creditworthiness of the buyer and the overall risk involved in the transaction.
Approval and Issuance:
The bank will approve your application and issue the Letter of Credit upon successful verification. The Letter of Credit will contain specific terms and conditions that the buyer and seller must adhere to to facilitate a successful transaction.
Communicate with the Beneficiary:
If you are the buyer, share the details of the issued Letter of Credit with the seller (beneficiary) and provide them with the necessary instructions for document preparation and submission.
Monitor the Transaction:
Throughout the transaction, it is crucial to communicate regularly with your bank and the beneficiary to ensure the smooth flow of documentation and compliance with the terms of the Letter of Credit. Promptly address any discrepancies or issues that may arise.
Letter of Credit Settlement:
Once the beneficiary presents the required documents to the bank per the terms of the Letter of Credit, the bank will review and verify them. If the documents are compliant, the bank will pay the beneficiary as stipulated in the Letter of Credit. The buyer will then settle the payment with the bank according to their agreement.
It is important to note that the process of applying for a Letter of Credit may vary depending on the specific requirements of your bank and the transaction itself. Consulting with your bank and seeking professional advice from legal and financial experts will ensure a smooth and successful application process.
Remember, a Letter of Credit is a legally binding instrument, and all parties involved should fully understand and comply with its terms to minimize the risk and ensure a secure trade transaction.
Advantages of a Letter of Credit
A Letter of Credit (LC) is a widely used financial instrument in international trade that offers several advantages for both buyers and sellers. Let’s explore them in detail:
- Payment Security: One of the primary benefits of a Letter of Credit is that it provides payment security for both parties involved. For the seller (beneficiary), it guarantees that they will receive payment once they fulfill the terms and conditions stated in the LC. On the other hand, for the buyer (applicant), payment will only be made if the seller complies with the agreed-upon terms.
- Risk Mitigation: A Letter of Credit helps mitigate various risks of international trade. It minimizes the risk of non-payment or payment delays for the seller, particularly when dealing with unfamiliar or financially unstable buyers. Similarly, for the buyer, it reduces the risk of receiving substandard or non-compliant goods, as payment is contingent upon the presentation of specified documents.
- Flexibility in Negotiating Payment Terms: A Letter of Credit allows both parties to negotiate and agree on the specific terms and conditions of the trade transaction. This includes payment, currency, delivery terms, and additional requirements. Such flexibility ensures that both buyer and seller are aligned and can confidently proceed with the transaction.
- Access to Financing: For sellers, a Letter of Credit can be utilized as collateral to secure financing from banks or financial institutions. This can be particularly helpful for small or medium-sized enterprises that may face challenges obtaining traditional financing options.
Differentiating between Commercial Letter of Credit and Revolving Letter of Credit
Commercial and revolving letters of credit are two financial instruments used in international trade. Here are the key differences between them:
- Commercial Letter of Credit: A commercial letter of credit is typically used for a specific transaction or trade deal. It provides a guarantee of payment from the buyer’s bank to the seller, ensuring that the seller will receive the agreed-upon payment once the specified conditions are met.
- Revolving Letter of Credit: On the other hand, a revolving letter of credit is designed for ongoing or repetitive transactions between the same buyer and seller. It establishes a predetermined credit limit, and once the credit is used, it is automatically reinstated, allowing for multiple transactions over a specified period.
- Commercial Letter of Credit: A commercial letter of credit is commonly used when there is a lack of trust between the buyer and seller, especially in international trade, where the parties may need to be more familiar. It offers security to the seller, ensuring that they will be paid for the goods or services provided.
- Revolving Letter of Credit: A revolving letter of credit is more suitable for long-term business relationships or when there is a need for a continuous supply of goods or ongoing trade. It simplifies the payment process and avoids the need to establish a new letter of credit for each transaction.
- Commercial Letter of Credit: A commercial letter of credit is a one-time arrangement established for a specific transaction. Once the transaction is completed, the letter of credit is typically closed, and a new letter of credit would need to be created for future transactions.
- Revolving Letter of Credit: A revolving letter of credit is set up with a fixed credit limit and a defined period, usually one year. Within that period, the buyer can make multiple draws on the credit. Once the credit is exhausted, it replenishes automatically.
The bottom Line:
Letters of credit are essential in facilitating trade transactions, and the type of letter of credit needed can vary depending on the specific circumstances. If you seek a letter of credit for a business transaction, you should begin your search with your current bank. They know your financial history and may be more willing to extend credit based on your existing relationship.
However, maintain accounts at a smaller financial institution with limited international reach or a smaller credit capacity. It may be necessary to broaden your search to include larger banks. These larger banks often have more experience and resources to handle complex trade transactions. They may offer a wider range of credit options to suit your needs.