What is a letter of credit?
A letter of credit (an "LC") is a flexible and internationally accepted form of financial guarantee. What it does depends upon what it says.
It is commonly organised to support the trade in goods. In this situation, it is transmitted by the importer's bank to the exporter's bank.
The importer's bank:
agrees to pay the exporter's bank
a specified sum of money if
certain documents are provided
by a certain date
for onward credit to a beneficiary (the exporter).
A couple of important points:
In practice, banks deal with each other over the detail of LCs. This means that the two parties (the importer and exporter) have to accept that any negotiations over the LC will happen between the banks involved.
There is an international body of rules called "UCP600" which regulates how LCs work. LCs should expressly refer to this set of rules - see a link here.
As already mentioned, the LC will operate based upon how it is drafted. It is important that a specialist is involved to make sure that the LC is fit for the purpose intended.
An LC is of almost no benefit to the exporter if the correct and accurate documents are not provided on time. See our note on discrepant LCs here.
What are the key features of a letter of credit?
An LC used to support the trade in goods typically follows a simple template. One bank "issues" it, the other bank "negotiates" it. In trade finance, the issuing bank and the applicant are on the importer side, and the negotiating bank and the beneficiary are on the exporter side. It is usually transmitted between the banks by SWIFT.
This typical kind of LC has different parts:
The parties (issuing bank, negotiating bank, applicant, beneficiary)
The documents that should be provided and the deadline
Rules on whether it can be transferred
The timing of cash pay-out when conditions are met
Potential rights to get cash quicker ("UPAS clauses")
What are the main types of LC?
There are many types but in trade finance, three types are commonly used in transactions involving the shipment of goods:
Standby LC: this works like a bank guarantee, and is usually unrelated to any specific trade. It is capable, sometimes, of being claimed by a beneficiary directly. It is not the type of LC that is typically required by an exporter to support a shipment of goods.
Sight LC: this supports a specific import-export deal, paying out when shipping documents matching the specified requirements are presented on time to the importer's bank;
Usance LC: same as the sight LC, just that the payment is made some specified number of days after the conditions are met.
When do I use a letter of credit in practice?
An import LC is used to give confidence to an exporter so that he can ship the goods to the importer before being paid. In some markets, a letter of credit from an importer is also used as collateral by an exporter to obtain local financing ("back-to-back"). An exporter may borrow against a purchase order that is supported by an LC arranged by the importer.
How do I get an LC?
A Letters of credit to support the import and export of goods are usually organised by the importer on a trade. The importer goes to his bank and asks them to issue a letter of credit. This means filling in forms, paying fees, putting up collateral and using banking lines.
What do LCs cost?
A letter of credit has fees everywhere. Issuance, negotiation, amendments, discrepancies, payments, couriers etc. The letter of credit process can cost 3%, 4%, even 10% of the cost of the goods that are involved when all the fees are taken into account.
Do letters of credit work?
For large commodity trades, letters of credit are an essential component in liquid and efficient international markets. Since trade values are large ($5m. $10m, $20m), the fees and charges are not of huge consequence - and properly-implemented and executed LCs are the lifeblood of these markets.
For the import-export of goods, FMCG, garments, toys, and manufactured products, letters of credit are not efficient and usually ineffective. When shipment values are below $1m, LCs start to become expensive. Moreover, the range of conditions applied to the LC become difficult to meet - leading to a discrepant LC which gives an exporter no protection.
Is there an alternative to the LC?
For transactions in goods, use a platform like www.prima.trade. Transaction costs are very low, communication is real-time and direct between importer and exporter, and exporters can still get paid before they hand over control over the goods. This is a much more efficient system, low-cost, simple to use - and real-time.