Letter of Credit
Letter of credit is an assurance by a bank to guarantee payment to a specified person under specified conditions. Letter of credit is mostly used in international trade, due to the risk of default by the buyer. A letter of credit as such provides complete financial security to the seller (the beneficiary). In a letter of credit, the bank assumes payment obligations on behalf of the buyer.
Letter of credits are used to offer a greater level of comfort to sellers. Due to the reluctance of sellers to enter into international trade with unknown buyers, a buyer can obtain a letter of credit from a bank to leverage the credit worthiness of the issuing bank. This gives the buyer a greater chance of securing the trade as sellers become more willing to participate as payment is guaranteed by the issuing bank. The downside to the letter of credit though is that as always, nothing is done for free. The issuing bank in extending a letter of credit bears a certain amount of risk in the case the buyer defaults in payment. With regard to this, the bank collects fees from the letter of credit parties to ameliorate the bank’s losses in case of default and also to make profit if the buyer makes payment.
To reiterate, a letter of credit is a contractual undertaking on the part of an issuing bank to pay a certain sum of money at the request of, and to the account of a beneficiary (seller) according to instructions given by the applicant (buyer) against delivery of certain documents and upon fulfillment of certain terms and conditions subject to the Uniform Customs and practice for Documentary Credits (“UCP) established for the International Chamber of Commerce.
Types of letter of credit
- Revolving letter of credit
- Transferable letter of credit
- Red clause letter of credit
- Back to back letter of credit
- Standby letter of credit
Revolving letter of credit: Revolving letter of credit as the name implies is a letter of credit that reoccurs for a pre-determined period of time. For example, a Nigerian retailer who procures goods from China on a monthly basis can enter into a revolving letter of credit, whereby the issuing bank domiciled in Nigeria guarantees monthly payment to the seller for a period of one year after which the Nigerian buyer renews the letter of credit for another year. In the simple sense, a revolving letter of credit is a letter of credit which is structured in a way that the issuing bank guarantees payment on a revolving basis either in value or in time covering multiple deliveries over a long period of time.
Transferable letter of credit: Transferable letter of credit is a letter of credit that permits the beneficiary of the letter, which in this case is the seller, to avail some or all the credit to a second party, thereby creating a second beneficiary. For there to be a transferable letter of credit, the issuing bank must approve the request.
Red Clause letter of credit:
This type of letter of credit avails the seller the opportunity to request an advance for an agreed amount subject to agreed upon terms and conditions by the issuing bank. The advance is typically utilized for financing the manufacture of, or the purchase of the goods to be delivered under the letter of credit. Due to the high risk nature of default from the seller in a red clause letter of credit, the seller is usually mandated to provide a written undertaking for the subsequent delivery of transportation documents before the credit expires. Note that the transportation document mentioned here is a document that conveys information about cargo that is being transported. They may include Air way bills, a transport documents used for air freight and Bill of Lading, a transport document used for sea freight.
Back to Back letter of credit :A back to back letter of credit is usually used in a transaction that requires an intermediary between the buyer and seller, or when the seller must first purchase the goods from a supplier before passing it on to the buyer. In a back to back letter of credit, there are effectively two letters of credit issued in the transaction. The first will be a letter of credit issued by the buyer’s bank to the intermediary, and the other issued by the intermediary’s bank to the seller.
Standby letter of credit : A standby letter of credit is a guarantee issued by the bank on behalf of a client, promising the seller or beneficiary that payment will be made following the failure of its client to meet his obligations or payment. Technically, a standby letter of credit (“SLOC”) Is a loan of last resort wherein the bank fulfills payment obligations at the end of the contract if the client fails to.
Processing of issuance of a letter of credit
To begin the process, the buyer or in this case the applicant approaches their bank to issue a letter of credit. The next step would be for the applicant’s bank to open the letter of credit after proper due diligence and scrutinizing of documents submitted, and then send it to their correspondent bank, in this case the advising bank to advise the same to the beneficiary. The final step will be for the beneficiary, i.e the seller to ship the cargo strictly as per the terms and conditions of the letter of credit.
For the payment process, after the seller ships the cargo, he approaches his bank (which in this case is the negotiating bank) and submits the required documents as per the letter of credit for the bank to take up the negotiation with the buyer’s issuing bank. The negotiating bank inspects the of documents with the terms and conditions of the letter of credit and if satisfied that the documents submitted strictly complies with the terms and conditions of the letter of credit , pays the amount of documents to the beneficiary. After the negotiating bank makes payment, he then approaches the issuing bank for payment.
Advantages of letter of credit
Advantages of letter of credit to the buyer
- A letter of credit ensures that the buyer receives the goods within the delivery time
- The buyer is assured that goods are shipped before making payment
- It provides clarity on terms and conditions of the trade finance
- Assures the timeline to plan the business cycle
- It provides for secured payment for the trade
Advantages of letter of credit to the seller
- Seller is assured of payment following the delivery of cargo according to the terms and conditions outlined in the letter of credit.
- Facilitates post shipment finance through a secured process
- Responsibility of payment to the seller lies with the bank and not the buyer.
Susan Warner., The letter of credit.
Thomas H. Ward., Letter of credit and documentary collections: An export and import guide.