Letters of credit: the full guide
Importers and exporters know only too well what it’s like to worry about paying for goods and receiving money for items. Long distances are often involved, making it tricky to track down debtors and chase companies that have failed to meet the terms of a contract.
This is where a letter of credit can be a sensible option, as it offers security for both buyers and sellers.
What is a letter of credit?
A letter of credit is a guarantee that payment will be made by one party to another under specified conditions. They're usually associated with international trade and are documents from a bank or other financial organisation that commit to a buyer’s payment being processed on time and for a specific amount. In practice letters of credit help the seller by securing the funds for the transaction and help the buyer by ensuring that no money changes hands until they are in receipt of the goods.
Why use a letter of credit?
As well as risks posed by the significant distances in international trade, it’s not always easy to assess the reliability of another company. In addition, different countries have different laws. Used correctly, a letter of credit can mitigate exposure to these unknown factors.
The bottom line is this: a letter of credit can help give you peace of mind and a form of insurance for your overseas trade.
How does a letter of credit work?
There are various kinds of credit letters (more on this later) but, as a general rule of thumb, the bank first guarnatees to pay for goods on behalf of a customer.
Depending on the lender’s terms and conditions, buyers may be required to pay the bank up front or allow the bank to freeze their funds until the transaction is made. Needless to say, banks are only likely to grant a letter of credit if they feel satisfied the buyer will and can pay.
Although it varies from lender to lender, in order for funds to be exchanged the seller may have to deliver goods to a specified address. In most cases the bank won't care what state the merchandise is in, or if something happens to it at the port of entry. It is only interested in seeing documentation showing that the seller met their end of the bargain.
Advantages for sellers and buyers
Aside from the fact that a letter of credit transfers the risk of non-payment or non-delivery onto the bank – and the creditworthiness moves from the buyer or seller to the issuing bank – in international trade a letter of credit can turn a disadvantage into an advantage. Firms can do business with partners they haven’t dealt with before or those who are fairly new acquaintances. It also means that traders can safely and quickly grow their businesses in new territories.
A letter of credit can also be tailored to each of the party’s needs and priorities. Terms and conditions can be agreed upon in advance to mutual benefit. In addition, there is documentary proof that each side will uphold their commitments. And, in the event that either side falls into bankruptcy, the bank is obliged to settle the sum agreed in the letter of credit.
Don’t forget that a letter of credit can also help exporters with financial planning. With payment terms agreed in advance and a timeframe set in writing, cash flow can be predicted with greater certainty.
Obtaining a letter of credit
If both parties are deemed creditworthy, getting a letter of credit can be pretty quick. The bank will need to verify all the necessary paperwork, including the exporter’s proof of materials and shipping documentation, and it may also require a pledge of securities or cash in return for providing the letter of credit.
Banks don’t do this kind of work for free. It’s important to do your homework and check the costs involved with using a letter of credit. In some cases, lenders levy a percentage of the transaction outlined in the letter of credit. Before signing on the dotted line, it’s sensible to balance up the fees against the security benefits.
Types of letters of credit
There are a number of different kinds of letter of credit so it’s crucial that you choose one suited to your circumstances. Here is a summary of the main types.
Revocable / IrrevocableA revocable letter of credit can be altered at any time by the bank or buyer without letting the seller know. Conversely, an irrevocable contract means that the seller has to consent to any changes.
Confirmed / UnconfirmedThis is an extra layer of security sometimes employed by the seller. While an unconfirmed credit letter will only be assured by the issuing bank, a confirmed document means that a bank in the seller’s own country will check its validity. In essence, the second bank will agree to make payment even if the first bank fails to do so.
TransferableAs the name suggests, the letter is transferable to another beneficiary.
StandbyThis ensures payment to the seller if anything goes wrong. Essentially, it’s an assurance that the buyer can meet their commitment.
RevolvingThese can be used for many payments between the same seller and buyer thus negating the need to issue a new letter of credit every time.
Back-to-backTypically used when an intermediary is part of the transaction but a transferable letter of credit is deemed to not the best option.
Letters of credit and the UCP 600
The Uniform Customs & Practice for Documentary Credits (UCP 600) was put together and agreed upon by the International Chamber of Commerce. The most recent version came into force in July 2007 and covers most commercial letters of credit. The goal is to reduce the risks of international trading and introduce standardised procedures and terms.
Not surprisingly, it is prudent to use letters of credit governed by these international rules.
Risks to a letter of credit transaction
While letters of credit seek to minimize risk, they are not without disadvantages. Strict terms often apply and can result in delays and extra bureaucracy. Letters of credit can be expensive to get issued and are not suitable for everyone. In fact, not all countries receiving goods require one and, in some cases, they are not standard practice.
If either party has a number of non-negotiable stipulations, it can cost time and money to draw up the letter of credit. And some banks insist on large amounts of information and can be very thorough when checking documents. Furthermore, letters of credit don’t guard against disputes if the merchandise is not of acceptable quality to the buyer.
A letter of credit isn’t the only choice when seeking to protect your business so it’s advisable to shop around before making a final decision and consider alternatives such as credit insurance.
Like most things in life, there are pros and cons to letters of credit. But, in a world where uncertainty seems to be the prevailing emotion, they are worth considering, and considering in detail.
Remember the key points: there are a number of different types, there are advantages and disadvantages for both buyers and sellers, and, in a nutshell, they transfer risk from you to the bank.
More on loan security types:
- Borrow up to £500,000
- Repay early with no fees
- From 1 day to 24 months
- Applying won't affect your credit score
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