What is a Letter of Credit?
When it comes to international export, there are a number of documents you should familiarise yourself with. In a previous post, we discussed the importance of export documentation and the difference between an ATR, EUR1, and a Certificate of Origin.
When dealing with new countries, you are often dealing with different languages and cultures, which can inevitably lead to confusion and misunderstanding. That’s why accuracy and transparency are of the utmost importance when it comes to export documentation.
Trading with unfamiliar buyers can be daunting, and exporters want to know assurance and guarantees are attached to their deals in the event that a new customer does not fulfil their part of the deal, which is when a letter of credit might be requested, offered as some form of assurance that you, the seller, may be paid.
So what exactly is a letter of credit, and why would one be used?
A letter of credit – also known as a documentary credit – is a financial document issued by a bank which acts as a guarantee of payment, provided the documents submitted are accepted as being compliant. A letter of credit would be raised by either the buyer, through a bank of their choice – which is likely to be their bank – and is essentially a written commitment that the bank will pay. It can be used to pay for goods and/or services and can be used in conjunction with any of the other payment terms.
When do I need a letter of credit?
Exporting comes with a number of risks, mainly related to payment. When dealing with new buyers or sellers of whom you have no previous experience, or when the transaction is for a substantial amount of money, a letter of credit is ideally be requested or it may be a mandatory condition of the destination country that you have to use a letter of credit or the seller may wish to have better control of their cashflow, so trust is not an issue
Conditions of a letter of credit
To ensure the guarantee is met, there are a number of obligations and conditions the beneficiary must meet.
A letter of credit depends on documents and details of said documents which must be compliant, match the letter of credit and each other, which must be submitted to the bank along with the letter of credit. These include any documents that prove the exporter has met the obligations.
A ‘bill of lading’ or other transport document will be requested to prove that the goods were shipped to the buyer. And a commercial invoice should be provided to prove that the transaction exists and the banks/authorities can see what is being paid for ie. goods and/or services It’s vital to be able to provide these documents as failure to adhere at any point may leave the bank unable to issue payment.
Types of letters of credit
There are several types the most common is an irrevocable letter of credit.
Transferable LC: Can be passed from one beneficiary to another and are commonly used when intermediaries are involved in a transaction.
Revocable LC: Can be changed or cancelled by the bank at any time for any reason,
Irrevocable: Cannot be changed or cancelled unless everyone involved agrees.
Standby letters of credit: the idea of a standby letter of credit is that it is never to be used, it’s prime use is to provide payment to the seller in the event of non-performance by the buyer. It is a ‘just in case’ comfort blanket to the seller.
Revolving letters of credit: Cover several transactions between a buyer and seller, used when shipping the same products to the same buyer.
Confirmed or unconfirmed letters of credit: If a buyer issues a letter of credit, they will likely do so with their own bank. For an added layer of security, the seller may require a letter of credit be ‘confirmed’. In this case, the second bank will give the guarantee of payment provided the documents are accepted as being compliant.
If you are considering a letter of credit, it’s worth spending some time thinking about which type you will need and the reason you are using the letter of credit as a payment term. As stated above, confirmed tend to be the most secure. But as with most export documentation, strict terms and conditions must be adhered to ensure prompt receipt of payment. Exporting should be a tool for business growth, so analysing the risks involved and ensuring you mitigate these accordingly is a vital step in getting the most from your export activities.