Definition of Letter Of Credit
In simple terms, a letter of credit is an undertaking by a bank to make a payment to a named beneficiary within a specified time, against the presentation of documents which comply strictly with the terms of the letter of credit.
Its main advantage is providing security to both the exporter and the importer, but the security offered, however, comes at a price and must be weighed against the additional costs resulting from bank charges. The exporter must understand the conditional nature of the letter of credit and the fact that payment will not be made unless the terms of the credit are met precisely.
A letter of credit is opened by an importer (applicant), to ensure that the documentation requested reflects and proves that the seller has performed under the requirements of the underlying sales contract, by the exporter by making them conditions of the letter of credit (N.B. The sales contract is not an inherent part of the Letter of Credit, although the Letter of Credit may contain a reference to such contract). For the exporter a letter of credit, apart from cash in advance, is the most secure method of payment in international trade as long as the terms of the credit are met
How a Letter of Credit Transaction Works.
1.The buyer (applicant) and seller (beneficiary) conclude a trade contract, wherein both agree on terms for delivery, amount, and quality of the goods, as well as on the payment method. The contract should also specify the important points to be included in the Letter of Credit;
2.The buyer gives instructions to his or her bank (Issuing bank) to open the Letter of Credit in favour of the seller;
3.The issuing bank sends the Letter of Credit to the Advising bank, which usually is located in the country of the seller;
4.The Advising bank tests the authenticity of the Letter of Credit, and informs the seller;
5.The seller compares the Letter with the contract. If the Letter matches the terms of the agreement the seller ships the goods and assembles all the documentation laid out in the contract;
6.The seller submits the documents to the advising bank;
7.The Advising bank verifies the documents. If the documents correspond to the terms of the letter of credit the Advising bank proceeds with the payment method that is specified in the Letter;
8.The Advising bank forwards the documents to the Issuing bank;
9.The Issuing bank verifies the documents and transfers the payment amount to the Advising bank.
When an exporter asks for payment by letter of credit, he is transferring the risk of non-payment by the buyer to the issuing bank (and the confirming bank if the letter of credit is confirmed), providing the exporter presents the required documents in strict compliance with the credit.
An importer should only be thinking of opening a letter of credit if his country’s exchange control regulations require it or if his supplier insists upon it. It is worth noting that over 50% of letters of credit are rejected on first presentation, which can cause expensive delays for both the exporter and importer.
Up to one half of these rejections could have been avoided if more care was taken to ensure the credit properly represented the sales contract.
Exporters will need to be certain that it is necessary to use a letter of credit.
Typical considerations include:
•Is it a legal requirement in the importing country?
•What is the value of the order - will the bank charges be out of proportion to the value?
•'Always Traded This Way' - always using letters of credit for a particular customer or region without periodically re-assessing the reasons for requesting this method of payment
•What is the credit rating of the importer and are they a new customer or has a trading relationship already been established?
•What is the country risk of the importing country (would a confirmed letter of credit be more suitable)?
•What is the standing of the issuing bank (would a confirmed letter of credit be more suitable)?
•What is the usual practice in trading with that country and in that particular commodity?
•Are there any other measures that could be taken to protect the exporter (e.g. credit insurance)?
•Insistence by a Credit Insurer to trade on letter of credit terms with buyers in certain markets.
•Recommendation by banks who may advise that the best method of payment is a 'confirmed irrevocable letter of credit' irrespective of the country, strength of issuing bank and without much regard to the value of the consignment.
•Strategic Decision Made by the Exporter - however, this strategy should be flexible to adapt to the changing risk profile of both the country and the buyer.
It is important to remember that all parties in the letter of credit transaction deal with documents, not goods.
PARTIES TO A LETER OF CREDIT
The following are the parties to a Letter Of Credit
1.APPLICANT/IMPORTER
He is the person who is the Opener on whose behalf the Letter Of Credit is opened by the bank.
2. APPLICANT’S / IMPORTER’S BANK
The bank who issues or opens the Letter of Credit on behalf of the Importer/ Customer.
3. EXPORTER
He is the beneficiary of the Letter Of Credit who is entitled to receive the payment of his bills according to the terms of Letter Of Credit.
4. INTERMEDIARY / CONFIRMING BANK
It is the bank usually a branch or the correspondent of the opening bank in the exporting country through which the credit is advised to the exporter.
If it merely forwards the credit without any obligations on its part it is called the ADVISING / NOTIFYING BANK.
If the beneficiary bank add its own undertaking to the credit while advising it to the beneficiary it becomes a CONFIRMING BANK.
5. PAYING / NEGOTIATING BANK
The bank which negotiates the beneficiary’s bills under the credit & pays for it is known as Paying/ Negotiating Bank
RIGHTS & RESPONSIBILITIES OF PARTIES TO LETTER OF CREDIT
All the parties to a Letter Of Credit have certain rights & responsibilities which are certified in the UNIFROM CUSTOMS & PRACTICE FOR DOCUMENTARY CREDIT.
It is important to note that all the parties deal with documents & not with goods, services or performances to which the documents may relate. Under FOB, C&F and CIF contracts the exporter has the rights to receive the payment against the documents covering the goods.
These documents are stipulated in two relative sales & purchase contracts & translated into documentary credit.
The letter of credit by its nature is separate from the sales contract
In simple terms, a letter of credit is an undertaking by a bank to make a payment to a named beneficiary within a specified time, against the presentation of documents which comply strictly with the terms of the letter of credit.
Its main advantage is providing security to both the exporter and the importer, but the security offered, however, comes at a price and must be weighed against the additional costs resulting from bank charges. The exporter must understand the conditional nature of the letter of credit and the fact that payment will not be made unless the terms of the credit are met precisely.
A letter of credit is opened by an importer (applicant), to ensure that the documentation requested reflects and proves that the seller has performed under the requirements of the underlying sales contract, by the exporter by making them conditions of the letter of credit (N.B. The sales contract is not an inherent part of the Letter of Credit, although the Letter of Credit may contain a reference to such contract). For the exporter a letter of credit, apart from cash in advance, is the most secure method of payment in international trade as long as the terms of the credit are met
How a Letter of Credit Transaction Works.
1.The buyer (applicant) and seller (beneficiary) conclude a trade contract, wherein both agree on terms for delivery, amount, and quality of the goods, as well as on the payment method. The contract should also specify the important points to be included in the Letter of Credit;
2.The buyer gives instructions to his or her bank (Issuing bank) to open the Letter of Credit in favour of the seller;
3.The issuing bank sends the Letter of Credit to the Advising bank, which usually is located in the country of the seller;
4.The Advising bank tests the authenticity of the Letter of Credit, and informs the seller;
5.The seller compares the Letter with the contract. If the Letter matches the terms of the agreement the seller ships the goods and assembles all the documentation laid out in the contract;
6.The seller submits the documents to the advising bank;
7.The Advising bank verifies the documents. If the documents correspond to the terms of the letter of credit the Advising bank proceeds with the payment method that is specified in the Letter;
8.The Advising bank forwards the documents to the Issuing bank;
9.The Issuing bank verifies the documents and transfers the payment amount to the Advising bank.
When an exporter asks for payment by letter of credit, he is transferring the risk of non-payment by the buyer to the issuing bank (and the confirming bank if the letter of credit is confirmed), providing the exporter presents the required documents in strict compliance with the credit.
An importer should only be thinking of opening a letter of credit if his country’s exchange control regulations require it or if his supplier insists upon it. It is worth noting that over 50% of letters of credit are rejected on first presentation, which can cause expensive delays for both the exporter and importer.
Up to one half of these rejections could have been avoided if more care was taken to ensure the credit properly represented the sales contract.
Exporters will need to be certain that it is necessary to use a letter of credit.
Typical considerations include:
•Is it a legal requirement in the importing country?
•What is the value of the order - will the bank charges be out of proportion to the value?
•'Always Traded This Way' - always using letters of credit for a particular customer or region without periodically re-assessing the reasons for requesting this method of payment
•What is the credit rating of the importer and are they a new customer or has a trading relationship already been established?
•What is the country risk of the importing country (would a confirmed letter of credit be more suitable)?
•What is the standing of the issuing bank (would a confirmed letter of credit be more suitable)?
•What is the usual practice in trading with that country and in that particular commodity?
•Are there any other measures that could be taken to protect the exporter (e.g. credit insurance)?
•Insistence by a Credit Insurer to trade on letter of credit terms with buyers in certain markets.
•Recommendation by banks who may advise that the best method of payment is a 'confirmed irrevocable letter of credit' irrespective of the country, strength of issuing bank and without much regard to the value of the consignment.
•Strategic Decision Made by the Exporter - however, this strategy should be flexible to adapt to the changing risk profile of both the country and the buyer.
It is important to remember that all parties in the letter of credit transaction deal with documents, not goods.
PARTIES TO A LETER OF CREDIT
The following are the parties to a Letter Of Credit
1.APPLICANT/IMPORTER
He is the person who is the Opener on whose behalf the Letter Of Credit is opened by the bank.
2. APPLICANT’S / IMPORTER’S BANK
The bank who issues or opens the Letter of Credit on behalf of the Importer/ Customer.
3. EXPORTER
He is the beneficiary of the Letter Of Credit who is entitled to receive the payment of his bills according to the terms of Letter Of Credit.
4. INTERMEDIARY / CONFIRMING BANK
It is the bank usually a branch or the correspondent of the opening bank in the exporting country through which the credit is advised to the exporter.
If it merely forwards the credit without any obligations on its part it is called the ADVISING / NOTIFYING BANK.
If the beneficiary bank add its own undertaking to the credit while advising it to the beneficiary it becomes a CONFIRMING BANK.
5. PAYING / NEGOTIATING BANK
The bank which negotiates the beneficiary’s bills under the credit & pays for it is known as Paying/ Negotiating Bank
RIGHTS & RESPONSIBILITIES OF PARTIES TO LETTER OF CREDIT
All the parties to a Letter Of Credit have certain rights & responsibilities which are certified in the UNIFROM CUSTOMS & PRACTICE FOR DOCUMENTARY CREDIT.
It is important to note that all the parties deal with documents & not with goods, services or performances to which the documents may relate. Under FOB, C&F and CIF contracts the exporter has the rights to receive the payment against the documents covering the goods.
These documents are stipulated in two relative sales & purchase contracts & translated into documentary credit.
The letter of credit by its nature is separate from the sales contract