A letter of credit (LC) is a guarantee of payment from an importer’s bank, addressed to an exporter. The payment promise is conditional, as it requires the exporter to provide named shipping documents to the advising bank within a specified time.
The English name ‘letter of credit’ derives from the French word ‘accreditation’, a power to do something, which in turn is derivative of the Latin word ‘accreditivus’, meaning trust.
Four Main Payment Methods for Exporters and Importers
A LC is one of the four main methods of payment used between exporters and importers. The other three are:
- Open account.
- Cash against documents.
- Payment in advance.
Apart from payment in advance, a LC is the most secure method of payment for the exporter. There are several forms of LCs: revocable, irrevocable, confirmed, transferable, revolving and standby.
Revocable, as its name suggests, can be withdrawn or cancelled at any time by the importer or its bank, so this provides little security for the exporter. Irrevocable, on the other hand, eliminates this risk, as both exporter and importer have to agree any change.
Confirmed LCs go a step further than irrevocable, as the exporter’s bank guarantees payment if the issuing bank should default. This type of LC is useful when dealing with markets where the risk of external political events could frustrate or delay the transfer of the chosen currency.
Back-to-back LCs are when two LCs are involved – one between the exporter and the applicant, and one between the exporter and the supplier. Transferable LCs are used when there is more than one beneficiary. Revolving LCs cover a series of shipments and allow payment by instalments. The LC is ‘topped up’ when a shipment is made to cover the next.
Standby LCs can also be used as alternatives to bank guarantees, and will only become activated if the applicant fails to perform.
Security Advantages of LCs
The seller gains a number of advantages by using LCs, such as payment security and security against any political event in the country (such as war or civil uprising) when using confirmed LCs. Funds are usually released as soon as conforming documents are presented which can mean an improvement in cash flow.
However, there are some disadvantages. Bank charges to both buyer and seller are incurred, as banks will charge for the administrative work involved and for taking a commercial risk. Confirmed LCs are the most expensive in terms of bank charges. There are also meticulous documentation demands in terms of ensuring the documents are in absolute conformity. The preparation of documents requires skilled and demanding standards from a knowledgeable member of the export shipping team. Your employees would also need to have an understanding of UCP600, which is the latest addition of ICC Uniform Customs and Practice for Documentary Credits.
Opening a LC
Opening a LC requires the importer to instruct its bank to open the LC in accordance with the terms of sale. LC Expedite, for example, checks applications prior to issue, thereby reducing risk of amendment charges and delays in shipment.
The issuing bank (the importer’s bank) will advise the credit details, usually by a SWIFT message to the exporter’s bank. The exporter’s bank will check the details and advise the LC to the exporter. The exporter needs to check the terms thoroughly to ensure the LC is workable. If any changes need to be made, these need to be agreed with the importer and arranged through the bank in the form of a LC amendment.
When checking LCs, it is advisable to check the following points:
- The LC is governed by UCP600.
- Is it irrevocable? Is it confirmed?
- Are documents payable at sight or by deferred payment?
- Does the value, currency, shipping incoterm (delivery), description of goods match the contract?
- Do you have enough time to manufacture and ship?
- Do you have enough time to present?
- What documents have been specified, can you fulfil these requirements?
- Is the LC operative?
- Is transhipment and part shipment allowed?
- Who will pay bank charges?
- Is the beneficiary and applicant’s name and address correct?
The above is not an exhaustive list of the details that should be checked, but gives you an idea of the type of details that, if overlooked, could cause difficulties later.
Some of the documents called for under a LC:
- Commercial invoice.
- Bill of exchange (also known as draft).
- Packing list.
- Transport document.
- Insurance certificate.
- License, embassy legalisation, origin certificate, inspection certificate, phytosanitary certificate, etc.
- Plus any other documents that were agreed within the sales contract.
Mistakes are Costly
Making mistakes, however slight, will result in rejection of the documents. It is estimated that banks reject 50% of LC presentations due to discrepant documents. This, combined with the ever-increasing demands of the shipping department, has led to some companies outsourcing this complex service to agencies. Agencies are able to focus solely on this element of the transaction leaving employees to focus on other aspects of the supply chain.
Re-checking documents puts a strain on the ever-reducing bank staff and triggers extra costs for the exporter or buyer (depending on who is liable for the bank charges within the LC).
If you are not versed with the procedures and intricacies of the LC process, then the costs can be significant. UK banks average charges are in excess of £50 for an amendment, and the same again if documents are found to be discrepant at the time of presentation.
If documents are discrepant, this will also lead to delays in getting paid, and original documents reaching the market of destination, resulting in delays for your customer in clearing the goods.
Outsourcing Increasingly Popular and Cost Effective
Outsourcing the LC function has become increasingly popular and cost effective. For example, LC Expedite, a specialist agency for handling LCs, charge fees from as little £125 for a ‘full presentation service’ depending on the complexity of the LC. We also check customer LC applications prior to LC issue, avoiding expensive amendments once the LC has been issued. Dealing with a LC agency ensures that accuracy is achieved on the first application and therefore transactions are expedited quickly and costs are minimised.
Some companies have outsourced their LC function because of the difficulties they have in recruiting skilled staff within this area. The advantages of using an outsource company are:
- Use of experienced staff who are trained and experienced in use of LCs for exports to worldwide destinations.
- Can often work out cheaper to use than employing your own staff as they tend to charge a one-off fee per presentation.
- Can solely focus on this area of the business, leaving your staff to concentrate on other key areas of the supply chain.
- It is fairly typical for some companies to use LCs irregularly, so when their staff do work with them they can be ‘rusty’ and out of date with regulations, increasing the risks of bank charges, and delays in shipment and payment.
- Delays caused by discrepancies can often cause frustration, and demurrage costs for your customer if goods are stuck in customs at destination waiting for the originals to reach them through the banking network.
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