Letters of credit
Trading internationally can involve risks. Exporters run the risk of buyers failing to pay for goods, while importers may risk paying but never receiving anything. Because of the distances involved, it may be difficult to resolve any disputes.
One way of reducing the risks is to use a letter of credit. A letter of credit is a written undertaking by a buyer's bank to pay the exporter's bank: it guarantees a payment of a specific amount of money, provided the exporter presents the required documents within a fixed timeframe. This can offer a conditions guarantee to the seller that they will be paid, and the buyer can be sure that no payment will be made unless the bank receive documents called for under the letter of credit.
There are several different types of letters of credit available to use, depending on the circumstances.
This guide highlights the advantages and disadvantages of letters of credit, explains when to use a letter of credit and the types of letter of credit available. It also explains the international rules for letters of credit.
What is a letter of credit?
A letter of credit - sometimes known as 'documentary credit' - is basically a conditional guarantee from a bank that a particular seller will receive a payment due from a particular buyer. The bank guarantees that the seller will receive a specified amount of money within a specified time providing documents called for under the credit are presented in order.
Why use a letter of credit?
Letters of credit are most commonly used when a buyer in one country purchases goods from a seller in another country. The seller may ask the buyer to provide a letter of credit to guarantee payment for the goods.
Read more about the advantages and disadvantages of letters of credit.
Advantages and disadvantages of letters of credit?
Before using letters of credit you should consider their advantages and disadvantages.
Advantages of letters of credit
The main advantage of using a letter of credit is that it can give security to both the seller and the buyer.
Advantages for sellers
- By asking for an appropriate letter of credit a seller is reassured that providing they present documents in order and within an agreed timeframe they will receive their money in full and on time
- A letter of credit is one of the most secure methods of payment for exporters as long as they meet all the terms and conditions
- The risk of non-payment is transferred from the seller to the bank (or banks)
Advantages for buyers
- When a buyer uses a letter of credit they get a guarantee that the seller will honour their side of the deal and provide documentary proof of this
Disadvantages of letters of credit
- It's important to be aware of the additional costs involved in using a letter of credit. Banks make charges for providing them, so it's sensible to weigh up the costs against the security benefits.
- If you're an exporter you should be aware that you'll only receive payment if you keep to the strict terms of the letter of credit. You'll need to give documentary proof that you have supplied exactly what you contracted to supply.
- Using a letter of credit can sometimes cause delays and other administrative problems.
When to use a letter of credit
Considering the options before deciding to use a letter of credit for an overseas transaction
Exporting can provide businesses with extensive trading opportunities but can also present some challenges, particularly in the area of finance. One of these challenges is a mutual lack of trust between buyer and seller.
Buyers on the one hand may be afraid of paying up front for goods due to the risk of them not being delivered and the sellers on the other hand may be uncomfortable supplying the goods for fear they may not get paid. A letter of credit is the most commonly used solution to this issue. Payment is guaranteed to the seller providing documents called for, by the buyer, are presented in order and within the agreed timeframe.
Read more about how to manage the risks of exporting.
Exporters - deciding whether to ask for a letter of credit
Think carefully about whether or not you need to ask an overseas customer for a letter of credit. Some important things to consider include:
- National Exchange Controls - does the country you're exporting to have any?
- Costs - does the value of the order justify the bank charges and extra costs involved, and who pays these costs?
- The customer's creditworthiness - do they have a track record with you?
- Risks associated with the country you're exporting to - is it politically stable with a good reputation as an international trading partner?
- Normal trading practices - is it standard practice for exporters to use letters of credit when trading with that country, and/or in that particular commodity?
- Available advice and guidance - banks may recommend using of a letter of credit in certain trading situations regardless of other factors, while credit insurers sometimes insist on it.
Give some thought to alternative arrangements, such as credit insurance, export factoring or cash in advance terms.
If you do decide that a letter of credit is the best option you'll need to consider which type of letter to use. A 'confirmed and irrevocable' letter of credit is the most secure type.
It's wise to have a clear policy in your business about when to consider using a letter of credit. Reviewing your policy on a regular basis will help you avoid using them unnecessarily and possibly putting off would-be customers.
Types of letter of credit
There are five commonly used types of letter of credit. Each has different features and some are more secure than others. Sometimes a letter of credit may combine two types, such as 'confirmed' and 'irrevocable'.
Common types of letters of credit
A revocable letter of credit is uncommon because it can be changed or cancelled by the bank that issued it at any time and for any reason.
An irrevocable letter of credit cannot be changed or cancelled unless everyone involved agrees. Irrevocable letters of credit provide more security than revocable ones.
A confirmed letter of credit is one to which a second bank, usually in the exporter's country adds its own undertaking that payment will be made. This is used when the exporter does not find the security of an unconfirmed credit sufficient due to issuing bank risk or political and/or economic risk associated with the importer's country.
An irrevocable and confirmed letter of credit has not only the commitment of the issuing bank but also a binding undertaking given by the confirming bank to pay when the documents are presented in accordance with the terms and conditions of the credit. So a confirmed letter of credit provides more security than an unconfirmed one.
An unconfirmed letter of credit is one which has not been guaranteed or confirmed by any bank other than the bank that opened it. The advising bank forwards the letter of credit to the beneficiary without responsibility or undertaking on its part but confirming authenticity.
A transferable letter of credit can be passed from one 'beneficiary' (person receiving payment) to others. They're commonly used when intermediaries are involved in a transaction.
Other types of letters of credit
|Standby||A standby letter of credit is an assurance from a bank that a buyer is able to pay a seller. The seller doesn't expect to have to draw on the letter of credit to get paid.|
|Revolving||A single revolving letter of credit can cover several transactions between the same buyer and seller.|
|Back-to-back||Back-to-back letters of credit may be used when an intermediary is involved but a transferable letter of credit is unsuitable.|
International rules for letters of credit
International rules and standards that govern most commercial letters of credit
To standardise terms and procedures and avoid misunderstandings, a set of international rules for letters of credit have been developed by the International Chamber of Commerce (ICC).
Most commercial letters of credit are governed by these rules, which are referred to as Uniform Customs and Practice for Documentary Credits (UCP). The current version of the rules is UCP 600, which came into effect on 1 July 2007.
The UCP standards give definitions of important terms that are used in letters of credit. When referring to letters of credit, banks and others involved in international trade will generally use the UCP definitions of key terms and phrases.
UCP also sets out general documentary requirements and standard practices for handling letters of credit.
Using UCP 600 letters of credit
Because UCP 600 standards are internationally recognised it's always best to use letters of credit that are covered by them. If you're an importer you may well find that sellers require you to use UCP letters of credit.
If a letter of credit is subject to UCP it will state this somewhere on it. It might include a statement like 'This letter of credit is subject to the latest version of Uniform Customs and Practice for Documentary Credits published and updated by the International Chamber of Commerce'.
Be aware that in some instances the definitions and procedures set out in the UCP standards may differ from the laws of a particular country.