When a given seller has some concerns about the credit-worthiness or solvability of his buyer, precautionary measures must be adopted. In much the same way, the buyer might want to make sure that he pays for goods that he ordered. This is where a payment known as the documentary letter of credit (L.C) comes in, as a secure solution for international trade transactions.
This payment method, developed in 1933 by the International Chamber of commerce is based on a set of rules, known as the Uniform Customs and practice for Documentary credits (UCP) which are considered as a worldwide standard by financial institutions and professionals alike.
Overtime, the UCP’s have experienced several revisions up to the “UCP 600” version, which is effective since the 1st of July 2007.
The figure below depicts the different steps of the letter of credit payment process.
The Buyer and the Seller make a deal and the sales contract indicates that the letter of credit is selected as a method of payment.
The buyer asks his bank to issue a letter of credit, by determining a set of instructions that must be met meticulously by the Seller.
The issuing bank sends a notification (via SWIFT) to the advising bank located in the buyer’s country, which includes the details of the letter of credit and the full instructions that must be followed by the beneficiary / exporter (documentation, validity period).
The Advising bank informs the Seller that he is the beneficiary of the letter of credit and transmits the full instructions.
Note that the advising Bank has not obligation to pay the beneficiary.
However, if the issuing bank is located in an exotic country (country risk), the beneficiary can ask the advising bank to confirm the letter of credit and by then, becoming the confirming bank. In this case, the confirming bank will have the obligation to pay the beneficiary, providing that the documentation requirements are rigorously met.
Furthermore, the beneficiary must ensure that the letter of credit is irrevocable, as in the case of revocable letter of credit the issuing bank can cancel it unilaterally and at any time. Conversely, the cancellation of an irrevocable letter of credit requires the beneficiary’s consent.
The Seller is advised that he is the beneficiary of a letter of credit and informed of the extent of his obligations. At this stage, it is crucial that the seller makes sure that he will be able to provide the full documentation demanded by the buyer.
Indeed, if for some reasons, some instructions are difficult to comply with, it is extremely important that the Seller ask the buyer to amend the documentation requirements accordingly, as failure to do so, might compromise Seller’s ability to be paid.
In addition, as previously highlighted if the seller has some doubts about the reliability of the issuing bank, he might ask the advising bank (the local bank) to confirm the letter of credit and by then becoming the confirming bank.
By doing so, the exporter will ensure that if he meets the documentation requirements, the confirming bank will fulfil its obligation and pay the beneficiary.
The Seller provides the full documentation requested to the bank (confirming bank), and the Seller is paid accordingly. The letter of credit can be honoured in 3 ways:
Payment at Sight (against payment):
In this case the payment is processed as soon as the required documents have been provided.
This is when the Exporter accepts to finance the importer by accepting to postpone the payment at a later date (30,60 or even 90 days). Therefore the issuing bank has the obligation to complete the payment at the agreed maturity.
Here the issuing bank accepts the bill of exchange (also known as draft) within which the agreed payment date is specified. Note that when the letter of credit is confirmed, the confirming bank must be the drawee . Alternatively the issuing bank can be the drawee if it is reliable enough .In other words, the Importer should never be the drawee as the risk of non-payment is higher than if a bank takes the engagement to honour the letter of credit.
The advising / confirming bank transmits the requested documents to the issuing bank which will process the reimbursement.
The issuing bank transmits the documents to the applicant (buyer) and debits his account following the terms of the letter of credit.
Note that the letter of credit must not be conflated with the sale contract, as the later defines the terms of the deal concluded, while the former is a payment method.
All in all, we can see that the letter of credit cycle is pretty straightforward and it insures the seller that he will be paid if he follows strictly the buyers’ instructions. By the same token, the buyer can make sure that the payment is not processed before the ordered goods have been shipped.
This explains why the letter of credit has been so successful in addressing major obstacles in cross-border trading.
Having said that, we must nonetheless stress 2 main shortcomings:
No guarantee that the goods ordered by the Importer will be delivered.
In fact both, the issuing and confirming bank are only required to check if the documentation requirement is rigorously met which is to say that there is no inspection of what is in the cargo.
Simply put, the payment will be processed despite any divergence that might be detected during the unloading process. In other words, any disputes will relate to a breach of the sales contract terms will not allow to stop the payment, as long as the Exporter meets the documentation requirements.
However, this risk can be avoided with new exporters by including a clause, which specifies that a pre-shipment inspection will have to be processed by a third party (see private pre-shipment inspection companies).
Extremely high level of formalism
Most the documentation requested in the letter of credit must abide a strict form. If for some reasons, discrepancies are detected this could compromise the payment .
Examples of such inconsistencies can include:
Needless to say, that when the seller relies on a third party for obtaining such kind of documents, he has virtually no control over their issuance and as a result, this tend to increase the overall level of risk.
This is why it is strongly recommended to select the right Incoterms rule (for an explanation of the Incoterms click here) as this can affect Exporter’s ability to provide transport documents for instance.
Indeed, for the FCA, FAS and FOB Incoterms rule (F- class), the Exporter is not liable for transport costs, which are paid by the buyer and as result; it might be difficult to obtain transport documents.
In addition, one should be mindful when choosing DAT, DAP and DDP incoterms (D-class) as the delivery documents tend to be produced when the delivery is completed in the buyer’s country which might affect the ability to produce documents on time (when issues with local authorities are encountered such export clearance or VAT clearance for instance). In this case one should consider letter of credit standby instead.
On the other hand, by choosing Incoterms such as CPT, CIF, CFR and CIP (C-class), the Exporter does have a carriage contract and then a full control of the transport documentation, which is why, those Incoterms are well adapted to the letter of credit.
In conclusion, the letter of credit is a very interesting payment tool, which enabled the International trade to grow overtime.
In this presentation we have developed the logic behind the letter of credit process however we would like to stress that professionals willing to use this method cannot rely exclusively on this website (or any other website). We strongly recommend that you refer to full set of rules of the UCP 600 issued by the International Chamber of commerce in order to check for yourself, the full extent of your obligations while using this payment method.
(Note that a full explanation of each article of the UCP 600 will be available soon)