What is a letter of credit?
It’s a tried and tested method of getting paid, but what exactly is a letter of credit, and what does it entail for an exporter? Once considered too paperwork-heavy, this payment method has seen a revival in this more risk adverse global economy.
A documentary credit (DC), also known as a letter of credit, can be described as advice issued by a party—usually a bank or other financial institution—authorising the payment of money to the exporter, against delivery of specified documents as evidence of the shipment of described goods.
A DC constitutes an undertaking by the issuing bank that, providing all the terms and conditions of the DC are met, they will pay the invoice amount. This payment undertaking is independent to the underlying contract of sale. DCs can be issued either at ‘sight’ or with credit terms, for example ‘60 days after sight’.
DCs are issued under a framework of rules to which all banks subscribe: the Uniform Customs and Practices for Documentary Credits published by the International Chamber of Commerce (ICC).
The creditworthiness of the issuing bank, (credit risk) and the country of issue (political risk) are important considerations when accepting DCs as a form of payment.
The importer requests a DC from the issuing bank, which may subject it to a credit assessment before agreeing to issue a DC. The issuing bank then forwards the DC to the beneficiary via an advising bank, typically in the country where the exporter resides.
Once goods have been shipped, the exporter collates the required financial and shipping documents including drafts, invoices, bills of lading and any other documents specified in the DC. The exporter then presents all requisite documents to a negotiating bank, normally located in the country of residence, for negotiation and/or payment.
The negotiating bank reviews the documents against the DC terms and conditions. They will advise whether the documents contain any ‘discrepancies’ against the DC terms. It is important that documents do not contain discrepancies as non-compliant documents can enable the issuing bank to waive its payment undertaking.
Benefits of Letters of Credit
Some benefits of DCs include that the issuing bank’s creditworthiness is substituted for that of the buyer’s; this security for the exporter is normally the fundamental purpose of a DC. The necessity for the seller to assess the buyer’s creditworthiness is removed as the seller has a greater certainty of payment while the buyer is sure of receiving documents.
Furthermore, for a fee, the exporter can ask the negotiating bank to underwrite the ‘documentary’ risk—ensuring documents conform to the DC’s terms—and payment risk, which is credit risk on the bank and country from where the DC is issued. This is known as a DC confirmation.
Exporters can use the DC to offer terms to buyers, giving them a competitive advantage without having to take on the buyer risk for payment. Exporters can ask their banker to purchase or discount conforming documents presented under the DC for early access to cash flow.
Other than pre-shipment payment, the DC remains one of the safest the payment options as it provides the exporter with greater payment security at a minimum level of risk. It also gives them a tool that can be used to obtain early cash flow from their bank.
DCs are also a tried and tested instrument with all parties having a clear framework, the ICC rules, under which disputes can be resolved.