What is a letter of credit?

What is a letter of credit? article image

documentsIt’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.

Drawbacks of Letters of Credit

On the flipside, DCs can be very detailed, so strictly complying with the terms and conditions can be problematic for some exporters. The fundamental reason the exporter asks for the DC as the trade settlement method is so they have better control of documents through the banking system and the issuing bank’s protection. As discussed, this protection is weakened if they fail to present compliant documents, which can result in the payment undertaking being waived. Banks will generally charge handling fees for processing DCs and assuming the payment risk; both exporters and importers may incur fees, so if buyer and country risk are sound, exporters might choose to settle using a method that incurs less cost. Exporters that have strong credit policies find using DCs appealing as it reduces credit risk by replacing buyer risk with the risk of the issuing bank. Many exporters insist on DCs for all sales, particularly in emerging export markets. Where the trading relationship with the buyer is a new one, an exporter may wish to use a DC for initial trading, then move to a different payment method once trust and a track record with a buyer has been established.

Letters of Credit and risk

In recent years, DC use declined as exporters became more comfortable with counterparty global risk, given the ability to attain information quickly through electronic sources. The long period of buoyant conditions and the desire to minimise costs saw a marginal decline in DC use. Other payment methods include open account payment, clean settlement by international payment without involving documents through banks; and documentary collections where banks, on behalf of exporters, handle documents without the implicit payment undertaking that a DC provides. Each method carries its own pros and cons, however, the only way an exporter can gain more safety than a DC is to be paid in full pre-shipment. In many occasions this is not commercially viable as the importer would be take the risk of non-delivery of goods. With the recent turmoil in financial markets, and subsequent defaults by corporations, including banks, on the rise, exporters have returned to the relative safety of DCs to mitigate payment risk issues and to allow a better control of documents through the sale process. There will always be a place in the market for DCs as they offer a secure way to facilitate cross border trade. Recent statistics suggest that DC activity has increased during this period of economic turmoil, which is a swing away from trends in the past decade. One could reasonably expect that post-global financial crisis, when exporters confidence returns, the level of DC settlement will again stagnate. Exporters with strong credit policies have and will continue to use DCs. In some markets, exporters trading on DC terms get better access to credit lines for working capital use. -Geoff Cox is the general manager of Trade and Supply Chain Finance and National Australia Bank:

Letters from the GFC

Consider this situation: you’re a growing small business producing machinery for a niche industry. You have a keen overseas buyer, but there are two obstacles to closing the deal. One, your buyer proposes to make payment by documentary letter of credit, but your Australian bank won’t confirm a letter of credit issued by the buyer’s overseas bank. Two, because of the high cost of the machine, the buyer wants to spread their payments over a number of years. This isn’t feasible, as it would put too much strain on your working capital. The current uncertain economic environment sees a tight credit market with banks averse to risk; this is reflected in an unwillingness to confirm letters of credit issued by banks they are unfamiliar with, or in jurisdictions they consider higher risk. There is also a growing reluctance among banks to confirm letters of credit that have a term of more than a few months. In this case, EFIC can issue a documentary credit guarantee to your bank. This means EFIC takes on the risk that the buyer’s bank won’t pay your bank, and enables your bank to confirm that it will make export contract payments to you. The added confidence that you’ll get paid, and therefore that your working capital won’t be stretched, may allow you to offer extended payment terms to an overseas buyer, making your contract bid more competitive. The letter of credit may be structured so that although your buyer makes payments to its bank over several years, your bank will pay you under the letter when you deliver the goods and provide the appropriate documents. In a recent example, EFIC helped a farm equipment manufacturer enter a contract with a buyer in Turkey. The machinery cost around $1 million per unit, so buyer requested extended payment terms. EFIC provided a guarantee to the exporter’s Australian bank, guaranteeing the payments due from the buyer’s Turkish bank under a letter of credit. EFIC’s involvement enabled the buyer to pay their Turkish bank for the equipment over five years, which was a deal winner for the Australian exporter. -Peter Pyrgiotis, former head of Business Development at the Export Finance and Insurance Corporation:


Leave A Comment

Spinning icon Saving your comment, please wait...
Spinning icon Saving your comment, please wait...