Letters of Credit are a bank instrument for facilitating trade. It alleviates the risk of the purchaser defaulting on their payment by transferring the risk onto the issuing bank. It ensures that the bank is now responsible for paying the seller, assuming all conditions are met.
Key learning objectives:
- Define Letters of Credit
- Explain the process of using Letters of Credit to remove the credit risk of the purchaser
- Outline the different specifications featured in Letters of Credit
What are Letters of Credit?
Letters of Credit (LCs) are a key bank instrument to assist with trade finance; a promise from the bank that payment will be made to the seller once certain documentary standards are met. A Letter of Credit removes the credit risk of the purchaser from the transaction by replacing it with the credit risk of the issuing bank. In cases where the bank itself is not a fantastic credit, the seller will get their own bank to confirm that the Letter of Credit is valid.
What is the difference between Letters of Credit and credit insurance?
Credit insurance covers the event where the purchaser is unable to pay, it does not cover the event where he is simply unwilling to pay because of a dispute over goods. An LC is an objective instrument which guarantees payment, as long as the key conditions precedent for payment are met.
What are the mechanics of using an LC?
The seller may ask the purchaser to provide them with a Letter of Credit in the event the seller is unwilling to pay the cost of transporting the goods, if they are uncertain the purchaser will be able to pay.
The purchaser goes to their bank and requests the issuance of a Letter of Credit. In most cases (especially for SMEs), the bank will require the purchaser to keep the relevant amounts of funds on deposit with them (“cash collateralisation”) during the life of the LC. Once the delivery of the goods has been made, the Issuing Bank will send the funds to the seller.
The LC, whilst not part of the commercial contract, will have a series of conditions attached to it relating to the documents that must be provided to the bank before payment is made. As long as those conditions are met then payment will occur and the purchaser cannot stop it.
What are the different specifications featured in Letters of Credit?
Sight vs. Deferred - Letters of Credit can either be “sight” (in that they are paid immediately upon production of documents) or “deferred”, where payment is made a given number of days after the presentation of documents.
Revocable vs. Irrevocable - They can be issued in “revocable” form (at the behest of the Issuing Bank or the buyer) or “irrevocable” form, in which case the bank, the buyer and the seller must all consent to variation.
Transferable vs. Untransferable - Letters of Credit can also be transferrable or untransferable. In many cases where the transaction forms are part of a supply chain, transferability is desirable so that sellers further up the supply chain can be beneficiaries of the transaction as well.
Are Letters of Credit regulated?
Yes, Letters of Credit are governed under a set of guidelines called UCP600, which were created by the International Chamber of Commerce. They lay out standard rules as to how banks deal with them.