Why is it more secure to have a Letter of Credit confirmed?

Why is it more secure to have a Letter of Credit confirmed?
A Letter of Credit is a document which means that a third party, generally a bank, stands between the buyer and seller of goods, guaranteeing that if the seller complies with the terms of the Letter of Credit, he will be paid in conjunction with its terms. It provides the necessary confidence to a seller that, irrespective of the fate of his client, if he ships the goods that have been ordered he will be paid on time.

Take, for example, a seller in the UK selling goods to a company in South Africa. The terms negotiated between the two parties are that the seller will pay all charges up to and including the loading of the goods onto a vessel at a UK port.

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He will need to provide a detailed invoice of the goods supplied, a certificate of origin of the goods, a bill of lading which shows that the goods have been taken by the shipper for transport to South Africa, and the bill of lading bears a stamp that the goods have been “shipped on board” a vessel for shipment within the prescribed date. Provided the documents are presented to the issuing bank within the validity of the Letter of Credit the shipper will receive payment.

bank advises the Letter of Credit to the Beneficiary
Most letters of Credit are delivered to the beneficiary (shipper) by a bank in its home country. This bank “advises” the Letter of Credit to the Beneficiary and while they will check the documents when they are presented; they have no obligation regarding settlement which is carried out by the issuing bank, generally in the country of the applicant. For all intents and purposes, the advising bank acts as little more than a post office and charges little more than a nominal fee for the service.

For several reasons you may want the letter of credit to be “confirmed” by the advising bank. In our example, the bank in the UK would add its confirmation to the Letter of Credit and become the confirming bank rather than simply advising. The Confirming Bank stands in the place of the issuing bank and guarantees payment irrespective of the issuing bank or applicant’s ability to pay. If documents that comply with the terms of the Letter of Credit are presented the confirming bank will settle under the payment terms.

If the terms of the Letter of Credit are not for payment at sight the Confirming Bank will add its acceptance to the usance draft and will often discount the draft allowing the beneficiary to receive his funds immediately.

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The confirming bank will charge a fee for adding its confirmation to the Letter of Credit which is considered compensation for taking on the risk of the issuing bank. If there is also an acceptance required, the confirming bank will charge an additional fee linked to the length of time the acceptance is outstanding.

A confirmed letter of credit is as secure as a shipper can get, he will receive payment if he complies with the Letter of Credit and ships the goods that have been ordered.

initial negotiation stage as they begin a relationship
It is normal that matters like fees etc. will be discussed and agreed upon between the two parties at the initial negotiation stage as they begin a relationship. A supplier may demand a confirmed L/C paid for by the buyer. As the relationship develops, the buyer may request that need for a confirmed L/C be dropped or alternatively that the shipper pays the premium demanded by the confirming bank. Eventually, as the relationship matures, an agreement may be reached where no L/C is necessary and the seller simply presents the documents through a bank to add a measure of security to the transaction.

An unconfirmed L/C is usually acceptable when the credit rating of the issuing bank is sufficient that the advising bank adding its confirmation would appear superfluous. Also, a bank will not be required to add its confirmation to a branch of the same bank overseas that issues an L/C in favour of one of its customers.

For example, HSBC would not be required to confirm an L/C issued by Deutsche Bank in Frankfurt as the confirmation would add little additional comfort. Also, Deutsche Bank in London would not add its confirmation to a Letter of Credit issued by Deutsche Bank Johannesburg.

The security provide by having a letter of credit confirmed in your home country means that you will be paid more quickly than were you have to wait for documents to be presented to the issuing bank. Furthermore, you can rely on the security of a bank regulated in your home country to be in a position to perform its duty under the terms of the L/c without and concern over its creditworthiness.

About Alan Hill

Alan has been involved in the FX market for more than 25 years and brings a wealth of experience to his content. His knowledge has been gained while trading through some of the most volatile periods of recent history. His commentary relies on an understanding of past events and how they will affect future market performance.”