The primary aim of a letter of credit is to provide increased assurance to both the buyer and seller of the fulfilment of each party’s obligations in a commercial trade.
There are both benefits and drawbacks to using a letter of credit. For international trade, it can provide convenience as well as greater protection for all parties involved. Within this article, we’ll go through the different types of letter of credit. The article will pinpoint the benefits and drawbacks, as well as how it can be applied to a single or multiple business transactions.
How does a letter of credit work?
Essentially, a letter of credit is a document from a bank that guarantees payment. Banks issue letters of credit when a business applies for one and has the assets or credit to get approved. There are various types of letter of credit which can provide security throughout the buying and selling process.
In a letter of credit, the issuing bank affirms that a purchaser will pay for goods or services on time and for the exact amount due. If the purchaser doesn’t pay on time and in full, the issuing bank guarantees to cover the remainder of the overdue balance or the full amount of the purchase. This is particularly beneficial for international trade as this provides greater levels of security for exporters.
Banks issuing letters of credit must conduct their business in accordance with Uniform Customs & Practice for Letters of Credit (UCP). These are a set of guidelines covering all aspects of letter of credit operations issued by the International Chamber of Commerce (ICC) .
When should you use a letter of credit?
Letters of credit are used to minimise risk in international trade transactions. This is particularly useful when the buyer and the seller have not carried out previous business transactions. It can be beneficial for an importer to ensure you only pay for goods once the supplier has provided evidence it’s been shipped. As a result, this doesn’t impact your immediate cash flow since you wouldn’t need to make any advance payments or deposits to the exporter. Finally, the letter of credit gives you instant credibility with an exporter by demonstrating your creditworthiness.
If you are an exporter, it’s insurance in case the buyer fails to pay for the goods you shipped. In this scenario, the financial institution would step in and cover the amount outstanding. The letter of credit also protects you against legal risks since you are ensured payment as long as delivery conditions have been met.
What are the different types of letters of credit?
There are a range of letters of credit to choose from. Depending on your business and credit guarantee, you might have a preference for a specific type. The most commonly used types of letter of credit are listed below:
Commercial letter of credit
A commercial letter of credit is most commonly used for international trade deals. A commercial letter of credit is typically used by a buyer of goods to pay the purchase price to the seller. In this case, the issuing bank will make the direct payment to the beneficiary. A commercial letter of credit must also be irrevocable as this provides all parties involved with security.
Standby letter of credit
A secondary payment method in which the bank pays the beneficiary only within the worst case scenario. Although a Standby letter of credit guarantees payment to a seller, the agreement has to be followed exactly as stipulated. For example, a shipping delay or misspelled name can cause the bank to refuse to make the payment.
Revolving letter of credit
A guaranteed payment arrangement with a bank that is used to facilitate repeat sales transactions in international trade. Essentially, this eliminates the need for businesses to complete a new letter of credit for each sale.
As a result, businesses can use the letter for numerous transactions until it has expired. Revolving letters of credit can be valid for at least 3 years or less. This can be beneficial for businesses who have a multitude of import & export orders based in different countries.
Traveller’s letter of credit
A traveller’s letter of credit guarantees that those going abroad, that issuing banks will honour drafts made at certain foreign banks.
Confirmed letter of credit
A confirmed letter of credit involves a bank other than the issuing bank guaranteeing the letter of credit. The second bank is the confirming bank, typically the seller’s bank.
By issuing the confirmed letter, the second bank agrees to pay the seller if the first bank fails to do so. Requiring this lowers the risk of default for the seller.
What are the benefits of using a letter of credit?
It reduces risk for international trade
A letter of credit is beneficial for various businesses who are importing and exporting goods. Letters of credit can act as indispensable tools for guaranteeing payment to buyers and sellers in many situations. This helps payment go smoothly in deals with complicated details, such as international laws. Additionally, it also helps build and strengthen relationships between new vendors just beginning to do business together.
It is customisable to suit unique trade transactions
A benefit of a letter of credit is the ability to adapt the terms and conditions for each deal. Therefore, with each transaction, there can be specific details which can be adapted. This creates greater flexibility to add or remove selected terms and conditions suited to businesses needs. If the bank doesn’t agree to your initial shipping terms, there is also the option of obtaining an amendment to a letter of credit.
Using a financial institutional bank provides greater assurance
With banks involved to facilitate payment, there is a greater level of assurance and security. It also shows that the importer of the goods is likely a credible business since a financial bank has agreed to provide credit for a single deal. Additionally, there is also lower risk as payments are transferred from the seller to the bank.
Are there any drawbacks?
It costs an additional fee
The expense of a business transaction is increased by a letter of credit. Banks charge a fee for this service, which might rise dramatically if the parties decide to include certain extra features. As a result, considering alternative methods than a bank could be beneficial.
There is a potential fraud risk
A letter of credit can include complicated regulating requirements. Consequently, some buyers or sellers could try to manipulate and take advantage of this. A potential fraud risk is the beneficiary of a letter of credit transaction preparing fake documents. The documents could look as if they comply with the terms and conditions on face value, to make the presentation to the issuing bank. As a result, the issuing bank may accept the documents. This could result in the applicant paying the issuing bank for goods which were never delivered.
There is no financial protection for mitigating circumstances
In the case of economic or financial market changes, businesses are not covered financially or able to renegotiate terms. There are a multitude of circumstances during transactions which could alter the total payment costs.
For instance, inflation can have an effect on foreign exchange rates and create supply chain issues. Although these are external issues, it doesn’t discount the fact that businesses are not protected by potential financial losses due to unforeseen events.
Is a letter of credit the right option for your business?
A letter of credit can be a useful option for businesses. In particular, this option could benefit businesses who are operating within international markets and want greater security for commercial transactions. With the letter of credit being customisable, contracts can include specific terms and conditions. As a result, businesses can make a document specific to each deal and fit the unique trade requirements.
Depending on your industry, business size, location and market could impact whether it’s the right choice for your business. There are various means and circumstances for using a letter of credit. For companies who operate in more than one country or import or export goods, there are definitely benefits to using it. Nonetheless, the additional costs will need to be factored in during the decision making process.
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