Letters of Credit:The Risks, Processes and Responsibilities

Letters of Credit:The Risks, Processes and Responsibilities
The typical letter of credit process starts with the application by the importer to his bank. As the bank will be “taking on” the risk of payment on its customers behalf, this is a credit decision which the bank will need to allocate a limit for. Once a limit has been established, the bank will transcribe the details of the application to an official document which becomes the letter of credit. Nowadays most letters of credit are issued in electronic form and are authenticated in the same manner.

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The requirement for issuance of a letter of credit

Letter of Credit Process

The letter of credit process has become second nature to many companies involved in international trade on both sides of the transaction. The requirement for issuance of a letter of credit is generally included in the sales contract issued by the seller, whether that relates to a one-off trade or a continual relationship. It is normal in an ongoing relationship that when an order is placed it is accompanied by a confirmation that the letter of credit has been applied for and marks the start of the L/C payment process.

Once the exporter has received a letter of credit, he will arrange for the terms of the contract to be fulfilled and the goods to be shipped. The exporter will need to be aware of the expiry date of the commercial letter of credit in order they can receive payment once they present documents. The documents must be presented to the bank for payment prior to the expiry date of the of the L/C but, at the latest, within three weeks of the “shipped on board date” of the bill of lading. The “shipped on board” date of a bill of lading is a date, stamped and signed upon the shipping document, that confirms that the goods have been accepted for shipment by the shipping company. Convention determines that documents must be presented for payment within twenty one days of that date.

sales contract between importer and exporter

Import Letter of Credit

The import letter of credit has a set expiry term, in accordance with the sales contract between importer and exporter. Several documents are required to be delivered by the seller in order to get paid.

Most commonly they consist of:

  • A Commercial Invoice, often with details specified under the terms of the L/C.
  • A bill of lading: This is a document issued by a shipping company which confirms they have taken delivery of the goods for shipment. The most important item on this document is that it has a shipped on-board date which means that the goods have been loaded on a vessel and are not sitting on the quayside.
  • An insurance document
  • A Certificate of Origin verified by a trade body such as a Chamber of Commerce

There are several ancillary documents which may be necessary for the shipment of certain goods or delivery to certain countries, but these are the common requirements.

Banks and other L/C issuers charge for the risk they are accepting

Trade Finance Letter of Credit

Trade finance letter of credit costs are generally split between the two principals to the transaction. Banks and other L/C issuers charge for the risk they are accepting, any additional work (such as issuing an amendment to the original L/C), and any out of pocket expenses.

It is usual for the importer to pay the issuance fee and the exporter to pay for confirmation. Of course, if the importer believes the requirement for a letter of credit to be superfluous, he may insist on the exporter paying. Equally if the exporter feels that accepting an L/C from a lowly rated country or bank is vital, he may insist on the importer paying the confirmation fee.

Amendments to letters of credit are common. They often relate to a shipping delay and the expiry date must be extended. Most amendments are due to the actions (or lack thereof) of one party or the other and the fee charged by both issuing and confirming banks are open to negotiation, unless there is a stipulation in the original shipping contract.

In summary, Letters of Credit have been in existence, in one form or another for centuries and it is essentially the method of their delivery that has changed.

Following the advances in financial technology and the acceptance of several types of new financial businesses, this is an area which has the potential to rival in size the non-bank payments networks.

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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.”