Using Letters of Credit for International Payments – Overview
This document presents an overview of how letters of credit are used as payment documents, primarily in international trade.
A letter of credit is a commitment by one or several banks to pay a seller a certain amount of money, provided the seller meets the terms of the letter of credit. The difference between a letter of credit and other types of payment is that the letter of credit requires the fulfillment of its terms before payment is made (for example, that samples must be sent, or that the goods must be delivered before a certain date).
Letters of credit constitute the safest payment method in international markets, mainly due to the internationally acknowledged regulations for using letters of credit.
Outcome
For more information, see Managing Trading Risk.
Before you start
Purpose
The purpose of the letter of credit is to function as a a commitment of payment between seller and buyer. The advantages of using letters of credit are:
- The seller is guaranteed by both the buyer and the buyer’s bank that the seller will be paid for the shipment, provided the seller comply with the terms of the letter of credit
- The buyer is guaranteed that there is no obligation to pay for the shipment until the seller has complied with the terms of the letter of credit
- There are several forms of letters of credit: Confirmed or unconfirmed, revocable or irrevocable, for example. This makes a letter of credit a very flexible payment document.
When
Making payments by means of letters of credit is in certain areas of commercial activity the established practice. For the most part, letters of credit are used to pay for merchandise in foreign trade.
Some specific situations in which an exporter may select letters of credit as the preferred payment method are:
| The Seller’s Situation | Advantages of Using Letters of Credit |
|---|---|
|
The seller is not able to afford any payment risk. Or, the seller has no previous knowledge of the buyer on which to base a credit decision. Or, the economic or political situation in the buyer’s country may be a major risk factor. |
The seller relies on the credit of a bank rather than on the creditworthiness of the buyer. The funds are available immediately. Collection costs are lower. |
| The seller needs bank credit to finance his/her part of the transaction, including the manufacturing and sale of the goods. |
The seller may arrange with his/her bank to receive payment as soon as all documents involved are approved. This is a common procedure in the Far East. In certain countries the seller may raise a loan on the letter of credit. |
| The seller wishes to facilitate the process of obtaining export permits. | Depending on the arrangement between the buyer and the seller, |
| The established practice requires of the seller to make payments using letters of credit. | The rules for using letters of credit follow an international convention. This means that the same rules are applied in practically the entire world. |
The buyer may ask the seller to use a letter of credit for making payment in the following situations:
| The Buyer’s Situation | Advantages of Using Letters of Credit |
|---|---|
| 1. The buyer wishes to make sure that the seller has complied with specific terms before having to pay for the goods. |
As a buyer, you can control the sales terms more effectively. For example, you may specify that samples be sent or indicate when the goods must be delivered. The seller will not receive payment until all these requirements are met. |
| 2. The buyer wishes to use letters of credit to finance the purchases. | Considering the safe nature of the letter of credit, it is easier to obtain a credit from the supplier. |
How
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Parties involved
The typical situation involves the following four parties:
Party Definition 1. Buyer, importer, or applicant The party for whose account and on whose behalf the credit is opened. 2. Seller, exporter, beneficiary, or shipper The party to whom the letter of credit is addressed and to whom payment is made. 3. Opening bank, buyer’s bank, issuing bank The bank which originally established the credit 4. Advising or confirming bank, the opening bank’s correspondent Usually the exporter’s bank and negotiating bank. (For the sake of simplicity in this document, we call this the seller’s bank.) -
The letter of credit flow
A typical flow of using letters of credit would look like this:
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The buyer wants to buy specific goods.
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The buyer checks the effect a letter of credit would have on his/her working capital and credit positions.
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The seller checks that the buyer is a reputable firm or individual.
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The buyer enters into an agreement with the foreign seller.
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The buyer requests his/her bank to open a letter of credit in favor of the exporter by sending in an application. The amount indicated should be made available until a specified time. Note: The form and wording of the letter of credit and the pertaining documentation as stated in the application is very important: If the seller has shipped the wrong article or quantity, for example, the buyer’s bank will still pay the seller, provided the documents on their face conform to the letter of credit.
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If the buyer is considered creditworthy, the buyer’s bank opens the letter of credit and sends it to the corresponding bank (usually the seller’s bank) together with instructions on goods delivery and the documentation required for confirming shipment of the goods. The buyer’s bank may also request the seller’s bank to confirm the letter of credit (see below).
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The seller’s bank notifies the seller and forwards the documents.
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The seller carefully and as soon as possible reviews the letter of credit and the terms stipulated. If any detail deviates from the original agreement or is incorrect, the seller contacts the buyer for correction.
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The seller prepares the delivery and the required documents.
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Immediately after the goods have been placed on board the carrying vessel, the seller sends the necessary documents to his/her bank.
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The seller’s bank checks that the documents are in agreement with the terms of the letter of credit.
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The seller’s bank sends them to the buyer’s bank. (If the letter of credit was irrevocable and confirmed by the seller’s bank, the seller’s bank may pay the seller already at this stage.)
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The buyer makes sure that the funds necessary for the import are made available to his/her bank.
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The buyer’s bank sends the money to the seller’s bank.
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Structure
The type of letter of credit used determines to what extent the seller is protected. There are two basic forms, together with a number of variations.
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Irrevocable or not
There are two main categories of letters of credit: Irrevocable and revocable.
- Revocable letters of credit may be canceled by the issuing bank at any time before the documents are presented at the seller’s bank. Consequently, the seller cannot rely on the letter of credit as a sure way of obtaining payment for the delivered goods. Revocable letters of credit cannot be confirmed (see below) and cannot be used as collateral.
- Irrevocable letters of credit may not be canceled before its expiration, unless all parties concerned consent to it. The seller can rely on the credit standing of the issuing bank. This is the most frequent category used.
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Confirmed or not
There are, in turn, two types of irrevocable letters of credit: Unconfirmed and confirmed.
- Unconfirmed letters of credit indicates that the seller’s bank has no legal obligation to honor the credit. Instead, it is advising the credit without any responsibility or engagement on its part.
- Confirmed letters of credit indicates that the seller’s bank has jointly assumed the buyer’s bank’s obligation. The seller’s bank is legally obliged to pay the seller, regardless of the ability of the buyer’s bank to pay. In practice, this means that the seller’s bank has extended a credit to the buyer’s bank. From the seller’s point of view, this is for natural reasons the most desirable arrangement.