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What is Letter of Credit
Letter of credit, in a broad perspective, is one of the payment methods in
international trade.
Some of the other payment methods in international trade are Cash-inAdvance, Documentary Collections and Open Account. All of these payment
methods inherit different risk levels for exporters and importers. Letters of credit
is the only payment method, which has a balanced risk structure for both
parties.
Figure 1: Payment Risk Diagram
Key Points
To succeed in todays global marketplace and win sales against International trade
presents a spectrum of risk, which causes uncertainty over the timing of payments
between the exporter (seller) and importer (foreign buyer).
For exporters, any sale is a gift until payment is received.
Cash-in-Advance
With cash-in-advance payment terms, the exporter can avoid credit risk because
payment is received before the ownership of the goods is transferred. Wire transfers
and credit cards are the most commonly used cash-in-advance options available to
exporters. However, requiring payment in advance is the least attractive option for
the buyer, because it creates cash-flow problems. Foreign buyers are also
concerned that the goods may not be sent if payment is made in advance. Thus,
exporters who insist on this payment method as their sole manner of doing business
may lose to competitors who offer more attractive payment terms.
Letters of Credit
Letters of credit (LCs) are one of the most secure instruments available to
international traders. An LC is a commitment by a bank on behalf of the buyer that
payment will be made to the exporter, provided that the terms and conditions
stated in the LC have been met, as verified through the presentation of all required
documents. The buyer pays his or her bank to render this service. An LC is useful
when reliable credit information about a foreign buyer is difficult to obtain, but the
exporter is satisfied with the creditworthiness of the buyers foreign bank. An LC
also protects the buyer because no payment obligation arises until the goods have
been shipped or delivered as promised.
Documentary Collections
A documentary collection (D/C) is a transaction whereby the exporter entrusts the
collection of a payment to the remitting bank (exporters bank), which sends
documents to a collecting bank (importers bank), along with instructions for
payment. Funds are received from the importer and remitted to the exporter
through the banks involved in the collection in exchange for those documents. D/Cs
involve using a draft that requires the importer to pay the face amount either at
sight (document against payment) or on a specified date (document against
acceptance). The draft gives instructions that specify the documents required for
the transfer of title to the goods. Although banks do act as facilitators for their
clients, D/Cs offer no verification process and limited recourse in the event of nonpayment. Drafts are generally less expensive than LCs.
Open Account
An open account transaction is a sale where the goods are shipped and delivered
before payment is due, which is usually in 30 to 90 days. Obviously, this option is
the most advantageous option to the importer in terms of cash flow and cost, but it
is consequently the highest risk option for an exporter. Because of intense
competition in export markets, foreign buyers often press exporters for open
account terms since the extension of credit by the seller to the buyer is more
common abroad. Therefore, exporters who are reluctant to extend credit may lose a
sale to their competitors. However, the exporter can offer competitive open account
terms while substantially mitigating the risk of non-payment by using of one or
more of the appropriate trade finance techniques, such as export credit insurance.
We have explained above that letters of credit can limit the risks of importers
and exporters. However, how can letters of credit achieve this? Letters of credit
can balance the risks of exporters and importers because responsibility of LC
operations is given to a third party, to the banks. We will explain this later on
detailly.
Definition of Letter of Credit:
"Credit means any arrangement, however named or described, that
is irrevocable and thereby constitutes a definite undertaking of the issuing bank
to honour a complying presentation." (UCP 600, article 2)
This letter of credit definition is taken from the UCP 600 (ICC Uniform Customs
and Practice for Documentary Credits) which is the latest version of the rules
published by ICC (International Chamber of Commerce ) regulating the letters of
credit operations all around the world.
Role of the ICC and UCP in Letters of Credit
International trade is exchange of capital, goods, and services across
international borders between people whom belong to different languages,
In this first article, we have seen what letter of credit is, its definition, the rules
that apply to them and the organization that publishes these rules. In the next
article, we will examine types of letters of credit.
Types of Letters of Credit
Traveler's letters of credit, which were commonly used in eighteenth century,
were the first financial instrument contains very similar characteristics with the
contemporary letters of credit.
From traveler's letters of credit days to today's complex global
economy, the letters of credit have been performing their duties as a secure and
reliable payment method. Actually, during this period letters of credit have
gained a very flexible structure that can satisfy different needs of different types
of international trade practitioners. In this article, we will discuss types of letters
of credit.
Commercial Letters of Credit
Commercial letters of credit are mainly used as a primary payment tool in
international trade such as exporting and importing transactions. Majority of
commercial letters of credit are issued subject to the latest version of UCP
(Uniform Customs and Practice for Documentary Credits). The ICC publishes
UCP, which are the set of rules that governs the commercial letters of credit
procedures.
Letter of credit that carries a provision (traditionally written or typed in red ink)
which allows a seller to draw up to a fixed sum from the advising or payingbank, in advance of the shipment or before presenting the prescribed
documents.
Beneficiary is the seller of the goods or the provider of the services in a standard
commercial letter of credit transaction. Letter of credit is opened by the issuing
bank in favor of the beneficiary.
Issuing Bank
Issuing Bank is the bank that issues a letter of credit at the request of an
applicant or its own behalf. Issuing bank undertakes to honor a complying
presentation of the beneficiary without recourse.
Nominated Bank
Nominated bank is the bank with which the credit is available or any bank in the
case of a credit available with any bank.
Advising Bank
Advising bank is the bank that advises the credit at the request of the issuing
bank. An advising bank that is not a confirming bank advises the credit and any
amendmend without any obligation to honor.
Confirming Bank
Confirming bank is the bank that adds its confirmation to a credit upon the
issuing bank's authorization or request. Confirming bank may or may not add its
confirmation to a letter of credit. This decision is up to confirming bank only.
However, once it adds its confirmation to the credit confirming is irrevocably
bound to honor or negotiate as of the time it adds its confirmation to the credit.
Even if the issuing bank fails to honor, confirming bank must pay to the
beneficiary.
Reimbursing Bank
Reimbursing Bank shall mean the bank instructed and/or authorized to provide
reimbursement pursuant to a reimbursement authorization issued by the issuing
bank.
What are the risks of the letters of credit which are payable with 90% at sight and 10% usance after consignee
accepts the quality of goods?
Risks in letters of credit can be discussed under four groups; general risks in
letters of credit, risks to the applicant, risks to the beneficiary and risks to the
banks.
General Risks in Letters of Credit:
Country Risk: (Political Risk)
The first risk factor that can be mentioned in the general risks group is the
country risk or the political risk. Let us assume that we are an exporter located
in a country X and we have a customer from the country Y. Our customer, which
is from the country Y, opened a L/C in favor of us. We have checked the L/C
conditions and they seem workable. We have produced and shipped the order as
per the L/C and transmit the required documents to the issuing bank before the
expiry date. The issuing bank found our presentation complying and informed us
that they will be honoring our payment claim at the maturity date. However,
before the maturity date due Country Y has changed its export regime, which
makes it impossible for the issuing bank to honor our presentation. This
illustrative is a good example of a country risks. Other examples of country risks
are mass riots, civil war, boycott, sovereign risk and transfer risk.
Fraud Risk:
As we have described before all conditions stated in a letter of credit must be
connected to a document, otherwise banks will disregard such a condition. In
addition, banks deal with only documents but not goods, services or
performance to which the documents may relate. This feature of the letters of
credit is the source of the fraud risk at the same time. As an example, a
beneficiary of a certain letter of credit transaction can prepare fake documents,
which looks complying on their face, to make the presentation to the issuing
bank. As the documents are complying on their face, the issuing bank may
honor the presentation and in this case, the applicant must pay to the issuing
bank for the goods it will never be receiving. Beneficiaries of L/Cs bear also
fraud risks. This happens if an applicant issues a counterfeit letter of credit. In
this case, the beneficiary never receives its payment for the goods it has
shipped.
Risks to the Applicant:
In a letter of credit transaction, main risk factors for the applicants are nondelivery, goods received with inferior quality, exchange rate risk and the issuing
bank's bankruptcy risk.
Risks to the Beneficiary:
In a letter of credit transaction, main risk factors for the beneficiaries are unable
to comply with letter of credit conditions, counterfeit L/C, issuing bank's failure
risk and issuing bank's country risk.
Risks to the Banks:
Every bank in a L/C transaction bears risks more or less. The risk amount
increases as responsibility of the bank increases.
that a good sales contract protects the party, which behaves in goodwill against
various kinds of risks.
2. After the sales contract has been signed, the importer (applicant) applies for
its bank to issue a letter of credit. The letter of credit application must be in
accordance with the terms of the sales agreement.
3. If the importer and its bank reach an agreement together on the working
conditions the importer's bank (issuing bank) issues its letter of credit. In case
the issuing bank and the exporter (beneficiary) are located at different
countries, the issuing bank may use another bank's services (advising bank) to
advise the credit to the beneficiary.
4. The advising bank advises the letter of credit to the beneficiary without any
undertaking to honor or negotiate. The advising bank has two responsibilities
against to the beneficiary. Advising bank's first responsibility is satisfy itself as to
the apparent authenticity of the credit and its second responsibility is to make
sure that the advice accurately reflects the terms and conditions of the credit
received.
before the latest shipment date stated in the L/C. The beneficiary ships the
order according to the terms and conditions stated in the credit.
6. When the goods are loaded, the exporter collects the documents, which are
requested by the credit and forwards them to the advising bank.
7. The advising bank posts the documents to the issuing bank on behalf of the
beneficiary.
8&9. The issuing bank checks the documents according to the terms and
conditions of the credit. In addition, the governing rules, which are mostly latest
version of the UCP are taken into account. If the documents are found complying
after the examination the issuing bank honors the payment claim.
10. The documents transmit to the applicant. The applicant uses these
documents to clear the goods from the customs.
Sight Payment : Sight payment refers to the payment which is made as soon
as the complying presentation is seen by the issuing bank or the bank
nominated in the letter of credit. The nominated bank fulfills its payment
obligation with recourse basis. Nominated bank can demand the amount paid to
the beneficiary back in case of documents are found noncomplying by the
issuing bank. Nominated bank's payment obligation is not strict as the issuing or
the confirming bank's payment obligation. UCP 600 states that a nominated
bank is not obligated to accept the nomination directed to itself unless
nominated bank inform its acceptance of nomination expressly to the
beneficiary. Even in this situation UCP 600 assumes non payment by the
nominated bank and describe the roles of the issuing and confirming banks.
Negotiation : Let us check the definition of the negotiation from the UCP 600 in
order to understand the term more clearly.
Negotiation means the purchase by the nominated bank of drafts (drawn on a
bank other than the nominated bank) and/or documents under a complying
presentation, by advancing or agreeing to advance funds to the beneficiary on
or before the banking day on which reimbursement is due to the nominated
bank. (UCP 600 - Article 2)
As can be seen from the above definition any letter of credit which is available
by negotiation could be issued in a way so that a draft may or may not be
required. Also the payment of the letter of credit may or may not be at sight. If
the nominated bank advance or agreeing to advance funds to the beneficiary
before it receives reimbursement from the issuing bank the negotiation
condition is fulfilled. This can happen in two ways. First possibility is, in a letter
of credit which is available by sight payment when the nominated bank
reimburse the beneficiary before it receives funds from the issuing bank. Second
possibility occurs when a letter of credit is available by negotiation requesting
presentation of a time draft, while the nominated bank reimburses the
beneficiary before the maturity date of the bill of exchange. (How does a
negotiable letter of credit work?)
When issuing a documentary credit via swift message banks show the
availability of a documentary credit in Field 41a.
BY ACCEPTANCE
BY DEF PAYMENT
BY MIXED PYMT
BY NEGOTIATION
BY PAYMENT
Payment means payment at sight. Mixed payment is not directly covered under
UCP 600.
confirmed lc?
Step 1 - Sale Contract: Exporter and Importer sign a sale contract. They
choose letter of credit as a payment method.
5 Things You Should Never Do When Working with a Letter of Credit for the First
Time :
Most of the times letter of credit is not the first payment option for
exporters and importers. Exporters and importers tend to choose other
payment options such as cash against document, advance payment or
mixed payments over letters of credit. But as situation dictates foreign
traders have to use letter of credit in international trade transactions. On
this article I would like to explain 5 most costly mistakes that exporters
repeatedly make in their lc operations.
Most costly mistake 1 : Doing a business with an importer to whom
you have no real information...
Business is not a virtual thing. You should have a real knowledge about
your counter party before starting to do any kind of transaction. I have
seen a lot of exporters who tried to finish a transaction without having a
decent information about their buyers by just trusting a letter of credit.
Letter of credit does not protect you against any immoral buyer.
Please answer below questions to understand how much you know about
your buyer.
Table 1 : Customer questionnaire
Yes
No
Yes
No
Yes
No
Yes
No
Yes
No
If you can not answer "yes" to all of these questions immediately, than
you should be starting to re-think about the whole business. If you
answered more than 1 question negatively, than you should be very
careful about the trade transaction in terms of risk issues.
Most costly mistake 2 : entering business offers which are too
good to be true...
In most cases scammers seduce exporters with unbelievable proposals. They
do not bargain for the prices, they order big quantities, they promise to pay
"at sight" not "usance" terms. As a buyer if you do not intend to pay anything
than sky would be the limit for you. You can propose whatever you think
would be necessary to seal the deal. These proposals can be sum up as "too
good to be true" type business offers. If you meet a buyer one day who is
promising very favorable conditions to you, please keep in mind that you
might be loosing money at the end.
Learn who your buyer is. Try to get references of your buyer from your
sector. If needed make a financial investigation.
Accept the fact that letter of credit is not flexible in terms of regulations.
Learn the rules. Read the credit well. Eliminate all gray areas.
UCP 600 defines four availability options ; A credit must state whether it is
available by sight payment, deferred payment, acceptance or negotiation (UCP
600 - Article 6- b). At sight payment is one of the payment terms in a letter of
credit transaction. Also confirmation means "a definite undertaking of the
confirming bank , in addition to that of the issuing bank, to honour or negotiate
a complying presentation" according to latest UCP rules. On this page I would
like to write about pros and cons of confirmation when letter of credit
is available with sight payment (l/c at sight)
Let us start by asking ourself a very simple question. Why sellers pay additional
money to have their L/Cs confirmed? The first reason is that sellers would like to
eliminate default risk of the issuing bank. Second reason is that they would like
to receive their payment sooner by removing the issuing bank out of the
equation.
Most of the small companies work with limited capital volume and they rely on
their suppliers credit terms such as 30 days after bill of lading date. Which
means that a seller have to pay to its supplier 30 days after he ships the goods.
This relatively short time could create problems in terms of cash flow, when we
take into account document examination period of 5 working day that each bank
has to examine the documents under a letter of credit presentation.
According to current letter of credit rules confirming bank means the bank
that adds its confirmation to a credit upon the issuing bank's authorization
or request. As a result banks can not add their confirmations to the letter
of credit without having a confirmation request by the issuing banks.
MT 700
Field 49: Confirmation Instructions :
DEFINITION
This field contains confirmation instructions for the Receiver.
CODES
One of the following codes must be used.
MAY ADD The Receiver may add its confirmation to the credit.
According to current letter of credit rules confirming bank means the bank
that adds its confirmation to a credit upon the issuing bank's authorization
or request. As a result banks can not add their confirmations to the letter
of credit without having a confirmation request by the issuing banks.
MAY ADD The Receiver may add its confirmation to the credit.
Confirmation fees
Confirmation Fee
political risk by having the letter of credit confirmed to a bank which is located
within the same country.
Confirming banks could only honour or negotiate a complying presentation. As a
result beneficiaries have to present complying documents in order to obtain
funds under letters of credit from either the issuing bank or the confirming bank.
For this reason complying presentation is the key for the payment for both
confirmed letters of credit and unconfirmed letters of credit.
Confirming banks take the default risk of the issuing bank as well as nonpayment risk of the letter of credit originated from the political risk of the
issuing banks country over themselves from the moment they have added their
confirmation to the letters of credit. Even if a confirming bank could not receive
any reimbursement from the issuing bank he has to make payment to the
beneficiary against a complying presentation under the letter of credit which he
has confirmed.
You might be wondering why a confirming bank would take such risks and
confirm a letter of credit. The correct answer is very simple and straight forward;
to make more profit.
Examples of Confirmation Fees:
Confirmation Fee Format 1: Exporters First Help Bank of New York confirms this
credit and hereby undertakes to honor all drafts and documents presented in
strict compliance with the credit terms. Our confirmation charges USD3.120,48.
Confirmation Fee Format 2: We shall charge our confirmation commission of
4,000000 PCT p.a., min. EUR200.00 p.q.
What happens if court stops payment of an irrevocable, confirmed letter of credit which
is payable 90 days after sight due to low quality of goods?
Saudi Arabian steel importer and South Korean steel supplier signed a
sales contract
A multinational company's Saudi Arabia branch signed a sales contract with a
South Korean steel supplier. The product being traded was Cold Rolled Steel
Sheets. Sales contract amount was 9.700.000,00 USD and quantity of goods was
10.000mtons.
Importer company which is the beneficiary under the letter of credit transaction
is Strong Saudi Steel Import Co. Ltd and exporting company which is the
applicant under the letter of credit transaction is Korean Shining Steel Exporter
Ltd.
Letter of credit issued by a commercial bank in Saudi Arabia
A Saudi Arabian commercial bank issued the letter of credit which is available by
a deferred payment payable 90 days after sight. Letter of credit is subject to
UCP 600 and it is irrevocable. Letter of credit is available with a South Korean
national commercial bank. Also issuing bank requested from the nominated
bank to confirm the credit.
You can find important details of the letter of credit on below MT 700 swift
message summary.
: TRADEBANKXXX
:
:
South Korean bank, which was initially the nominated bank, confirmed the letter
of credit as per instructions received from the issuing bank. Once South Korean
bank confirmed the letter of credit, it became the confirming bank.
Under UCP 600 rules confirming banks have to honor complying presentations.
Confirming banks can also discount letters of credit upon exporters demand.
Complying presentation
After having the letter of credit confirmed, exporter arranged the shipment and
made the presentation to the South Korean Bank which is not only the
nominated bank but also the confirming bank.
Confirming bank checked the documents and found them complying. Confirming
bank determined that the documents have been presented was free of errors.
Confirming bank sent the documents to the issuing bank.
One week before the maturity date, the issuing bank informed the confirming
that the letter of credit payment has been stopped by the court order. In this
regards the issuing bank sent two subsequent authenticated SWIFT messages to
the confirming bank as follows:
"Please kindly be informed that we would like to draw your attention to the
following facts:
1.The Court Order dd. 15.February.2013 of the Court of First Instance is
addressed to your bank, in order to proceed with the suspension of payment
according to the instructions of applicant of L/C. This court order forbids your
payment to be effected to the beneficiary.
2.According to Art. 7c of the UCP 600 of ICC
a) your bank is obliged to reimburse the nominated bank, i.e. confirming bank,
at maturity
b) your undertaking to reimburse us is independent of your undertaking to the
beneficiary
3. According to Art. 12b of the UCP 600, you authorized us to prepay or purchase
a deferred payment undertaking incurred by us
4. As you are aware we prepaid the deferred payment undertaking to the
beneficiary.
As a matter of fact we, confirming bank, are the owner of the receivables and
entitled to receive the counter-value without any further delay. Summarizing the
above, we regard you as a highly reputable bank with an excellent standing and
experience in the international business, including documentary credits, and
thus anticipate your assistance in solving the pending problem by appealing
against the court order and to immediately remit funds in favour of our bank."
Conclusion:
ICC banking commission states that local law will prevail over the letter of credit
transaction. As a result banks must act according to court orders.
However, the credit was subject to UCP 600 and apparently contained no
exclusion to the rule appearing in sub-article 12 (b). Due to the content of sub-
article 12 (b) and sub-article 7 (c), the issuing bank should seek to resist such an
injunction in order to preserve the integrity of its credit and the UCP. It must be
expected that the issuing bank will seek to have the injunction removed by
referring the court to the appropriate articles of UCP 600 and the terms and
conditions of the credit. The issuing bank would also be well advised to inform
its applicant(s) of the content and effect of sub-article 12 (b) for this and any
future transactions. It is the responsibility of the applicant to cover any issues
concerning quality of goods in the documents called for and the data content
required to appear on those documents, and not to seek redress that affects the
right of a nominated bank to receive reimbursement in respect of a complying
presentation.
This case study created by the author based on the informations gathered from ICC Opinion R629
/ TA672rev.
Author:
Ozgur Eker is an independent trade finance consultant based in Izmir, Turkey.
He has been 10+ years of experience in international trade finance field. He is
also the founder of letterofcredit.biz.
As we have discussed earlier there are some risk factors exist for each party in a
letter of credit transaction. When we look at the risk issue from the beneficiaries'
perspective, we will observe two main risk factors that beneficiaries must bear ;
the country and the insolvency risk of the issuing bank. Confirmation can be
"Confirming bank means the bank that adds its confirmation to a credit upon the
issuing bank's authorization or request."
As can be seen on the above definitions confirming bank adds its undertaking to
the letter of credit in addition to that of the issuing bank. In this way
beneficiaries receive a second payment guarantee from another bank.
Insolvency risk of the issuing bank is eliminated by addition of this second
payment guarantee to the letter of credit.
Mostly confirming banks and the beneficiaries are located in the same country
and when this is the case the country risk of the issuing bank is eliminated as a
bank which locates in the same country with the beneficiary adds its
undertaking to the letter of credit in addition to that of the issuing bank.
Confirmed Letter of Credit
During the issuance phase of a letter of credit, the issuing bank should
"authorize or request" the potential confirming bank to add its
confirmation to the letter of credit.
other payment method works. No matter how many advantages letters of credit
have they have one big disadvantage. They are expensive.
As a result you should understand your costs before finalizing a letter of credit
deal.
We can answer this question by either looking at the rules or by looking at the
real life situations because what rules say is not what is really happening on
practice.
In real life situations applicant pay only issuing bank's charges and
remaining bank charges will be paid by the beneficiary unless beneficiary
is very strong against applicant. We need to look at field "71B: Charges"
in a letter of credit text issued by swift format to understand how bank
charges will be paid by letter of credit parties.
Samples :
Issuing bank charges will be paid by applicant and all other cherges will
be paid by beneficiary : Field "71B: Charges : ALL BANKING CHARGES
OUTSIDE BRAZIL ARE FOR BENEFICIARY'S ACCOUNT." This letter of credit
issued by a Brazilian bank.
Field "71B : Charges and Fees: OTHER THAN THE ISSUING BANKS ARE
FOR THE ACCOUNT OF THE BENEFICIARY. ISSUING BANKS CHARGES ARE
FOR THE ACCOUNT OF THE APPLICANT."
Inspection Certificate
Certificate of Analysis
Health Certificate
Almost all of the ICC opinions issued so far are related to complaints about
"alleged discrepancies". What we can see from the results of the ICC opinions is
that ICC Banking Committee does not agree with banks in most cases.
Inconsistency in Application :
Letter of credit rules are often find to be very complicated and hard to
understand by exporters and importers.
Most of the small and medium scale export and import companies do not
have enough resources to hire a letter of credit specialist in their
organizations.
Banks open over detailed letters of credit. Sometimes we see that banks
demand almost impossible conditions from the beneficiaries on their
letters of credit texts.
Before entering a letter of credit transaction you need to learn the letter
of credit rules very well. You should buy one original copy of current letter
of credit rule book, UCP 600. Please follow this link how to find a copy of
UCP 600 online.
You should starting to study letter of credit text as early as you can. As
one of the letter of credit guru indicated "you can not solve lc problems at
the presentation stage." The earlier you start to work on the letter of
credit text the better it would be.
Demand a letter of credit draft from your buyer before having the original
letter of credit issued. Work on this letter of credit draft carefully.
Check required documents field one by one. Make sure that you can
supply all the required documents as requested by the letter of credit.
Check additional conditions field one by one. Make sure that conditions
stated in this field is not going to create any problem for you on the
presentation stage.
If you find a condition or clause that you can not comply with get in touch
with your buyer to amend the letter of credit.
Complete the documents as requested by the credit. Make sure that you
also take into account the letter of credit rules and international standard
banking practices when preparing the documents.
Make sure that you will be presented all required documents without any
absence.
Make sure that you presented correct number of originals and copies as
requested by the credit.
Make sure that the dates on the documents are in accordance with the
dates mentioned on the credit. For example you would not be making
either a late shipment or a late presentation.
Make sure that you will collect all requested documents by credit as soon
as you make the shipment. Once you collect all documents you need to
make the presentation without losing time.
After Presentation Stage :
Follow the situation of the documents day by day with the advising bank. Give
necessary information to your buyer. And stay in alert mode until you received
your payment.