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Letters
of Credits |
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Definition
Letters of Credit (L/C) are a common form of payment,
known as a documentary credit, established by the buyer
and guaranteeing payment to the seller providing all the
documentary terms of the instrument are strictly adhered
to. By having a bank issue a letter of credit, in essence,
one is substituting the bank's credit worthiness for that of the
customer.
Types
There are two basic forms of letters of
credit: Standby and Documentary. Documentary letters of credit can be
either Revocable or Irrevocable, although the first is extremely rare.
Irrevocable letters of credit can be Confirmed or Not Confirmed. Each
type of credit has advantages and disadvantages for the buyer and for
the seller, which this information will review below. Charges for each
type will also vary.
However, the more the banks assume risk by
guaranteeing payment, the more they will charge for providing the
service.
Documentary Revocable Letter of
Credit
Revocable credits may be modified or
even canceled by the buyer without notice to the seller. Therefore,
they are generally unacceptable to the seller.
Documentary Irrevocable Letter of
Credit
This is the most common form of credit
used in international trade. Irrevocable credits may not be modified
or canceled by the buyer. The buyer's issuing bank must follow through
with payment to the seller so long as the seller complies with the
conditions listed in the letter of credit. Changes in the credit must
be approved by both the buyer and the seller. If the documentary
letter of credit does not mention whether it is revocable or
irrevocable, it automatically defaults to irrevocable. See Credit
Administration, Sample Procedure for Administration of a Documentary
Irrevocable Letters of Credit for a systematic procedure for
establishing an irrevocable letter of credit.
There are two forms of irrevocable
credits:
Unconfirmed credit (the
irrevocable credit not confirmed by the advising bank)
In an unconfirmed credit, the buyer's bank issuing the credit is the
only party responsible for payment to the seller. The seller's
advising bank pays only after receiving payment from the issuing bank.
The seller's advising bank merely acts on behalf of the issuing bank
and, therefore, incurs no risk.
Confirmed credit (the
irrevocable confirmed credit)
In a confirmed credit, the advising bank adds its guarantee to pay the
seller to that of the buyer's issuing bank. Once the advising bank
reviews and confirms that all documentary requirements are met, it
will pay the seller. The advising bank will then look to the issuing
bank for payment. Confirmed Irrevocable letters of credit are used
when trading in a high-risk area where war or social, political, or
financial instability are real threats. Also common when the seller is
unfamiliar with the bank issuing the letter of credit or when the
seller needs to use the confirmed letter of credit to obtain financing
its bank to fill the order. A confirmed credit is more expensive
because the bank has added liability.
Standby Letter of Credit
This credit is a payment or performance
guarantee used primarily in the United States. They are often called
non-performing letters of credit because they are only used as a
backup should the buyer fail to pay as agreed. Thus, a stand-by letter
of credit allows the customer to establish a rapport with the seller
by showing that it can fulfill its payment commitments. Standby
letters of credit are used, for example, to guarantee repayment of
loans, to ensure fulfillment of a contract, and to secure payment for
goods delivered by third parties. The beneficiary to a standby letter
of credit can cash it on demand. Stand-by letters of credit are
generally less complicated and involve far less documentation
requirements than irrevocable letters of credit. See Credit
Administration, Sample Procedure for Administration of a Standby
Letter of Credit for a systematic procedure for establishing a standby
letter of credit.
Special Letters of Credit
The following is a brief description of
some special letters of credit.
Back-to-Back Letter of Credit
This is a new letter of credit opened
based on an already existing, nontransferable credit used as
collateral. Traders often use back-to-back arrangements to pay the
ultimate supplier. A trader receives a letter of credit from the buyer
and then opens another letter of credit in favor of the supplier. The
first letter of credit serves as collateral for the second credit.
Deferred Payment (Usance) Letter of
Credit
In Deferred Payment Letters of Credit,
the buyer accepts the documents related to the letter of credit and
agrees to pay the issuing bank after a fixed period. This credit gives
the buyer a grace period for payment.
Red Clause Letter of Credit
Red Clause Letters of Credit provide
the seller with cash prior to shipment to finance production of the
goods. The buyer's issuing bank may advance some or all of the funds.
The buyer, in essence, extends financing to the seller and incurs the
risk for all advanced credits.
Revolving Letter of Credit
With a Revolving Letter of Credit, the issuing bank restores the
credit to its original amount once it has been used or drawn down.
Usually, these arrangements limit the number of times the buyer may
draw down its line over a predetermined period.
Transferable Letter of Credit
This type of credit allows the seller
to transfer all or part of the proceeds of the original letter of
credit to a second beneficiary, usually the ultimate supplier of the
goods. The letter of credit must clearly state that it is transferable
for its to be considered as such. This is a common financing tactic
for middlemen and is common in East Asia.
Assignment of Proceeds
The beneficiary of a letter of credit
may assign all or part of the proceeds under a credit to a third party
(the assignee). However, unlike a transferred credit, the beneficiary
maintains sole rights to the credit and is solely responsible for
complying with its terms and conditions. For the assignee, an
assignment only means that the paying bank, once it receives notice of
the assignment, undertakes to follow the assignment instructions, if
and when payment is made. The assignee is dependent upon the
beneficiary for compliance, and thus this arrangement is riskier than
a transferred credit. Before agreeing to an assignment of proceeds
arrangement, the assignee should carefully review the original letter
of credit.
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For a comprehensive export guide, you can purchase The Export Handbook.
The handbook takes you through the practical aspects of exporting essential for both experienced and novice exporters. It covers Export Procedures and Documentation, Customs Export Regulations, Internet Commerce, Banking and Finance, Export Risk and Credit Insurance, Marine Insurance, Shipping and Air Cargo, Freight Forwarding, Export Packaging and Resources for International Trade.
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