Letter of credit


A letter of credit, also known as a documentary credit or bankers commercial credit, or letter of undertaking, is a payment mechanism used in international trade to provide an economic guarantee from a creditworthy bank to an exporter of goods. Letters of credit are used extensively in the financing of international trade, when the reliability of contracting parties cannot be readily and easily determined. Its economic effect is to introduce a bank as an underwriter that assumes the counterparty risk of the buyer paying the seller for goods.
Typically, after a sales contract has been negotiated, and the buyer and seller have agreed that a letter of credit will be used as the method of payment, the applicant will contact a bank to ask for a letter of credit to be issued. Once the issuing bank has assessed the buyer's credit risk, it will issue the letter of credit, meaning that it will provide a promise to pay the seller upon presentation of certain documents. Once the beneficiary receives the letter of credit, it will check the terms to ensure that it matches with the contract and will either arrange for shipment of the goods or ask for an amendment to the letter of credit so that it meets with the terms of the contract. The letter of credit is limited in terms of time, the validity of credit, the last date of shipment, and how late after shipment the documents may be presented to the nominated bank.
Once the goods have been shipped, the beneficiary will present the requested documents to the nominated bank. This bank will check the documents, and if they comply with the terms of the letter of credit, the issuing bank is bound to honor the terms of the letter of credit by paying the beneficiary.
If the documents do not comply with the terms of the letter of credit they are considered discrepant. At this point, the nominated bank will inform the beneficiary of the discrepancy and offer a number of options depending on the circumstances after consent of applicant. However, such a discrepancy must be more than trivial. Refusal cannot depend on anything other than reasonable examination of the documents themselves. The bank then must rely on the fact that there was, in fact, a material mistake. A fact that if true would entitle the buyer to reject the items. A wrong date such as an early delivery date was held by English courts to not be a material mistake. If the discrepancies are minor, it may be possible to present corrected documents to the bank to make the presentation compliant. Failure of the bank to pay is grounds for a chose in action. Documents presented after the time limits mentioned in the credit, however, are considered discrepant.
If the corrected documents cannot be supplied in time, the documents may be forwarded directly to the issuing bank in trust; effectively in the hope that the applicant will accept the documents. Documents forwarded in trust remove the payment security of a letter of credit so this route must only be used as a last resort.
Some banks will offer to "Telex for approval" or similar. This is where the nominated bank holds the documents, but sends a message to the issuing bank asking if discrepancies are acceptable. This is more secure than sending documents in trust.

History

The letter of credit has been used in Europe since ancient times. Letters of credit were traditionally governed by internationally recognized rules and procedures rather than by national law. The International Chamber of Commerce oversaw the preparation of the first Uniform Customs and Practice for Documentary Credits in 1933, creating a voluntary framework for commercial banks to apply to transactions worldwide.
In the late 19th century and early 20th century, travelers commonly carried a circular letter of credit issued by a relationship bank, which allowed the beneficiary to withdraw cash from other banks along their journey. This type of letter of credit was eventually replaced by traveler's checks, credit cards and automated teller machines.
Although letters of credit first existed only as paper documents, they were regularly issued by telegraph in the late 19th century, and by telex in the latter half of the 20th century. Beginning in 1973 with the creation of SWIFT, banks began to migrate to electronic data interchange as a means of controlling costs, and in 1983 the UCP was amended to allow "teletransmission" of letters of credit. By the 21st century, the vast majority of LCs were issued in electronic form and entirely "paperless". LCs were becoming more common. Marcell David Reich popularised the use of letters of credit in the oil trade.

Terminology

UCP 600 regulates common market practice within the letter of credit market. It defines a number of terms related to letters of credit which categorise the various factors within any given transaction. These are crucial to understanding the role financial institutions play. These include:
  • The applicant is the person or company who has requested the letter of credit to be issued; this will normally be the buyer.
  • The beneficiary is the person or company who will be paid under the letter of credit; this will normally be the seller.
  • The issuing bank is the bank that issues the credit, usually following a request from an applicant.
  • The nominated bank is a bank mentioned within the letter of credit at which the credit is available.
  • The advising bank is the bank that will inform the beneficiary or their nominated bank of the credit, send the original credit to the beneficiary or their nominated bank, and provide the beneficiary or their nominated bank with any amendments to the letter of credit.
  • Confirmation is an undertaking from a bank other than the issuing bank to pay the beneficiary for a complying presentation, allowing the beneficiary to further reduce payment risk, although confirmation is usually at an extra cost.
  • A confirming bank is a bank other than the issuing bank that adds its confirmation to credit upon the issuing bank's authorization or request thus providing more security to the beneficiary.
  • A complying presentation is a set of documents that meet with the requirements of the letter of credit and all of the rules relating to letters of credit.

    Function

A letter of credit is an important payment method in international trade and used worldwide. It is particularly useful where the buyer and seller may not know each other personally and are separated by distance, differing laws in each country, and different trading customs. It is a primary method in international trade to mitigate the risk a seller of goods takes when providing those goods to a buyer. It does this by ensuring that the seller is paid for presenting the documents which are specified in the contract for sale between the buyer and the seller. That is to say, a letter of credit is a payment method used to discharge the legal obligations for payment from the buyer to the seller, by having a bank pay the seller directly. Thus, the seller relies on the credit risk of the bank, rather than the buyer, to receive payment. As will be seen, and is observed in Image 2, the bank will pay the seller the value of the goods when the seller provides negotiable instruments, documents which themselves represent the goods. Upon presentation of the documents, the goods will traditionally be in the control of the issuing bank, which provides them security against the risk that the buyer will repay the bank for making such a payment.
In the event that the buyer is unable to make payment on the purchase, the seller may make a demand for payment on the bank. The bank will examine the beneficiary's demand and if it complies with the terms of the letter of credit, will honor the demand. Most letters of credit are governed by rules promulgated by the International Chamber of Commerce known as Uniform Customs and Practice for Documentary Credits. The current version, UCP 600, became effective July 1, 2007. Banks will typically require collateral from the purchaser for issuing a letter of credit and will charge a fee which is often a percentage of the amount covered by the letter of credit.

Types

Several categories of LCs exist which seek to operate in different markets and solve different issues. Examples of these include:
  • Import vs export : The same credit can be termed an import or export letter of credit depending on whose perspective is considered. For the importer it is termed an import LC and for the exporter of goods an export LC.
  • Revocable vs irrevocable: Whether an LC is revocable or irrevocable determines whether the buyer and the issuing bank are able to manipulate the LC or make corrections without informing or getting permissions from the seller. According to UCP 600, all LCs are irrevocable, hence in practice the revocable type of LC is increasingly obsolete. Any changes or cancellation of the LC is done by the applicant through the issuing bank. It must be authenticated and approved by the beneficiary.
  • Confirmed vs unconfirmed: An LC is said to be confirmed when a second bank adds its confirmation to honor a complying presentation at the request or authorization of the issuing bank.
  • Restricted vs unrestricted: Either the one advising bank can purchase a bill of exchange from the seller in the case of a restricted LC, or the confirmation bank is not specified, which means that the exporter can show the bill of exchange to any bank and receive a payment on an unrestricted LC.
  • Deferred vs usance: A credit that is not paid or assigned immediately after presentation, but after an indicated period that is accepted by both buyer and seller. Typically, seller allows buyer to pay the required money after taking the related goods and selling them.
Additionally, a letter of credit may also have specific terms relating to the payment conditions which relate to the underlying reference documents. Some of these include
  • At sight: A credit that the announcer bank immediately pays after inspecting the carriage documents from the seller.
  • Red clause: Before sending the products, seller can take the pre-paid part of the money from the bank. The first part of the credit is to attract the attention of the accepting bank. The first time the credit is established by the assigner bank, is to gain the attention of the offered bank. The terms and conditions were typically written in red ink, thus the name.
  • Back-to-back: A pair of LCs in which one is to the benefit of a seller who is unable to provide the corresponding goods for unspecified reasons. In that event, a second credit is opened for another seller to provide the desired goods. Back-to-back is issued to facilitate intermediary trade. Intermediate companies such as trading houses are sometimes required to open LCs for suppliers and receive export LCs from buyers.
  • Standby letter of credit : Operates like a commercial letter of credit, except that typically it is retained as a standby instead of being the intended payment mechanism. In other words, this is an LC which is intended to provide a source of payment in the event of non-performance of contract. This is a security against an obligation which is not performed. If the bank is presented with demands of non-payment it is not a guarantee; the trigger is not non-payment but documentation. UCP600 Article 1 provides that the UCP applies to standby LCs; ISP98 applies specifically to standby letters of credit; and the United Nations Convention on Independent Guarantees and Standby Letters of Credit applies to a small number of countries that have ratified the convention.