Trade Finance Article

Letters of credit: when and how to use them

30 November,2018 | Tim Nicolle

International trade has been supported for many years by letters of credit. Here is a simple guide to the letter of credit – how they work – and when they should be used. A letter of credit (“LC”) is a complicated financial instrument. There are many varieties, and it is easy to get lost in the details. Here we cut through the complexity and tell you what you need to know.

If an LC is needed but the importer (the buyer) cannot provide one, then call us at PrimaDollar. We arrange LCs so that importers do not have to arrange them and so that exporters get the financial support that they need upfront. Our LCs are simple, reliable, easy to use and understand.

1. What’s the problem?

Suppose you run a factory in Asia making garments. Excellent news has just arrived – a new customer appears and places an order with you. But you might need to borrow money from your local bank to buy the materials and pay the wages in order to make the garments. Your bank might tell you that the new customer is far away – and that there is no guarantee the customer will pay when the garments are shipped, and so the bank cannot help you.

This is when you need a letter of credit.

If you have an LC, your local bank can help you with the finance that you need to make the garments. Moreover, you can ship the garments and sleep at night, because you know that you should get paid.

2. But LCs are rather complicated?

An LC is a promise to pay money in the future.

It appears to be complicated because it is flexible. There are many variations and technicalities which can be included in an LC. But, actually, we find that the LCs which we arrange are basically always the same. The flexibility is there, but not really needed. Sticking to a standard approach is nearly always the right answer.

So this article covers the usual, normal, standard approach. This is what you should be doing if you are a regular importer or exporter of manufactured products. If the LC that you are looking at is different to the one that we describe here – then ask questions and find out why.

Important points:

  1. LCs are simpler than you may imagine.

  2. Keep it simple – and it will likely give you what you need (whether you are an Importer or an Exporter).

3. What is a letter of credit?

There are four organisations involved in a standard letter of credit:

  • An “Importer” – for example, a retailer in the US

  • An “Exporter” – for example, a factory making goods in Asia

  • The importer’s bank – who can be called the “Issuing Bank”

  • The exporter’s bank – who can be called the “Negotiating Bank

An LC is a promise by the Issuing Bank (on behalf of the Importer) to pay a certain amount of money to the Negotiating Bank (for the benefit of the Exporter). The promise is conditional, and the conditions are:

  • Specific documents are provided; and

  • Specific timing is achieved.

Important points:

  1. The LC is conditional. That means the Issuing Bank will only pay if specified documents are provided and specified timing is achieved.

  2. The payment goes from the Issuing Bank to the Negotiating Bank; it does not go between the Importer and the Exporter.

4. So an LC is a contract between two banks then?

Yes – LCs are an agreement between two banks, not between the Importer and the Exporter. This is important, because it underlines why the LC is useful.

First, banks tend to trust each other. They are usually substantial organisations, regulated in their home markets, with international reputations. So, whilst the Importer and the Exporter might not be very well known, the involvement of the banks adds reliability and security to the overall arrangement of shipping goods out (on the one hand) and paying for them (on the other).

Second, the Exporter usually has borrowed money from his local bank to finance the production of goods. When the goods are sold, the local bank would really like the payment to come directly to him, rather than to go somewhere else. By receiving the payment directly, the local bank controls the export arrangement and can be confident that the finance he has provided to the Exporter will be repaid.

Third, the shipping documents can be held safely and managed by the banks, and sent between them. Shipping documents (like the original “bills of lading”) are valuable and confer control over the goods to the parties who hold them. The LC process allows the shipping documents to move between the banks rather than between the Importer and Exporter.

Important points:

  1. Banks are trusted to handle money and shipping documents – whereas Importers and Exporters may not be well-known to each other and may not be trusted.

  2. As both Importers and Exporters may be borrowing money, routing the money between the two banks makes it easier for the bankers involved to control the process and ensure that their loans are repaid – thereby helping to make the loans available in the first place.

5. As an Importer – why should I organise an LC?

LCs are a hassle for Importers.

Arranging an LC involves costs for the Importer, use of his banking lines, provision of collateral and annoying paperwork. Most banks also expect their Importer clients to maintain some expertise in LCs, so that there is no risk of trades being done that clients have not fully understood. All of this adds up to a lot of trouble.

But Exporters who are short of working capital tend to take shortcuts with production and may end up borrowing from unregulated money-lenders (at high costs) rather than from local banks. Importers have therefore understood that Exporters should not only receive a fair price, but should also have access to sufficient working capital. Provided the local bank is supportive, arranging an LC in support of a purchase order provides financial support to the Exporter without the Importer having to provide a potentially risky cash payment in advance.

Another important benefit for Importers is that LCs also provide a way to check that the goods have been made and shipped before a payment is made. This is achieved by setting appropriate conditions that have to be met before the LC settles. Typical conditions on a standard LC are described below.

Of course, our business (PrimaDollar) can provide the LC if the Importer does not want to be troubled with it, delivering all these benefits but without the hassle.

Important points:

  1. LCs are painful, but can be very necessary.

  2. Good trading relationships are a partnership – where both parties support each other.

  3. If the Exporter needs an LC but you, the Importer, don’t want to provide one – PrimaDollar can do it for you.

6. What does an LC say?

An LC is a structured document. What that means is that there is a standard format, governed by established rules (known as “UCP600”).

An LC has the following parts to it:

PEOPLE:

  1. Who is the applicant (this would be the Importer, or it would be PrimaDollar if we step in to help)?

  2. Who is the beneficiary (Exporter)?

  3. Which banks are involved: Issuing Bank and Negotiating Bank.

DOCUMENTS:

Here is the “minimum”, standard list of required documents:

  1. Bills of lading (allows the holder to get possession of the goods, and proves that the goods are on the ship)

  2. Packing list (shows what has been loaded onto the ship, the details should match the bill of lading)

  3. Inspection report (approves the goods for shipment, often prepared by a representative of the Importer)

  4. Commercial invoice (issued by the Exporter, showing the amount that the Importer is expected to pay)

Additional documents can be required, for example, a certificate of origin (required by many countries for customs clearance and local regulations, and when the shipment is to the EU from a country that has a favourable tax status, a GSP form may also be needed).

CONTROL:

  1. The LC will state who will control the goods in transit by setting out the names that are on or added to the bills of lading (meaning who will be the consignee and whose name may also be endorsed onto the documents).

  2. The LC will also state who should be told about the shipment (the “notify parties”) so that third parties (for example, the Importer) are informed about the shipment whilst the documents are travelling between the Negotiating Bank and the Issuing Bank.

TIMING:

  1. There is a latest shipment date. This is the latest date by which the goods have to be shipped, and would be shown on the bill of lading. Miss this date, and you are late.

  2. There is a latest presentation date. This is the date by which the documents should be presented to the Issuing Bank.

  3. There is a payment date. This is the date when the Issuing Bank will pay the Negotiating Bank. There are two options:

    1. “Sight” – which means that the payment will be made as soon as the documents are reviewed and accepted

    2. “Usance” or deferred payment – which specifies that the payment will be made a number of days after the documents are accepted; this is often 60, 90 or 120 days. If this option is employed, it means that the Negotiating Bank has to wait for the money, but knows that the money will come.

If PrimaDollar is involved, then the LC will always be at "sight" – so that there is no need to wait for the money. Waiting for the money blocks the Exporter's credit facilities, and may get in the way of completing further orders or taking on new business.

Important points:

  1. If your LC is more complicated than the type described above, then you need to ask questions (whether you are an Importer or an Exporter). Probably the LC will not work for the Exporter (he may be unable to use it to raise finance from his local bank).

  2. LCs are not that complicated. It is common sense.

7. How does my LC work in practice?

There is a simple set of steps involved in the LC process.

  1. Agree your purchase order. This is the contract between Importer and Exporter.

  2. If an LC is needed, call PrimaDollar or agree that the Importer will arrange the LC.

  3. Always ask for a draft of the LC before it is issued, so you know what you are getting.

  4. The LC is then issued by the Issuing Bank (on the instruction of the Importer, or, PrimaDollar if we are arranging it).

  5. The LC is received by the Negotiating Bank – and then the Exporter can access his pre-shipment credit facilities.

  6. Goods are made. Goods are loaded onto the ship. Shipping documents are produced.

  7. Documents are provided to the Negotiating Bank who checks them.

  8. The documents are then sent by the Negotiating Bank to the Issuing Bank (note that the Exporter cannot deal directly with the Issuing Bank himself).

  9. The Issuing Bank reviews the documents.

    1. If the documents and timing conditions are met, then a payment confirmation is given.

    2. If either the documents or the timing conditions are not met (and the Exporter cannot correct the discrepancy within the allowed period), the Issuing Bank will talk to the Importer to get an authorisation to proceed. It would be unusual for the Importer not to agree to proceed, although it can happen. With the authorisation to proceed, the payment confirmation is given.

  10. The documents are then released to the Importer.

  11. Payment then follows in line with the period specified in the LC. The Issuing Bank pays the Negotiating Bank (not the Exporter).

If the conditions are not met and the Importer does not agree to proceed, the Issuing Bank will return the documents to the Negotiating Bank – and the trade has failed. This rarely happens with LC-supported trades.

Important points:

  1. There is a procedure to follow. It is not complicated, but it must be followed.

  2. Documents go between the banks, not between the Importer and the Exporter.

  3. Cash goes to the Negotiating Bank, not to the Exporter.

8. What can go wrong?

LCs do sometimes go wrong – but not often.

Here are examples of things which cause problems:

  1. LC expires. This happens if the shipment or other arrangements are so late that the LC simply goes beyond its latest operational date. In our experience, managing this situation is just a matter of effective communication between the parties and the LC can still be operated even quite a few weeks after expiry. It is also usually better to continue within the existing LC framework than to try and settle arrangements outside.

  2. Short payment. This happens if the Issuing Bank deducts charges (often many $100s) from the settlement which can be an unwelcome surprise. This can be avoided by working with PrimaDollar where we operate on a transparent basis with all the parties.

  3. LC conditions not met. This is always a risk for the Exporter and the Negotiating Bank – and can result in the shipment being rejected by the Importer. This is a also usually matter of managing communication between the Importer and Exporter. All the parties to the arrangements should remember that the LC has conditions that need to be met if an automatic payment is expected.

Most of the time, problems arising with LCs are about communication, ensuring that correct information is provided in the right format, sent by the right people to the right people. If PrimaDollar is involved, then we can help significantly, as we have the expertise and experience to ensure that the communications are flowing correctly. This is our business.

Important points:

  1. Most of the issues that arise on LCs are solved by good and clear communications.

  2. LCs really can work well, but only if the rules are followed.

  3. Using PrimaDollar’s LCs can avoid one of the main headaches, which is short payment to the Exporter.

9. What if an LC is required, but none is available?

Call PrimaDollar.

Importers and Exporters can often benefit from having a someone else step in and facilitate the trade.

  • Exporters often need financial support for the purchase orders that they accept. This is because they need money upfront to buy materials and pay wages. But Importers prefer to pay after shipment, often asking for additional time so that they sell the goods before making payment. This is the cash flow gap.

  • Importers expect their suppliers (Exporters) to finance the work involved in making and shipping the goods. But, increasingly, pressure on margins means that Importers (buyers) are looking to find suppliers in lower-cost locations. Often, such suppliers may not have good access to working capital.

PrimaDollar fixes the cash flow gap.

  • If the Exporter (supplier) needs a letter of credit, we provide one so that the Importer (buyer) does not have to

  • We always pay at shipment and the Importer can pay us later (30, 60, 90, 120 days after shipment).

Here is how you can work with us:

  1. Agree your purchase order in the usual way.

  2. Give us a call (at PrimaDollar). We don’t mind if we are called by the Importer or the Exporter – our service is equally important to both parties in the trade

  3. Provided we can accept the credit risk of the Importer, we will arrange the LC so that the Importer does not have to.

  4. The Issuing Bank will be our bank (Barclays Bank), and the Importer’s bank is not involved.

  5. There is no use of Importer’s banking lines or credit capacity; no one has to provide any collateral; there are no charges to the Importer and there are no complicated forms to fill in.

  6. Our sight LC is simple and adopts the standard structure set out above.

  7. The Negotiating Bank (for the Exporter) will happily accept our sight LC and provide the pre-shipment finance that the Exporter needs.

  8. Documents go between the Negotiating Bank (for the Exporter) and our bank (Barclays Bank). If the documents are acceptable, we will forward them to the Importer. If not, they will go back to the Negotiating Bank in the usual way.

  9. Payment is always at sight - and it will come from our bank, Barclays Bank directly to the Exporter's bank (the Negotiating Bank).

  10. Unless otherwise stated, the LC will settle in full (without short payment), even if there are discrepancies; the Exporter should receive the cash amount that he expects.

Important points:

  1. PrimaDollar’s involvement solves the cash flow gap for both Importer and Exporter.

  2. We arrange the LC so that the Importer does not have to.

  3. Our LC is standard, always pays at sight, and comes from Barclays Bank – one of the largest banks in the world.

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