What is it?
A letter of credit (“LC”) is a flexible and internationally accepted form of financial guarantee. What it does depends upon what it says. But with that caveat, it is commonly organised to support the trade in goods. In this situation, it is transmitted by the importer’s bank to the exporter’s bank.
The importer’s bank:
- agrees to pay the exporter’s bank
- a specified sum of money if
- certain documents are provided
- by a certain date
- for onward credit to a beneficiary (the exporter).
A couple of important points:
- In practice, banks deal with each other over the detail of LCs. This means that the two parties (the importer and exporter) have to accept that any negotiations over the LC will happen between the banks involved.
- There is an international body of rules called “UCP600” which regulates how LCs work. LCs should expressly refer to this set of rules.
- As already mentioned, the LC will operate based upon how it is drafted. It is important that a specialist is involved to make sure that the LC is fit for the purpose intended.
An LC is of almost no benefit to the exporter if the correct and accurate documents are not provided on time. See our note on discrepant LCs here.
What are the key features of a letter of credit?
An LC used to support the trade in goods typically follows a simple template. One bank “issues” it, the other bank “negotiates” it.
In trade finance, the issuing bank and the applicant are on the importer side, and the negotiating bank and the beneficiary are on the exporter side. It is usually transmitted between the banks by SWIFT.
This kind of LC has different parts:
- Who are the parties (issuing bank, negotiating bank, applicant, beneficiary)?
- What documents should be provided by when?
- Can it be transferred?
- What happens with additional costs?
- When will the cash pay-out happen after meeting the conditions?
What are the main types of LC?
There are many types but in trade finance, three types are commonly used in transactions involving the shipment of goods:
- Standby LC: this works like a bank guarantee, and is usually unrelated to any specific trade. It is capable, sometimes, of being claimed by a beneficiary directly. It is not the type of LC that is typically required by an exporter to support a shipment of goods.
- Sight LC: this supports a specific import-export deal, paying out when shipping documents matching the specified requirements are presented on time to the importer’s bank;
- Usance LC: same as the sight LC, just that the payment is made some specified number of days after the conditions are met.
When do I use a letter of credit in practice?
An import LC is used to give confidence to an exporter so that he can ship the goods to the importer before being paid.
In some markets, a letter of credit from an importer is also used as collateral by an exporter to obtain local financing (“back-to-back”). An exporter may borrow against a purchase order that is supported by an LC arranged by the importer.
How do I get an LC?
Letters of credit to support the import and export of goods are usually organised by the importer on a trade.
There are two ways:
- The importer goes to his bank and asks them to issue a letter of credit. This means filling in forms, paying fees, putting up collateral and using banking lines.
- Use a specialist arranger like PrimaDollar who can organise the LC for you.
or, of course, use our platform and avoid the need for an LC altogether.
Are there alternatives to the letter of credit?
Letters of credit are not very popular. It is a complicated topic requiring specialist expertise, and they can be expensive. Moreover, many LCs provide little or no comfort in practice because the conditions that have to be met for settlement are difficult or impossible to comply with.
Instead of relying upon an LC, the trading parties can agree to work on open account (which means that the goods are shipped, payment may come later, the buyer has to be trusted). In this situation, the exporter has to find the cash himself.
PrimaDollar can assist with import trade finance – arranged with the support of the buyer:
- Introduce us to the buyer directly so that we can organise the finance, then
- We pay the exporter when he ships.
- The importer can pay later and we take the credit risk of the importer
- If the exporter wants a guarantee before shipment, for example to support “back-to-back”, then PrimaDollar can provide one
This is quicker, cheaper and simpler than the LC. Moreover, PrimaDollar’s online system connects and suppliers, buyers, financiers together with a real time view of cash, documents and shipments.
How can I find out more?
With a global network and global coverage, talk to us.