Letters of Credit – Letter of Credit Consultancy Services

Advantages and Disadvantages of Letters of Credit

Ozgur Eker (CDCS) Advantages of Letters of Credit, How to Work With a Letter of Credit, International Payment Methods, Letter of Credit Basics, Letters of Credit 7 March 201918 April 2021Advantages of a Letter of Credit, Disadvantages of a Letter of Credit

Letter of credit is one of the payment methods in international trade. Just like other payment methods it has certain advantages and disadvantages.

Advantages of letter of credit:

It simply works: In some situations, letter of credit works when other payment options not.
It is a balanced payment option: Importers and exporters could reach reasonable payment terms via letter of credit.

Disadvantages of a letter of credit:

It is expensive: Both exporters and importers have to pay high fees when choosing the letter of credit as a payment option.
It is difficult: Letters of credit requires experienced stuff who possess certain amount of trade finance knowledge.

After explaining the advantages and disadvantages of a letter of credit briefly, we can now proceed for further descriptions.

Advantages of a Letter of Credit:

For Exporters:

Reach out New Customers: Establishing a new business connection is not easy. It is difficult to find a new buyer who is ready to make an advance payment to an untested exporter. By offering a letter of credit, the exporter can increase the chance of securing the order.
Increasing Export Coverage: Exporters can increase their export coverage by regional means if they can effectively use letters of credit. For example, letter of credit is the main payment option for majority of the Middle East countries.
Mitigates Default Risk of the Importer: By using a letter of credit, the exporter can replace default risk from the importer to the importer’s bank, because the letter of credit is a conditional payment undertaking of the issuing bank.
Eliminates Importing Country’s Political Risks via Confirmation: By adding confirmation, the exporter can eliminate importing country’s political risks, at least in theory. For further information please read our post “Confirmation and Confirmed Letter of Credit“.
Discounting Possibilities: It is possible to discount letters of credit that do not payable at sight. Once the issuing bank or confirming banks determines that the letter of credit documents are complying, the respected bank can discount the credit.

For Importers:

Proof of Creditworthiness: By issuing a letter of credit from a reputable bank, the importer proves that he is a financially reputable company.
More Favorable Payment Terms: The importer may be able to convince the exporter to work with a deferred payment terms instead of an at sight payment via a letter of credit. As the exporter can discount the credit any time after the complying presentation, deferred payment should not a big issue for him. Most frequently used deferred payment options under the letters of credit are 30 days, 60 days or 90 days after the bill of lading date.
Timely Shipments: Importers can determine the shipment period by using a letter of credit. If the exporter can not shipped the goods on time, he may face a late shipment discrepancy.

Disadvantages of a Letter of Credit:

For Exporters:

Higher Learning Costs: Letter of credit is one of the most complex fields of the international trade. Exporters acting with lack of letter of credit expertise and experience may face unpleasant consequences.
Higher Bank Fees: Exporters may have to pay high letter of credit fees to the banks under different names comparing to other payment methods.
Time Consuming Procedures: Letter of credit is a conditional payment undertaking of the issuing bank. The condition is known as complying presentation. Making a complying presentation is not easy and a very time consuming process.

For Importers:

Fraud Risks: While not common, it is possible that exporters can reach to the funds under letters of credit by submitting fraudulent documents.
Higher Bank Fees: Just like exporters, importers have to pay high letter of credit fees to the banks under letters of credit transactions.
Risks Associated with Shipment of Low Quality Goods: It is not easy to stop payment under the letter of credit once the issuing or confirming bank determines complying presentation. The importer may have to pay for the goods not consistent with the sales contract.

Payment Methods in International Trade

Ozgur Eker (CDCS) Advanced Payment, Bank Payment Obligation, Cash Against Documents, International Payment Methods, Letters of Credit, Open Account 20 February 20194 June 2019Cash Against Documents, Cash in Advance, International Payment Methods, Letters of Credit, Open Account

There are 5 types of payment methods available in international trade.

These payment types are cash-in-advance, open account, documentary collections, documentary credits (letters of credit) and bank payment obligation.

Short Descriptions of International Payment Methods:

Cash-in-Advance: Cash in advance is a payment method in international trade in which an order is not processed until full payment is received by the supplier in advance.

Sometimes cash in advance is called cash with order.

Please always keep in mind that under the cash in advance payment, the funds received by the exporters before the ownership of the goods is transferred to the importers.

Cash in advance posses highest risk to the importer, lowest risk to the exporter.

Open Account: Open account means that buyers pay the cost of the goods after goods have been shipped by the supplier.

In an international trade transaction open account defines as a sale where the goods are shipped and/or delivered before payment is due, which is usually in 30 or 60 days.

Open account posses highest risk to the exporter, lowest risk to the importer.

Documentary Collections: International trade procedure in which a bank in the importer’s country acts on behalf of an exporter for collecting and remitting payment for a shipment.

The exporter presents the shipping and collection documents to his or her bank (in own country) which sends them to its correspondent bank in the importer’s country.

The foreign bank (called the presenting bank) hands over shipping and title documents (required for taking delivery of the shipment) to the importer in exchange for

cash payment (in case of ‘documents against payment‘ instructions) or
a firm commitment to pay on a fixed date (in case of ‘documents against acceptance‘ instructions).

A documentary collection (D/C) is a transaction whereby the exporter entrusts the collection of a payment to the remitting bank (exporter’s bank), which sends documents to a collecting bank (importer’s 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.

Documentary Credits: Documentary credits, also known as letters of credit, are one of the payment methods in international trade.

Letter of credit defined by International Chamber of Commerce publication of UCP 600 as “any arrangement, however named or described, that is irrevocable and thereby constitutes a definite undertaking of the issuing bank to honour a complying presentation.”

risks associated with international payment methods — Source : http://trade.gov/media/publications/abstract/trade_finance_guide2008desc.html

Bank Payment Obligation: Bank payment obligation is a new payment method in international trade.

Bank payment obligation (BPO) is an irrevocable undertaking given by an Obligor Bank (typically buyer’s bank) to a Recipient Bank (usually seller’s bank) to pay a specified amount on a agreed date under the condition of successful electronic matching of data according to an industry-wide set of rules adopted by ICC.

What are the Key Points of Consideration When Choosing an International Payment Method?

Financial Needs of the Parties: Open account payment term is a credit granted by the exporter in favor of the importer. In contrast, cash in advance is a credit granted by the importer in favor of the exporter.

Letters of credit available by deferred payment and documentary collections payable with time drafts are also financial credits supplied to the buyers.

For these reasons financial needs of the parties is a key element determining the payment terms in international trade transactions.

Negotiation Power of the Parties: Sometimes exporters are in pressure to sell their products. On the other hand, importers are desperate to find a particular good in a short period of time.

If balance of the trade power diminishes in favor of one party, then the stronger party may want to benefited from the situation and dictates most favorable payments terms.

Country Risk of the Exporter and the Importer: As an example if the importer residents in a developed country whereas the exporter sits in a risky country, then the importer may do not want to take risks and choose the most secure payment method for himself.

Sector of the Transaction Parties: Occupying sector of the exporter and the importer is one of the most influencing element that effects the determination of the payment method. For example, food and textile sector practicing open account payments or documentary collections, on contrary oil sector uses letters of credit.

Willingness to Take Risks of the Parties: Willingness to take risks is one of the key factor determining the payment method in international trade.

Occasionally exporters want to take extra risk, while importers tend to trust their suppliers.

A risk taking exporter may ship the goods against open account terms whereas a risk taking importer may decide to pay in advance.

If both parties want to limit their risks, then they should either choose documentary collections or documentary credits.

Legal Legislation: If you want to export to Algeria, you have to choose either documentary collections or letters of credit as a payment method. This is an Algerian legislation and every exporter that makes business with Algeria has to obey this rule.

“At the beginning of August 2009, the Algerian government released the ‘Complementary Finance Law 2009’ which decreed that all imports into the country, with a value exceeding $1000, would require a documentary letter of credit (LC)”

Source: http://www.tradefinancemagazine.com/Article/2471154/LC-boom-in-Algeria.html

Country Practices: Middle East countries tend to use letters of credit intensely, when importing goods. Chinese exporters also use letters of credit in great volumes. USA importers using documentary collections for small value purchases. German importers would like to pay 30 days after bill of lading date under open account payment terms.

Revolving Letter of Credit

Ozgur Eker (CDCS) International Payment Methods, Letter of Credit Types, Letters of Credit, Revolving Letter of Credit 7 November 20186 April 2019Commercial Letter of Credit, Letter of Credit Types, Revolving Letter of Credit

Revolving letter of credit is a special type of letter of credit, which is not covered under the UCP 600 rules.

Contrary to popular belief, revolving letters of credit are not used frequently.

They may be utilized in limited occasions in international trade, especially when exporters and importers sign a long term commercial sales contract, which covers shipments of the same commodity on a regular basis such as;

Shipments of 10.000 mtons of iron ore from Australia to China monthly basis for a 6 months period of time
Shipments of textile products monthly basis from China to USA for a 12 months period of time.

An exporter and importer, who have concluded a contract as indicated above and wish to have a letter of credit issued to satisfy their contractual payment obligations, may apply for a revolving letter of credit.

Definition:

A revolving letter of credit is a special letter of credit type, which is structured in a way so that it revolves either in value or in time covering multiple-shipments over a long period of time under a single letter of credit.

Types of Revolving Letters of Credit:

i. Revolvement Based on Time: A fix amount could be drawn under letter of credit within each specific period of time as indicated in the documentary credit until letter of credit expires.

Example: Letter of credit stipulates that 100.000,00 USD can be drawn on monthly basis for a 12 months validity period.

Type 1 – Non-Cumulative Revolving Letter of Credit: For a non-cumulative revolving letter of credit, the beneficiary can draw each revolving amount for any given period, and any unused portions cannot be drawn on the subsequent periods.

Example: Using the above example, the shipper could still ship USD 100.000,00 each month and be fully paid. If the shipper shipped USD 90.000,00 in a given month, they would still be paid provided that partial shipment is allowed for each shipments, but they could not get the additional USD 10.000,00 by shipping excessive amount on the upcoming months.

Type 2 – Cumulative Revolving Letter of Credit: Cumulative revolving letter of credit means that the unused sums in the L/C can be added to the upcoming shipments.

Example: Using the above example, the shipper could still ship USD 100.000,00 each month and be fully paid. If the shipper shipped USD 90.000,000 in a given month, they would still be paid, and they could get the additional USD 10.000,00 by shipping extra in the next months until letter of credit reaches to expiry.

ii. Revolvement Based on Value: A fixed amount is replenished every time just after it is utilized by the beneficiary within the overall validity of the revolving letter of credit.

Revolvement dependent upon value could be very risky for the issuing banks as beneficiaries can make excessive presentations if issuing banks fail to specify maximum letter of credit limit.

Confirmed L/C at Sight

Ozgur Eker (CDCS) At Sight, Confirmed Letter of Credit, International Payment Methods, Letter of Credit Basics, Letter of Credit Types, Letters of Credit, Payment Types of Letter of Credit 6 November 20186 April 2019At Sight, Confirmation, Confirmed Letter of Credit, Confirming Bank

Confirmed L/C at sight covers two definitions: Confirmed letter of credit which is payable at sight.

Letters of credit can permit the beneficiary to be paid immediately upon presentation of specified documents (at sight letter of credit), or at a future date as established in the sales contract (term/usance letter of credit). (1)

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.

By reading this post, you should understand the responsibilities of confirming banks, benefits of confirmed at sight letters of credit and why in some situations at sight confirmed letters of credit mechanism does not work.

Definition of at Sight Letter of Credit:

Latest letter of credit rules, 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.

At sight letter of credit can be defined as a letter of credit that is payable as soon as the complying documents have been presented to the issuing bank or the confirming bank.

Definition of the Confirmation:

According to latest UCP rules confirmation means,

“a definite undertaking of the confirming bank , in addition to that of the issuing bank, to honour or negotiate a complying presentation”

Confirming Banks’ Responsibilities:

UCP 600 define confirming banks’ responsibilities as follows,

Article 8 – Confirming Bank Undertaking

a. Provided that the stipulated documents are presented to the confirming bank or to any other nominated bank and that they constitute a complying presentation, the confirming bank must:

i. honour, if the credit is available by

a. sight payment, deferred payment or acceptance with the confirming bank;
b. sight payment with another nominated bank and that nominated bank does not pay;
c. deferred payment with another nominated bank and that nominated bank does not incur its deferred payment undertaking or, having incurred its deferred payment undertaking, does not pay at maturity;
d. acceptance with another nominated bank and that nominated bank does not accept a draft drawn on it or, having accepted a draft drawn on it, does not pay at maturity;
e. negotiation with another nominated bank and that nominated bank does not negotiate.

ii. negotiate, without recourse, if the credit is available by negotiation with the confirming bank.

b. A confirming bank is irrevocably bound to honour or negotiate as of the time it adds its confirmation to the credit.

c. A confirming bank undertakes to reimburse another nominated bank that has honoured or negotiated a complying presentation and forwarded the documents to the confirming bank. Reimbursement for the amount of a complying presentation under a credit available by acceptance or deferred payment is due at maturity, whether or not another nominated bank prepaid or purchased before maturity. A confirming bank’s undertaking to reimburse
another nominated bank is independent of the confirming bank’s undertaking to the beneficiary.

d. If a bank is authorized or requested by the issuing bank to confirm a credit but is not prepared to do so, it must inform the issuing bank without delay and may advise the credit without confirmation.

Benefits of At Sight Confirmed Letter of Credit?

Why exporters pay additional fees to have their L/Cs confirmed?

First reason is that the exporters 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.

Why in some Situations At Sight Confirmed Letter of Credit Mechanism Does not Work?

The nominated banks, whom added their confirmations and became the confirming banks, keep sending documents to the issuing banks and wait for reimbursement even under confirmed at sight letters of credit.

Unfortunately even the confirmation couldn’t eliminate typical nominated bank action: wait for reimbursement, then pay to the beneficiary!

Confirming banks should pay the credit amount against confirming documents to the beneficiaries under at sight letters of credit as letter of credit rules dictate.

But in practice they are ready to act in this way only if they have determined that the issuing bank is defaulted.

Sources:

Documentary Letters of Credit: A Practical Guide, Scotiabank International Trade Services, Page:2

What Are the Differences Between Cash Against Documents and Letters of Credit?

Ozgur Eker (CDCS) Cash Against Documents, International Payment Methods, Letters of Credit 20 May 20187 April 2019Cash Against Documents, International Payment Methods, Letters of Credit

Letters of credit (l/c) and cash against documents (documentary collections, cad) are both payment methods in international trade.

Their combined share is around 50% in all trade finance practices.

Letters of credit and cash against documents have some similarities. We can identify major common points of these two payment methods as follows:

Both payment methods are executed by banks,
Documents play a key role under both payment options,
Both of them are governed by internationally accepted rules.

Despite these similarities they have significant differences as well.

On this article I would like to identify the main differences between Letters of credit (l/c) and cash against documents (documentary collections, cad).

What are the Main Differences Between Cash Against Documents and Letters of Credit?

Let us examine the differences between these two important payment methods of international trade article by article below.

Governing Rules: Letters of credit transactions are governed by UCP 600 and cash against documents are governed by URC 522 rules. You can get detailed information regarding these two sets of rules by reading my related articles.

Transaction Flow: Letters of credit are opened by the issuing banks with the request and authorization which they have received from the applicants.

Applicant is the importer in a commercial letter of credit. As a result letters of credit are initiated by the importers.

On the other hand, cash against documents or documentary collections as we called them in trade finance are initiated by the exporters.

Basic cash against documents transaction flow

Risk Degree: Letters of credit give more assurance to the exporters than cash against documents. For this reason the letter of credit is accepted as a more secure payment method in international trade than the documentary collection.

Responsibilities of Banks : Banks play a key role in letters of credit transactions and they have high levels of responsibilities against the exporters.

On the other hand in documentary collections banks have almost no valid responsibilities against the exporters.

As an example, the banks do not control the documents in documentary collections, but in documentary credit transactions banks check the documents to determine whether the presentation is complying or not.

Complexity : Documentary collections are much more easy in operational perspective than letters of credit.

Cost : The costs of the documentary collections are less than the cost of the documentary credits.

Letters of credit are one of the most expensive payment methods in international trade.

Please read my article for detailed information : How to deal with high banking commissions under letters of credit as an exporter?