Negotiation

How Does a Negotiable Letter of Credit Work?

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How Does a Negotiable Letter of Credit Work?

What Does Negotiation Mean?

Negotiation means the purchase by the nominated bank of drafts (drawn on a bank other than the nominated bank) and/or documents under a complying presentation, by advancing or agreeing to advance funds to the beneficiary on or before the banking day on which reimbursement is due to the nominated bank.

What Are the Benefits of a Negotiable Letter of Credit to the Exporters?

Exporters can reach the payment sooner with negotiable letters of credit, while offering usance terms to the importers.

With the help of the negotiable letters of credit, exporters can balance their cash flows, and able to propose competitive payments terms to the importers.

Who Should Pay Negotiation Fees?

Negotiation fees generally covered by the exporters, although this is contrary to the letter of credit rules.

How to Understand if a Letter of Credit Negotiable or Not?

In order to understand if a letter of credit is negotiable or not, you need to look at field “41A-Available with/by” field in a MT700 swift message.

If letter of credit is negotiable, it must be mentioned under field 41A that the letter of credit is available by negotiation.

How Does a Negotiable Letter of Credit Work?

How does a negotiable letter of credit work?

  • Step 1: Exporter and importer enter into a sales contract by agreeing on the terms and conditions of the business transaction.
  • Step 2: Importer contacts to the issuing bank for the issuance of the negotiable letter of credit.
  • Step 3: Issuing bank issues negotiable letter of credit in swift format and sends it to the nominated bank, who is also negotiating bank and advising bank.
  • Step 4: Negotiating bank advices the letter of credit to the exporter. Exporter checks the letter of credit conditions, if they are acceptable to the exporter, he starts production of the goods.
  • Step 5: Exporter ships the goods within the validity of the letter of credit and not later than latest date of shipment indicated in the L/C.
  • Step 6: Exporter presents the documents to the negotiating bank within the presentation period allowed under the letter of credit. Remember if presented documents contain a transport document, presentation must be completed within 21 days after date of shipment.
  • Step 7: Negotiating bank checks the documents presented by the exporter and, if determines that they are compliant, advances cash to the exporter. The “negotiation” is effectively the purchase of documents from the exporter at a discount.
  • Step 8: Negotiating bank presents the documents to the issuing bank.
  • Step 9: Issuing bank checks the documents and, if compliant, accepts them to be paid to the negotiating bank at maturity. At the same time, issuing bank gets in touch with the importer and delivers documents to him according to the financial agreement between the issuing bank and the importer.

Sample Negotiable Letter of Credit Swift Message 

————————————- Message Header ——————————————-
Swift OUTPUT FIN 700 Issue of a Documentary Credit
Sender : COBADEFFXXX
COMMERZBANK AG
(HEAD OFFICE)
FRANKFURT AM MAIN DE
Receiver : BOBIHKHH
BANK OF BARODA, HONG KONG
Hong Kong HK
————————————- Message Text———————————————–
27: Sequence of Total
1/1
40A: Form of Documentary Credit
IRREVOCABLE
31C: Date of Issue
140922
40E: Applicable Rules
UCP LATEST VERSION
31D: Date and Place of Expiry
05FEB15 HONG KONG
41A: Available With…By… – BIC
ANY BANK
BY NEGOTIATION
42C: Drafts At
AT 90 DAYS AFTER BL
42A: Drawee
BOBIHKHH

What Does “With Recourse” and “Without Recourse” Mean in International Finance?

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What does "with recourse" and "without recourse" mean in international letter of credit transaction?

Recourse means the right to claim a refund of an amount paid in connection with the negotiation of a documentary credit or the discounting of a bill of exchange. (1)

With recourse and without recourse are two terms defining whether or not the paying bank shall claim refund from the beneficiary in case it could not get reimbursement from the issuing bank.

On this post I will be answering below questions with the help of the graphic illustrations.

  • What is the meaning of with recourse term in international trade finance terminology?
  • What is the meaning of without recourse in international trade finance terminology?
  • Which banks pay with recourse and which bank pay without recourse basis?

What is the Meaning of With Recourse and Without Recourse Terms in International Trade Finance Terminology?

With recourse term defines the situation in which the paying bank will be able to claim refunds from the beneficiary in case the letter of credit documents are not paid by the issuing bank.

In general, the nominated bank or the negotiated bank pay the letter of credit amount to the beneficiaries with recourse terms.

with recourse and without recourse

Without recourse term defines the situation in which the paying bank will not be able to claim refunds from the beneficiary in case the letter of credit documents are not paid by the issuing bank.

In general, the confirming bank pay the letter of credit amount to the beneficiaries without recourse terms.

Important Note: The nominated bank may also pay to the beneficiary against discrepant documents with recourse basis.

These types of payments should be covered with a formal indemnity.

References:

Documentary Credits, Nordea Trade Finance, Page: 305

Letter of Credit Discounting

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discounting a letter of credit

Letter of credit is not a cheque, but rather it is a conditional payment undertaking of the issuing bank.

As a result a beneficiary first of all needs to fulfill his obligations under a letter of credit, before considering himself to be eligible of the issuing bank’s payment.

The beneficiary can fulfill his obligations under a letter of credit by making a complying presentation.

Complying Presentation and Payment Mechanism:

Once the issuing bank receives the complying presentation from the beneficiary, it must honor, which means that;

  • to pay at sight if the credit is available by sight payment,
  • to incur a deferred payment undertaking and pay at maturity if the credit is available by deferred payment,
  • to accept a bill of exchange (“draft”) drawn by the beneficiary and pay at maturity if the credit is available by acceptance.

discounting a letter of credit

Most of the exporters think that they could discount a letter of credit as soon as they have received it from their banks.

This belief is not correct at all.

The beneficiary needs to make a complying presentation in order to receive any form of payment under the letter of credit.

No complying presentation means no payment under the letters of credit.

What Types of Letters of Credit Are Available to Discounting?

Letter of credit discounting is related to the letters of credit which are available with deferred payment, acceptance or negotiation.

At sight letters of credit should not require any discount mechanism as issuing banks or confirming banks must honor at sight credits as soon as they determine that beneficiary’s presentation is complying.

Some examples of letters of credit which can be subject to discounting:

EXAMPLE 1:

  • 41D AVAILABLE WITH/BY: ANY BANK BY NEGOTIATION
  • 42C DRAFTS AT: AT 90 DAYS AFTER BILL OF LADING DATE

EXAMPLE 2:

  • 41A AVAILABLE WITH/BY: DEIFUKISXXX BY DEF PAYMENT
  • 42P: DEFERRED PAYMENT DETAILS: AT 60 DAYS AFTER SHIPMENT DATE

EXAMPLE 3:

  • 41A AVAILABLE WITH/BY: EXPOUSTKXXX BY ACCEPTANCE
  • 42C DRAFTS AT: AT 120 DAYS AFTER INVOICE DATE

Understanding the Differences Between Discounting With or Without Recourse Basis:

In trade finance the letter of credit discounting and letter of credit negotiation used used in the same manner.

However they could have different meanings in regards to banking practice and commercial law.

Negotiation is defined under UCP 600 as follows: Negotiation means the purchase by the nominated bank of drafts (drawn on a bank other than the nominated bank) and/or documents under a complying presentation, by advancing or agreeing to advance funds to the beneficiary on or before the banking day on which reimbursement is due to the nominated bank.

Nominated banks discount the letters of credit with recourse basis. This mechanism defined as negotiation.

Confirming banks discount the letters of credit without recourse basis. This mechanism defined as forfaiting.

With forfaiting the bank cannot demand repayment of the amount in case it is not reimbursed by the issuing or the confirming bank. Nor can the bank demand payment of interest if refund is delayed. (1)

Special Hints on Letter of Credit Discounting for Exporters:

  1. Keep in mind that you cannot get any payment from banks unless you make a complying presentation under a letter of credit.
  2. Letter of credit discounting is related to the letters of credit which are available with deferred payment, acceptance or negotiation.
  3. At sight letters of credit should not require any discount mechanism as issuing banks or confirming banks must honor at sight credits as soon as they determine that beneficiary’s presentation is complying.
  4. If you would like to discount a letter of credit you should try to get discount approval from your bank before letter of credit is issued. You can get your bank’s discount approval and discount conditions by applying them with a draft letter of credit.
  5. Nominated banks discount the letters of credit with recourse basis. This mechanism defined as negotiation.
  6. Confirming banks discount the letters of credit without recourse basis. This mechanism defined as forfaiting.
  7. Confirmed letters of credit can be discounted more easily than unconfirmed letters of credit. For this reason try to have the letter of credit confirmed by your bank to ease up the discounting process.

References:

  1. Documentary credits in practice, Second edition – 2009, Reinhard Längerich, Page: 185

Availability of Letters of Credit

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payment types in a letter of credit transaction

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Letters of Credit are flexible instruments because they incorporate various payment options.

According to letter of credit rules, a credit must state whether it is available by sight payment, deferred payment, acceptance or negotiation. (UCP 600 – Article 6- b)

The credit must explicitly indicate its availability as: (i) immediate payment (sight), (ii) payment at a future determinable date (deferred), (iii) acceptance of a time draft drawn on the issuing, nominated bank, or confirming bank, or (iv) negotiation with or without recourse to the beneficiary.

Sight payment ensuring prompt payment upon document compliance. Deferred payment, allowing for payment at a future date. Acceptance LCs involve the bank’s commitment to pay at a later date via draft acceptance. Negotiation LCs offer the possibility of receiving early payment by discounting drafts.

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