Letters of credit, a basic guide to understanding them

Definition, different types and main purposes of letters of credit

When talking about foreign trade, letters of credit are essential. They fulfill three main functions: guarantee, payment of fees and financing. For a company that is accessing these markets for the first time it can be a great unknown, which is why we have a quick guide on letters of credit.

First, we will see what they entail and their basic operation; then, we will focus on the different kinds of letters of credit and the most common fees; finally, we will see the advantages and disadvantages of letters of credit both for the importer and for the exporter.

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Letter of credit: definition and how it works

A letter of credit is a payment order that an importer issues through its financial institution in order to, directly or through another bank, pay the amount of the transaction to the exporter, as long as said exporter strictly adheres to the conditions of the letter of credit (usually the delivery of specific documentation). We are going to look at it in more detail in order to understand the role that each party plays:

1. The first step is for the importer and exporter to reach an agreement, have an international purchase contract and specify the conditions of the letter of credit, including all the documents required to be contained in it. At this point, the importer will request their bank to open the letter of credit on behalf of the exporter, including all the conditions of the letter in this request.

2. The second step depends on the issuing bank (importer), which receives the credit application, studies the documentation and the risk of the operation and proceeds to approve it or deny it. If approved, the credit is issued and the document is signed with a bank in the exporting country (advising bank) where the letter of credit is realized, which the importer is informed of.

3. The third step depends on the bank of the exporter, which reports the opening of the letter of credit and informs it of the conditions. The exporter will study these conditions and if they agree to the contract with the importer, the goods will then be sent.

Once the goods are shipped, the exporter will submit all the required documentation to the bank. In this case, if everything is as stipulated, the advising bank pays the exporter the amount of the credit, either on demand or at a later date. Afterwards, the issuing bank sends the documentation and confirms the terms of payment. The issuing bank will reimburse the amount paid in advance and will deliver the received documentation upon the immediate payment or upon acceptance of the payment at a later date.

Lastly, the issuing/importing bank will make the payment and with the documentation received, the issuing bank can withdraw the goods. The payment can be on demand or at a later date, depending on the conditions of the credit.

Practical example

A Spanish company (the payer) imports sugar cane from Jamaica for a million euros. As agreed with the Jamaican exporter (payee), the company goes to its bank (confirming) requesting that it open a credit document (also known as a letter of credit) for this amount.

This document or letter states that the issuing bank will pay that amount when the exporter provides them with the required documentation. This is usually the bill of lading of the goods, plus any other documentation deemed appropriate (sanitary certificates, reports, insurance, etc.).

Along with the normal risk of being paid or not paid inherent in all trading operations, there is also the fact that they are often large operations, with complex claims to carry out and different jurisdictions intervening. Therefore, a letter of credit is a risky operation for the financial institution .

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Types of letters of credit

Letters of credit can be revocable or irrevocable. Revocable letters of credit do not make a lot of sense, as they can be canceled after being issued, which means they do not fulfill the function of guarantee. Therefore, irrevocable letters of credit are more common.

Unconfirmed letter of credit. The bank issuing the credit will use a bank in the exporter's country to inform it of the letter of credit. This bank is called the advising bank who will act on behalf of the issuing bank, communicating the opening of the letter of credit, collecting the documentation, paying if applicable.

If that is all the advising bank does, the letter of credit is unconfirmed. A confirmed letter of credit is issued when the exporter requests, and the issuing bank confirms, that a bank in its country, either the advising bank or another bank designated by the payee, guarantees that the issuing bank will pay.

Depending on when the payment is made, this will be on demand when the documentation is delivered or at a later date following the delivery.

Transferable letters of credit are those in which the payee can specify other individuals who can share said guarantee and to whom the money will be paid. This is common if the exporter is just an intermediary or broker who is acting on behalf of other clients.

Another modality with similar aims is the back-to-back letter of credit, which is when the exporter-intermediary opens or orders a letter of credit with the guarantee from someone other than the payee.

The letter of credit can have a partial advance payment clause in favor of the payee before delivery of the documentation. If it is a red clause letter of credit it will be just upon receiving the funds or an endorsement. If it is a green clause letter of credit, ownership of the goods has to be proven.

Lastly, let's consider revolving letters of credit, which can be reused over a certain period of time.

Common fees for letters of credit

Remember that a letter of credit is a hybrid between a bank guarantee and a method of payment, which allows it to be used as a financing tool. The fees that affect this type of credit is distributed between the payer and payee.

The payer will pay structured fees such as endorsement fees: a start-up fee and a quarterly-risk fee. If the payment is deferred, the quarterly-risk fee is replaced by an equivalent deferred-payment fee from the documentation delivery date. If the credit has to be modified or if there are discrepancies (disagreements over the documentation delivered), fees are also normally charged. SWIFT expenses also often occur which is used in the whole process.

The payee has to cover the fees, such as the notice from the paying bank, the confirmation fee, the transfer fee and the cash payment fee. This can be negotiated so that the payer takes responsibility for these.

Advantages and disadvantages of letters of credit

The advantages for the exporter include highly guaranteed payments, as well as timely payments if all of the required documents are presented. It also enables financing with a guarantee from the letter of credit itself. To the importer it offers security involving the date and conditions for delivering the goods. It also provides a guarantee of its solvency to the exporter.

As for the disadvantages, it has a higher cost than other payment methods. The exporter may find it difficult when submitting all the required documents. For the importer, the major drawback could involve having to make the payment without verifying the characteristics of the goods.

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