Letters of Credit: How Do They Work?

The concept of a letter of credit is easy to understand if you already have some knowledge of escrow services. Basically, the bank acts as an independent 3rd party, holding on to the funds until some criteria, necessary for the funds to be released, are fulfilled. Such letters are common not only in global trade but also in matters pertaining to domestic trade and transactions.

process flow how letters of credit are used in international trade payments

Quick Points about Letters of Credit (LOC):

  • Buyers or sellers are meant to be protected with a letter of credit.
  • In order to get such a letter, the business has to ‘apply’ for it and prove that it fulfills the necessary requirements.
  • Due to their complicated nature, they need to be dealt with carefully as a small mistake can be very expensive.

How does the bank ensure payment on a Letter of Credit?

We know that the bank acts on the customer’s behalf to fulfill the payment requirements but where does this money come from?

When the bank promises to make the payment on behalf of the customer, it is usually sure that the buying party will fulfill its responsibilities and pay. However, in some cases the bank simply asks the buyer to pay upfront, or allow it to freeze some of the funds belonging to the buyer at that bank. Alternatively, the bank can loan the money to the buyer in the form of a line of credit.

From the seller’s perspective, trust is equally important. He not only needs to trust the issuing bank but also believe that it will indeed make the payment as agreed under the conditions stipulated in the contract. To ensure things are carried out smoothly and as expected, the seller can demand a ‘confirmed’ letter of credit. This letter basically acts as a guarantee from a more dependable bank that the payment will indeed be made.

It is common for sellers to use their local bank to confirm a letter of credit.

From the seller’s perspective, trust is equally important.

When is LOC Payment Made?

The letter of credit will always lay out the specific requirements that need to be fulfilled for before funds will be released to the seller. One such example can be found in international trade. A seller delivers products at a port and receives a confirmation of delivery. He/she then forwards that confirmation to the bank that sees that the delivery has been carried out successfully and therefore releases the payment. Note that in some cases, it is quite possible that the product is damaged during delivery. This is not necessarily an issue for the seller and he/she receives his/her full payment.

If the buyer wants to ensure the products are delivered in perfect condition, he/she can ask for an inspection certificate. He/she has to work on these details with the seller. The bank, however, has no interest in the state of the goods. The bank only cares about the right documentation. If the seller has performed the right actions as per the agreement, the money is released.

The bank only cares about the right documentation. If the seller has performed the right actions as per the agreement, the money is released.

The Risks of International Payment

The purpose of a letter of credit is to reduce different kinds of risks while doing business. However, things can go horribly wrong even due to minor mistakes. It is therefore important that a lot of care is taken while reviewing and signing these documents.

Here are a few tips that will help you during the process:

  • Before signing any agreement, review ALL the requirements very carefully.
  • Make sure you know what documents you need to provide. In case of any confusion, always ask the bank.
  • Make sure you will actually be in a position to successfully provide all the documents in the condition required. For example if the requirement is to provide a signed original copy of the Bill of Lading, ensure that you will receive this in time. Carefully consider the risks in case you are unable to get certain documentation ready in time. If you fail to provide the documents you agreed to provide, you will have a hard time getting the bank to release payment.
  • Expanding on the above point, make sure that not only that your service provider will deliver the documents to you in time but also that you will be able to send them to your bank in time.
  • Read and understand if there are any time limits set out in the letter. Consider if these time bars can actually be met easily.
  • Carefully consider the title and description of the documents required according to the letter of credit. Any typos or substituted names can lead to serious payment problems.
  • Remember the bank is acting as an independent party. It is the job of the bank to be extremely cautious and follow the contract strictly before funds can be released.

Relevance in International Trade

The use of letters of credit in international trade show how important they are to businesses worldwide. When a person does business with someone overseas, there are many risks involved. You may come across a dishonest buyer or someone who deliberately gets into business with you solely for the purpose of fraudulent activities. On the other hand, there may be genuine business people who are unable to complete a transaction due to troubles in their own region. On top of all that, communicating with people in a different language who are far away in ‘hard to work with’ time zones can itself lead to misunderstanding and collapse of business deals.

What makes letters of credit so useful in such businesses is the fact that all the details are clearly determined right at the start. Both parties know what limited risks they have and how much payment is guaranteed. This means that right from the word go, both parties know what to do in case of any unforeseen events.

On top of all that, communicating with people in a different language who are far away in ‘hard to work with’ time zones can itself lead to misunderstanding and collapse of business deals.

LOC Terminology

Here are a few basic terms that should help you get started with working with letters of credit.

Applicant: This is the entity that desires to use the letter of credit and applies for it. Usually it is the individual who has to make the payment to the beneficiary. In most cases, this represents a buyer or an importer who purchases something using a letter of credit.

Beneficiary: The entity that receives the payment in the end. In order to have more financial security, the Beneficiary (exporter or seller in most cases) requests the buyer to obtain a letter of credit for doing business.

Negotiating Bank: This is the banking institution that deals with the seller or the beneficiary. For ease of business it is often a bank located in his/her own country. Due to the fact that letters of credit may require upfront payments or freezing of funds, it is often a bank where he/she already has an account. This bank ensures that with the letter of credit, both parties can do successful business.

Confirming Bank: Sometimes beneficiaries prefer to have a backup bank who can guarantee payment provided that the conditions agreed upon have been fulfilled. Such a bank is called the Confirming Bank. Note that the negotiating bank can also act as the confirming bank.

Advising Bank: Also sometimes referred to as the notifying bank, this is the bank where the letter of credit is sent to. Once the letter is received, the beneficiary is notified. This bank can be the same as the confirming and negotiating bank.

Issuing bank: This is the bank that triggers the issuance of a letter of credit. It is usually a bank with a local presence where the trader is doing business.

Intermediary: This is the firm that brings buyers with sellers together. The intermediary uses the letters of credit as a mean to ensure business transaction run smoothly. They also often use transferable or back to back letters of credit.

Freight Forwarder: The firm that facilitates businesses that have to ship products internationally. Letters of credit often require documentation that has to be obtained from Freight Forwarders.

Shipper: The firm that moves products from one place to another.

Examples where Letters of Credit are used

  1. A soft toys manufacturer in Vietnam accepts a new order from customer in Singapore. The manufacturer has never done business with this customer before. The order is large and the manufacturer is concerned that the buyer may not pay for the shipment once delivered to Singapore.
  2. In order to manage risks, the seller requests that payment be made via letter of credit upon successful delivery.
  3. The buyer in Singapore agrees to these terms. The buyer applies for a letter of credit with a Singapore bank.
  4. The Singapore bank will work with a Vietnamese bank nominated by the manufacturer or a local branch office of the Singapore bank in Vietnam.
  5. Once the cargo is delivered to the vessel, the seller can submit the agreed documents to the local bank in Vietnam to collect payment.
  6. After funds are released, the bank will send the required documents over to the buyer so that he/she can take control and title of the cargo once it arrives in Singapore.

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