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Letters of Credit a.k.a. Documentary Credits

The way to win-win

Presented by

Brian Ward MICM, CICP

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In an ideal world - prepayment

Seller perspective

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Seller Buyer

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In an ideal world – open account 180 days

Buyer perspective

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Seller Buyer

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In the real world – letter of credit at 60 days

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Seller Buyer

Compromise needed

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Why ask your buyer for a letter of credit?

» The buyer country risk is higher risk than supports open account terms

» Buyer’s creditworthiness is unknown to the seller

– Country filing requirements are inadequate to support credit decisions

» You move the credit risk from buyer to buyer’s bank

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Why do letters of credit work?

» Regulation

– Documentary Credits ( Letters of Credit) are covered by ICC Uniform Customs & Practice (UCP600) (International Chamber of Commerce)

» They are irrevocable unless specifically stated as otherwise (revocable)

– One party in the transaction cannot unilaterally change any term or condition of the LC.

– The exporter must specifically accept any amendment.

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What is a letter of credit?

» A letter of credit is a written undertaking from the importer’s bank to pay for the exporter’s goods or services, provided the exporter presents documents as stipulated by the credit.

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How is a letter of credit communicated?

» A letter of credit is communicated by the Issuing (overseas bank) to the U.K.(advising bank) via SWIFT.

» Society for Worldwide Interbank Financial Telecommunication supplies secure messaging services and interface software to wholesale financial entities.

» Once received and validated by the Advising bank, that bank forwards the full text of the LC by mail and/or email to the Exporter (Beneficiary)

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Stipulations Which? Where? When?

» Which documents to present

– Invoice and transport documents etc.

» Where the documents should be presented

– The bank to which the exporter delivers the documents

» When to present the documents

– Deadline to present the documents

These conditions/stipulations will all be stated on the LC

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When do Letters of Credit work best?

» The overseas bank is a strong bank

» Seller and buyer agree mutually acceptable terms and conditions for the LC in advance

» The Letter of Credit calls for an Ocean Bill of Lading to be produced

» Documents for presentation are kept to a minimum

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Basics

» If you don’t get your documentation absolutely consistent with the conditions of the letter of credit and if you don’t present your documents within the time limits laid down, you will not get paid under the terms of the credit

» Banks are required to check your documents for exact compliance with the terms of the credit

» Banks are required to check your documents for consistency between documents

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Documents

Exporter (beneficiary)

Importer (applicant)

UK Bank(advising/nominated

bank) Overseas Bank(issuing bank)

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Documentary Credits / Letters of Credit Routing

Issuing bank

forwards original

documents to buyer

9

Buyer sends details

to issuing bank

1

Issuing bank

check documents if

clean authorise

payment to advising

bank

8

Advising bank

checks documents &

Pays if nominated or

forwards to issuing

bank

7

Seller forwards

documents to

advising bank

6

Issuing bank

opens LC and

sends to

Advising bank

2

Advising bank

checks details &

forwards LC to seller

(may add

confirmation)

3

Seller ships order

as per LC details

4

Customer/Buyer

Seller

Issuing

bank

Advising

or

confirming

bank

B/Ls, Invoices, Bills of Exchange,

packing lists, insurance certs, certs of

analysis, legalisation etc

5

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Certainties

» Your bank cannot advise a Letter of Credit to you unless they have first authenticated the swift message

» Your customer does not want discrepancies on presentation

– Buyer has already paid for the LC (in cash or credit) and he wants the material

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Why add confirmation? Belt and braces

» Political and/or banking stability is in question

– We may ask a “first class Western bank” to add their confirmation to a letter of credit issued by another bank

• This moves risk from an unknown bank to a known party

» Default on payment would be catastrophic to seller

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Other forms of letters of credit

– Standby letter of credit- this can be used to underwrite open account business so that we are not bound by onerous conditions in a letter of credit

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Other forms of letters of credit

– Revolving letter of credit –

– this is suited to repetitive business where the letter of credit may be renewed in relation to time or value

• Where an importer needs repetitive shipments of similar or same value they can open a revolving credit which replenishes the value of the credit as it pays out, in this way the importer caps his utilisation of his credit line at his bank

• The exporter should benefit from easier compliance on presentations as the documents required will be very similar each time

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Other forms of letters of credit

» Red clause/advance payment —

– Red clause DCs contain a clause (traditionally written in red ink) authorising the nominated bank to advance a proportion of the value of the DC to the beneficiary before shipping documents are presented. This enables the beneficiary to purchase raw materials or to pay other costs (eg, transportation) prior to receiving full payment, once conforming documents have been presented.

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Other forms of letters of credit

» Back-to-Back

– This is where a DC is issued on the back of, and against the security of, another DC (the Master DC) on the understanding that reimbursement will stem from the documents presented under the Master DC. Both DC’s cover the shipment of the same goods. You will need to arrange for a DC facility with your bank if you are planning to use Back-to-Back DCs.

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Other features of letters of credit

» Confirmation – The seller can arrange to have a first class bank to add their

confirmation to a letter of credit moving risk from buyers bank to a U.K. Bank.

» Silent confirmation

– The seller can arrange to have a first class bank to add their confirmation to a letter of credit without the buyer’s knowledge

» Discounted LC

– Letters of credit may be discounted or sold for settlement by the bank today although the term of payment is long e.g. 180 days

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Who normally pays the bank charges on LCs

Buyer (Applicant)

» Costs in buyers country

– Opening charge

– LC Commission

– Amendment costs

Seller (Beneficiary)

» Costs outside buyer’s country

– Advising costs

– Confirmation costs

– Discrepancy fees

– Discounting fees (if used)

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Why and when a win-win with LCs

Seller

» Security of a bank underwriting the trade

» Security of a Western bank underwriting the trade if required

» Can give seller advantage over competition calling for pre-payment

» Cash planning with confidence

» Where credit term is long LC can be discounted for early payment

Buyer

» Access to credit where it may not otherwise be available

» Confidence that goods have been shipped as per contract

» The higher the LC value the lower the cost versus cash interest payments

» The longer the credit period the lower the cost versus cash interest payment

» Benefit from interest rate differentials between buyer’s country and U.K.

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