A letter of credit is defined as an undertaking by an issuing bank to the beneficiary to make payment within a specified time, against the presentation of documents which comply strictly with the terms of the credit. Therefore, the risk to the seller of non-payment by the buyer is transferred to the issuing bank (and the confirming bank if the letter of credit is confirmed) as long as the exporter presents the documents in strict compliance with the credit. It is important to remember that all parties in the letter of credit transaction deal with documents, not goods.
Other than cash in advance, a letter of credit is the most secure method of payment in international trade, with the payment undertaking of the bank, as long as the terms of the credit are met. The letter of credit also provides security for the importer who can ensure all contractual documentary requirements are met by making them conditions of the letter of credit.
Uniform Customs and Practice for Documentary Credits (UCP)
UCP were originally formulated in 1933 by the International Chamber of Commerce and are the universally recognised set of rules governing the use of the documentary credits in international trade. The most recent revision came into effect in 1994 (ICC publication 500). All definitions and general documentary requirements referred to in this report are in accordance with UCP500 unless otherwise stated (it should be remembered that in some instances this may differ from national law).
With effect from 1 April 2002 UCP500 has an electronic supplement called eUCP, which provides for electronic presentation of documents. Although the survey did not distinguish between electronic and paper credits further work could be carried out into the use of electronic credits, their rejection rates and reasons for rejection. Additionally SITPRO has the opportunity to look at the use of WebElecTra (the web based export documentation software system) in letter of credit operations.
Those Involved in a Letter of Credit Transaction
- Applicant - the importer
- Issuing Bank - the bank issuing the credit on the instructions of the applicant.
- Beneficiary - the exporter
- Advising Bank - usually the correspondent bank of the issuing bank in the exporter's country, which verifies the authenticity of the letter of credit and forwards it to the beneficiary.
- Nominated Bank - the bank authorised, within the letter of credit, to make payment to the exporter and to whom the documents are presented. The payment undertaking, however, is purely from the issuing bank so the country risk is not covered.
- Confirming Bank - usually the advising bank in the beneficiary's country, which adds its confirmation (where this is required) to the credit and undertakes an independent obligation to pay the exporter provided the terms of the credit are met.
It is important to negotiate, at contractual stage if possible, which party will bear bank charges. It is worth remembering that on a small transaction these may be totally out of proportion and if these costs are not included in the pricing any profit may be completely eroded.
Types of Letter of Credit
- Revocable
A revocable letter of credit can be amended or cancelled at any time without the beneficiary's agreement (unless documents have been taken up by the nominated bank). Little protection is offered to the beneficiary with a revocable credit and they are rarely seen. - Irrevocable
An irrevocable letter of credit can neither be amended nor cancelled without the agreement of all parties to the credit. Under UCP500 all letters of credit are deemed to be irrevocable unless otherwise stated. - Unconfirmed
An unconfirmed letter of credit is forwarded by the advising bank directly to the exporter without adding its own undertaking to make payment or accept responsibility for payment at a future date, but confirming its authenticity. - Confirmed
A confirmed letter of credit is one in which the advising bank, on the instructions of the issuing bank, has added a confirmation that payment will be made as long as compliant documents are presented. This commitment holds even if the issuing bank or the buyer fail to make payment. The added security of confirmation needs to be considered in the context of the standing of the issuing bank and the current political and economic state of the buyer's country. A bank will make an additional charge for confirming a letter of credit. - Standby Letters of Credit
A standby letter of credit is used as support where an alternative, less secure, method of payment has been agreed. They are also used in the United States of America in place of bank guarantees. Should the exporter fail to receive payment from the buyer he may claim under the standby letter of credit. Certain documents are likely to be required to obtain payment including: the standby letter of credit itself; a sight draft for the amount due; a copy of the unpaid invoice; proof of dispatch and a signed declaration from the beneficiary stating that payment has not been received by the due date and therefore reimbursement is claimed by letter of credit. The International Chamber of Commerce publishes rules for operating standby letters of credit - ISP98 International Standby Practices. - Revolving Letter of Credit
The revolving credit is used for regular shipments of the same commodity to the same buyer. It can revolve in relation to time or value. If the credit is time revolving once utilised it is re-instated for further regular shipments until the credit is fully drawn. If the credit revolves in relation to value once utilised and paid the value can be reinstated for further drawings. The credit must state that it is a revolving letter of credit and it may revolve either automatically or subject to certain provisions. Revolving letters of credit are useful to avoid the need for repetitious arrangements for opening or amending letters of credit. - Transferable Letter of Credit
A transferable letter of credit is one in which the beneficiary has the right to request the paying, or negotiating bank to make either part, or all, of the credit value available to one or more third parties. This type of credit is useful for those acting as middlemen especially where there is a need to finance purchases from third party suppliers. - Back-to-Back Letter of Credit
A back-to-back letter of credit can be used as an alternative to the transferable letter of credit. Rather than transferring the original letter of credit to the supplier, once the letter of credit is received by the exporter from the opening bank, that letter of credit is used as security to establish a second letter of credit drawn on the exporter in favour of his supplier. Many banks are reluctant to issue back-to-back letters of credit due to the level of risk to which they are exposed - a transferable credit will not expose them to higher risk than under the original credit.
The above is a brief explanation covering the basic issues of using a letter of credit. For fuller explanation readers are invited to look at the many publications available giving much fuller detail on this subject.
- Contents
- Executive Summary
- Section 1 - Introduction
- Section 2 - Letters of Credit - An Explanation - Return to top of page
- Section 3 - Global Payment Patterns
- Section 4 - The Survey
- Section 5 - Demonstrated Best Practice
- Section 6 - Conclusions
- Glossary of Commonly Used Terms in Documentary Credits
- Appendix 1 - List of Discrepancies and Frequency
- Appendix 2 - Organisations Providing Letter of Credit Training
- Appendix 3 - Checklist for Compiling Documents Under a Letter of Credit
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