What are the advantages of Letter of Credit? Why do exporters prefer it to other payment instruments? In this article, we will be focusing on the types of LC and its advantages to importers and exporters. Keep reading.
Letter of Credit ranks among the best payment instruments in an international transaction. It is one of the most preferred legal tenders by exporters.
What is Letter of Credit?
According to Investopedia, a letter of credit is a letter from a bank guaranteeing that a buyer’s payment to a seller will be received on time and for the correct amount. In other words, it is a letter assuring a seller that the issuing bank is ready to make payment in case their fails.
Letter of Credit ranks among the best payment instruments in international transactions. Also, it is one of the most preferred legal tenders by exporters.
Furthermore, an LC serves as a debt recovery instrument for the seller in case the buyer fails to make payment for the goods purchased on credit. Also, the issuing bank serves as a guarantor for their customers who intends to buy goods from a foreign seller.
A Letter of Credit is one of those needful payment instruments necessary for international trading. In case of payment default, the issuing bank will take full responsibility for total outstanding debt.
It is primarily controlled by The International Chamber of Commerce Uniform Customs and Practice for Documentary Credits.
Who Funds LC?
A bank is not a place to get free money so, the customer must be sure his net worth exceeds the value of the proposed letter of credit. However, banks serve as guarantors for customers with good financial standing.
Types of Letter of Credit
Import/Export LC. There is no difference between the two LCs because it only derives its name from the users perspective. It serves as an Import LC to an importer but serves as an export LC to an exporter.
Stand-by LC A stand-by LC implies that buyers bank is sure ready to make payment in case their customer is unable to make payment as promised.
Revocable LC. A revocable LC is a term given to a letter of credit that the issuing bank makes some amendments even after issuing it to the beneficiary. Sellers no longer accept this as payment assurance.
Irrevocable LC. It is the exact opposite of the revocable letter of credit LC. In other words, the issuer does not have any right to cancel the instrument except the beneficiary permits it.
Confirmed LC. A confirmed letter of credit requires confirmation from another bank believed to be more credible than the first bank. Read more on Confirmed LC in our subsequent articles.
Unconfirmed LC. It is a type of LC that does not require any form of endorsement from another bank. In this case, the seller believes the issuing bank is credible; no need for confirmation.
A Deferred LC/Usance LC. This type of payment instrument gives room for the buyer to defer payment for some time. The reason for the waiting is to allow a buyer to take possession of goods. In order words, submitting documents matter less.
Payment at Sight LC. It is a type of LC that guarantees prompt payment provided sellers provides all relevant documents.
Restricted LC. A Restricted Letter of Credit is where the issuing bank of the LC only lets the customer redeem the LC from a specific bank and vice versa.
Unrestricted LC. An Unrestricted LC is a Letter of credit with no restrictions concerning which bank the beneficiary chooses for negotiation.
Red Clause LC. Red Clause LC is an LC that gives room for advanced payment to sellers who possibly do not have enough money to fund a transaction. It is common when dealing with trusted suppliers.
Back-to-back LC. It involves two dependent LCs that share everything in common. It does not permit any form of variation on the two LCs.
Transferable Letter of Credit. This type of LC permits payments to a third party who is possibly the transaction financier or producer. Other parties to a transaction usually demand transferable LC to avoid losing money to co-supplier.
For detailed explanation about different types of Letters of Credit, kindly read up Commonly Used Letters of Credit. Also, for other payment instruments such as Bank Guarantee, kindly read up Benefits of Bank Guarantee in Local & Export Business.
What Are the Advantages of Letter of Credit?
Some of the advantages of letters of credit are guaranteed payment, easy access to funding, future business support, and quick dispute resolution. Others include benefits transfer, order security, instant settlement, and distance barrier braking.
Let me quickly explain some of the listed benefits.
First, a letter of credit is an instrument for guaranteed payment. If the buyer’s bank sends you an LC, you are sure of collecting your money from the issuing bank even if your buyer default.
Second, you will be able to raise money to fund your business transactions. With an LC, you can access loans and advances from your bank to finance your orders. In other words, provided your buyer is ready to issue an LC, your bank will sure fund your deal without delay.
Third, another benefit of LC is the ability to plan for future business deals. With an LC from a credible bank, you can make plans for future business knowing fully well that the current one is a done deal. Without doubt, a Letter of Credit allows you to project into the future.
Fourth, with a Letter of Credit, you are sure of prompt payment. For example, Payment-at-Sight LC guarantees payment within seven days after submitting all relevant documents.
Other Advantages of Letter of Credit
Fifth, raising of a dispute by a buyer is not enough to stop your payment. The fact that there is a conflict over quality does not mean his bank will not honour your LC. However, this is not to say that a seller can ship scrap to and expect payment.
Sixth, in addition to the fact that dispute cannot stop payment, LC aids quick dispute resolution. It is easy to resolve disputes arising from a Letter of Credit. Moreover, The Uniform Customs and Practice of Documentary Credit is always on ground to resolve all LC-related disputes.
Seventh, using LC reduces distance barriers that are mostly common to foreign trade. As a seller, you do not need to travel several kilometres to verify the financial strength of a purchaser.
Eighth, it is not possible to cancel orders. This advantage separates irrevocable LC from others because a buyer cannot cancel his order. It does not matter if he receives a lesser offer from other sellers as his current contract with you remains valid.
Ninth, another advantage of letters of credit is that it is transferable. You can transfer ownership from one beneficiary to another provided its stated on the LC.
Letter of Credit With Conditions
There are some LCs with conditions attached which include Red Clause, Back-to-Back, Payment at Sight, and Stand-by Letters of credit. In this case, parties to the contract have to fulfil certain conditions to avoid losing money.
Turning A Letter of Credit into Cash
For a beneficiary to receive payment due on an LC, he may have to provide some documents such as commercial invoice, Bill of Lading, Bill of Exchange, Insurance Certificate etc. All the required papers are usually in prints as contained in the soft corporate offer and sales and purchase agreements.
Moreover, all Incoterms transactions such as Cost, Insurance and Freight or Free on Board, and Ex-Works always have it.
Difference Between LC and Bank Guarantee
But for a few difference, Letters of Credit and Bank Guarantee share so many things in common concerning payment assurance.
Other Differences Between Letter of Credit And Bank Guarantee
| Letter of Credit | Bank Guarantee |
|---|---|
| Letters of credit helps in guarding against payment default.. | bank guarantee helps in ensuring both parties meets contractual obligation. |
| All it takes to effect payment on an LC is for the seller to fulfill all the conditions on the instrument. | Bank guarantee becomes cash when there is non-performance of obligations on the part of one of the parties. |
| An LC is more suitable for Import and Export business most especially commodity sales. | Bank guarantee is common with government contracts such as construction of roads and real estates |
| The risk-bearing is mostly on the issuing bank while the merchant hardly feels any pressure except has pledged some assets against default. | In the case of Bank Guarantee, the merchant bears the burden for payment because his fund is at stake if the transaction goes wrong. |
Example of How Letter of Credit Works
Let us assume you request to purchase petroleum products from us, and we agree to trade with you. Having agreed to the terms of the contract, we want to be sure you are going to pay us on time. If we settle for an LC as our preferred payment instrument, we will demand it from your bank.
Note that transaction has not commenced until we receive LC from your bank. Also, we expect its details not to negate our initial agreement. In other words, issuance of LC does not guarantee the execution of the contract should there be any discrepancy on the instrument.
Caution On The Use Of LC
As good as LC is, seller must be careful not to run into trouble with the issuing bank. His failure to follow stipulated details such as shipment date may jeopardize payment. Also, you need to be careful when transacting business with new partners, so you do not get trapped with fake documents. Trade safely.
Can I use Letter of Credit as Collateral for a Loan?
LC, especially Standby LC, can be used as collateral for the opening of a credit line or as a means of insurance in export contracts. Therefore, you can use the Standby LC as a letter of guarantee. The caveat here is that the issuing and confirming banks must possess good credit rating (AA or AAA).
Kindly read up our article on the importance of Bank Guarantee.