A Letter of Credit, also known as a documentary credit, is a method of payment that makes international sales more secure for both the buyer and the seller. Predominantly, the letter of credit process is used for international sales contracts.
Buyers expect to receive what is paid for, whereas the sellers expect to receive the agreed amount in exchange for goods sold.
This would be a simple transaction when the buyers are present to inspect the cargo physically and the sellers are there to receive compensation in real-time.
This proves to be impossible in the scope of international sales. Because of that, there is a trust void between the buyer and the seller which may not be ideal for both parties.
Hence, one unbiased party has to be involved as a “transactional lubricant” to fill that trust void. Financial institutions, therefore, has devised the letter of credit to provide just that.
Even though international banks boast a global presence that most business entities do not have. It is still farfetched to assume that international banks are present in every known sovereign country. Thus, international banks from different countries work together to provide such credit services for international sales.
With that in mind, there are now 4 main interested parties in the full letter of credit process: –
- Issuing Bank (Buyer’s Bank)
- Advising Bank (Seller’s Bank)
A 4-way information flow standard has to be elected to govern a letter of credit. Thanks to the International Chamber of Commerce (ICC), with its Uniform Customs & Practice for Documentary Credits (UCP) publications. We can understand wholly what a letter of credit process would look like.
In this article, we will summarize the UCP 600 publication, to provide you with a top view of how a letter of credit process looks like.
International Sales Contract and Payments
To elaborate further, international sales contracts and letters of credit go hand-in-hand; One cannot exist without the other.
Whatever is comprised in the letter of credit is directly based upon the international sales contract drawn and agreed by the seller and the buyer.
Consequentially, the first order of the letter of credit process is actually the preparation of a proper international sales contract.
The UCP 600 publication provided sales contract guidelines for the sellers to follow.
Of course, both the buyer can add in additional exceptions and clauses to reflect both party’s request in a sales contract. But for all international sales contracts. Here are some details that is non-negotiable: –
Description of Goods
Goods description has to be as precise and concise as possible. Moreover, it is better to incorporate the nature of the goods as well.
Here are two examples of a goods description, take a gander and guess which one is preferred: –
Outer Footwear Sole made of Rubber
Without a doubt, the second description is preferred. Because in an international trade’s supply chain, any goods coming in-and-out of a country requires custom approval.
Ambiguous descriptions such as “Sole” can easily be misunderstood as a type of fish, instead of the intended footwear sole.
This can be interpreted as a deliberate way to hide what is actually imported, the penalties for this type of misrepresentation may vary, but strict.
Shipping Terms, or INCOTERM has to be prominently displayed in an international sales contract. Some examples of an INCOTERM include: –
- EXW (Ex-Work)
- FAS (Free Alongside Ship)
- FCA (Free Carrier)
- FOB (Free On Board)
- CIF (Cost Insurance Freight)
- CFR (Cost and Freight)
- CPT (Carriage Paid To)
- DDU (Delivery Duty Unpaid)
- DDP (Delivery Duty Paid)
- DAP (Delivery At Place)
An INCOTERM exists specifically to draw the line as to which part of the logistic leg the seller or buyer is responsible for.
|INCOTERM||Abbreviation||Main Mode of Transportation|
|Ex Work||EXW||Land, Sea, Air, or a mixture of them|
|Free Carrier||FCA||Land, Sea, Air, or a mixture of them|
|Carriage Paid To||CPT||Land, Sea, Air, or a mixture of them|
|Carriage and Insurance Paid To||CIP||Land, Sea, Air, or a mixture of them|
|Delivered At Place||DAP||Land, Sea, Air, or a mixture of them|
|Delivered at Place Unloaded||DPU||Land, Sea, Air, or a mixture of them|
|Delivery Duty Paid||DDP||Land, Sea, Air, or a mixture of them|
|Free Alongside Ship||FAS||Sea Only|
|Free On Board||FOB||Sea Only|
|Cost and Freight||CFR||Sea Only|
|Cost Insurance and Freight||CIF||Sea Only|
Additional Reading: Which INCOTERM Should I Use?
The price displayed in the commercial invoice (the international sales contract) is the amount the letter of credit financing. Evidently, the letter of credit requires this to determine the payment.
The quantity of goods sold is equally as important as the price of the goods sold. Both the advising bank and the issuing bank has a vested interest in knowing whether the remitted amount is for the promised quantity of goods sold.
Participating Banks in a Letter of Credit
The mark of the beginning of an international trade is the sales contract (commercial invoice); the mark of the beginning of the Letter of Credit is when the buyer starts an application with the issuing bank.
The applicant (buyer) presents all supporting documents as evidence that the sales contract is enforced.
So, if there is any doubt as to who is the one to begin the letter of credit process. We reiterate that it is the buyer that begins the whole process.
Here are some of the charges the issuing bank imposes onto the buyer
DBS Bank – Singapore (Importer/Buyer)
|LC Issuance||1/8% per month, Min 2 months, but not less than SGD 80|
|Pre-advice of LC (Telex/SWIFT)||SGD 50|
|Deferred payment commission||1/8% of invoice value per month, from expiry date of LC to due date. Min SGD 80|
|Discrepancy Fee||SGD 80|
|Amendment Fee||Extension – 1/8% per month on the outstanding balance.|
Min SGD 80 Amount – 1/8% per month on the difference
between the increased amount and the original amount.
Min 2 months. Min SGD 80
|LC Cancellation Fee||SGD 80|
|Withdrawal of application||SGD 50|
|Cable Cost||SGD 100|
|Processing Fee (Advanced Arrangements)||SGD 100|
Additional Reading: Who Pays for Letter of Credit Services?
Transport Document flow is different from the Letter of Credit Document Flow.
We have to keep one important fact in mind, to avoid any confusion, is that the cargo delivery flow and the transport document flow is entirely different from the process flow of letter of credit.
To elaborate, although the buyer initiates the letter of credit process by applying with an issuing bank, the documents required to deliver the goods and facilitate the letter of credit actually start from the seller the advising bank.
The issuing bank issues the letter of credit by sending a SWIFT (Society for Worldwide Interbank Financial Telecommunication) message, a codified transmission message to the bank at the port of discharge.
The advising bank represents the seller.
Once the issuing bank issues the SWIFT message, the advising bank then creates an operative original of the issuer’s credit and delivers it to the seller under its own cover letter.
Once the operative is created and issued, the UCP 600 code requires the advising bank to honour the credit transaction. In other words, no “backsies”.
The core concept is, the seller receives payment remittance from the advising bank; the advising bank receives payment from the issuing bank; and the issuing bank receives payment from the buyer before releasing the document of title to the buyer to receive the cargo.
Transport Document Flow of Letter of Credit
Document Flow of a Letter of Credit
Cargo Flow will invariably be from the seller to the buyer, so too is the document flow.
Documents introduces a whole new dynamic to the interactions between the parties involved in a Letter of Credit: –
- Advising Bank
- Issuing Bank
- Third Party Logistics Provider
A letter of credit facility not only requires documents from an international sales contract, but also the third-party logistics service provider as well.
Here is the list of documents potentially required at the source of those documents: –
|Bill of Lading||Carrier|
In practice, trade financing banks do not go to lengths to confirm that the seller has delivered the cargo per the international sales contract.
It is both logistically impossible, and financially unsound.
In addition, the banks do not investigate, or examine the goods too.
Therefore, the UCP 600 guidelines rely entirely on the presented documents such as the one listed above. The banks then cross examine the presented documents against the documentary conditions of the letter of credit.
The strict compliance rule that banks adheres to are the one that often catches buyers and sellers off guard.
It is not uncommon where banks do not issue the payments to the seller because of a minute discrepancy such as a slight spelling error, or a misplaced comma on the shipping documents.
Example Bill of Lading Document Flow
For simplicity sake, we will look only at the Bill of lading’s document flow in a trade that involves a letter of credit.
Let’s say that a contract is made to sell and transport 1 20’ container worth of cocoa powder from the Port of Rotterdam to Port of Los Angeles. The shipment is arranged with CFR Los Angeles INCOTERM.
Recall that under the INCOTERM CFR, the seller has the obligation to arrange transportation up to the consignee’s port of discharge, and undertakes all the risks of transportation up to the Port of Los Angeles as well.
The seller, therefore, is required to appoint arrange sea freight transportation with a Carrier.
- Once the advising bank receives the operational instruction from the Issuing bank via SWIFT message, the Letter of Credit is in effect.
- The seller books an ocean freight transportation with a carrier.
- Once the carrier receives the cocoa powder cargo, the carrier then issues 3 copies of “To Order Bill of Lading”.
- The seller retains one original copy, and presents another it to the advising bank along with commercial documents.
- Carrier begins the carriage by sea according to its schedule.
- The advising bank submits the shipping and commercial documents to the issuing bank for examination.
- The issuing bank checks the shipping and commercial documents
- Once payment arrangements between the issuing bank and the buyer has been agreed on, the buyer receives the original copy of bill of lading, along with instructions from the bank to release the cargo to the buyer.
- The buyer presents the original documents to the carrier to exchange with the delivered goods.
Payment Flow of a Letter of Credit
Relative to the document flow of a letter of credit, the payment flow is relatively straight forward.
The most direct form of payment flow is when there are no other parties involved in the letter of credit transaction.
- Buyer pays the contracted amount to the issuing bank.
- Issuing bank remits payment to the advising bank.
- Seller receives payment from the advising bank.
This is the core concept of the payment of goods via the bank as an intermediary.
But there are many other permutations of this payment flow that needs to be understood. Part of the reason why sellers and buyers prefer to use Letter of credit is not only for the added financial security, but for the added financial flexibility a trade bank provides to the buyer/seller.
Using Letter of Credit to Finance Seller’s Supplier
Letter of Credits permit the credits to be transferred. In other words, the seller can use the letter of credit as a facility to finance the raw materials required to manufacture and sell to the intended buyer.
For the cocoa powder example, the seller originates from Netherland, but the raw materials for cocoa powder is actually cocoa bean.
The seller can finance its purchase of cocoa beans via a Letter of Credit.
The credit transfer can be portioned according to what is owed to the seller’s supplier.
There are two criteria for a Transferrable Letter of Credit to work: –
- The applicant must notify the issuing bank in the application
- The advising bank has to agree to provide the transferrable letter of credit facility
Transferring the Right to Draw to another Party
By contrast, transferring a right to draw to another party essentially transfer the right to the payment to another vested party.
Why Do We Use Letter of Credit?
It is likely that both the buyer and seller are in business together for the first time.
So there remains a question mark as to each party’s creditworthiness, product quality, and delivery commitment.
An international sales contract built with a letter of credit as a foundation, both the buyers and sellers are answerable to their respective financing banks.
Of course, a trade financing bank will also gauge a buyer’s or seller’s creditworthiness, product quality and delivery commitment. They are also in a better position to do so, seeing that each bank has the right to request for additional supporting documents.
Perhaps even, a trade financing bank that rejects the request of the buyer’s application for letter of credit is a tell-tale sign that the buyer may not be fiscally strong enough to honour the sales contract.
A letter of credit also indirectly bridges other barriers. The language barrier may be the prominent enough as a deciding factor for a sales contract. Letters of credit allows a sense of information parity.
Even a fiscally strong buyer may default in its payment obligations. Even then, sellers can be rest assured that the banks are there to act as a payment guarantor.
Document Processing Security
The documentary hurdles one has to overcome when preparing a letter of credit are many. One can also argue that the stringent document processing requirements may deter buyers and sellers from applying a letter of credit.
But these stringent document requirements are required for a reason. The UCP 600 guidelines illustrates that a “strict compliance” is the key to drafting a executable letter of credit.
Upon the application of the letter of credit, buyers can dictate that sellers need to provide additional documents such as health certificates, certificates of origin, insurance certificate, or any other international accreditation certificate.
In certain cases, a letter of credit is mandatory.
The Bangladesh government enforces a strict requirement that all imports into Bangladesh has to be accompanied with a Letter of Credit.
Granted there are certain leniency in the rule. For example, the importation of books, journals, magazines, and certain agricultural products does not require an accompanying Letter of Credit.
Frequently Asked Questions?
Can Letter of Credit be Cancelled or Amended?
A cancellable letter of credit is also called a revocable letter of credit.
According to the UCP guidelines, a letter of credit can neither be cancelled or amended without the approval from the all parties of the trade.
Unless it is explicitly mentioned, all letter of credits is prepared as an irrevocable letter of credit.
But if the issuing bank receives instructions to prepare a revocable letter of credit, the buyer reserves the right to amend or cancel the letter of credit without notice or consent to the seller.
We are merely discussing the tip of the iceberg with regards to a letter of credit’s process and procedures.
But the information presented in this article is fundamental in understanding this trade financing tool.
If utilized wisely, both buyers and sellers may open more sales avenues with much needed financial security.