For both importers and exporters, a letter of credit (LC) usually offers the best protection and assurance of payment and delivery. Banks will act as trusted intermediaries to the transaction and guarantee payment, once the necessary conditions are fulfilled. Additionally, for importers, an LC can be used as collateral against which to obtain financing for the shipment. Overall, it is the safest and most standardized way to govern and settle international trade transactions, as the rules are generally similar around the world.
How They Work
While there can be many banks and beneficiaries involved, an LC usually works as follows. The importer will request their bank to draw up an LC for the desired value and with the desired terms. The importer’s bank will then send the LC to the exporter’s bank. Now the LC is official. Once the shipment has been successfully consigned, the exporter will present the invoice and shipping documents to their bank, who will examine them and then send them across to the importer’s bank. Once everything checks out, the payment will be made, less any fees the banks may charge.
This kind of LC is usually referred to as a sight LC as payment is due ‘on sight’ of the documents. However, other types can also exist. Discussing all of the various types is beyond the scope of this article, but commonly used ones include standby, irrevocable/revocable, deferred payment, red clause, back-to-back, and confirmed/unconfirmed LCs. Each of these variations has its own use cases. LCs can be amended if all parties are in agreement.
Parties Involved
In a standard, basic LC there are four parties involved: the applicant (importer), beneficiary (exporter), issuing bank (importer’s bank), and advising bank (exporter’s bank). However, additional parties may become involved in certain circumstances, such as when more than two parties are involved in a trade deal or when an extra intermediary bank needs to get involved.
Margin
To issue an LC, banks may demand a certain percentage value of the shipment to be placed as a margin. This can usually be done either in cash or cash-like instruments/assets. In some jurisdictions, this may be a mandatory requirement. Importers may also keep collateral with their banks, such as property, against which LCs can be issued.
Documents Required
This may vary depending on the jurisdiction, but usually, the following documents will be required:
- Business registration documents
- Tax certificates/registration
- Licenses or permits, if any are required
- Proforma Invoice that clearly states all the details of the shipment
Choice of Bank
When using an LC, for international trade settlements, it is crucial to choose a reputed, tech-savvy international bank that specializes in trade finance, such as Euro Exim Bank. This will ensure speed and reliability. Also, if your business is based in a jurisdiction with excessive regulatory controls, an international bank can help you transact with more ease.
