Talking trade deals and connecting with importers or exporters is one thing, but one of the most important considerations in an international trade deal is payment and delivery. For exporters, the big concern is how you will be paid, while for importers some kind of guarantee of delivery is often crucial. This is where a letter of credit can work to equally protect both importers and exporters.
What is a Letter of Credit?
A letter of credit is a type of trade finance instrument, also called documentary credit, and is issued by the importer’s bank in favour of the exporter and sent to the exporter’s bank. Once the exporter fulfils all the requirements and conditions in the letter of credit, then the exporter is guaranteed payment for the shipment. Thus, a letter of credit serves to mitigate risk equally for both importer and exporter. The two banks will act as intermediaries to make sure that the needs and requirements of both parties are met.
Letters of credit are issued under various terms, for various purposes. For example, “at sight”, “usance” and “standby”; to be paid immediately upon presentment of shipping documents, to be paid at a later fixed date and to be used as a payment method of last resort, respectively.
The Basic Process
A typical letter of credit, regardless of the type, will usually involve seven steps as follows:
- An importer instructs their bank (the issuing bank) to open a letter of credit in favour of an exporter.
- The issuing bank will then send the letter of credit to the exporter’s bank (the nominated bank), who will forward it to the exporter.
- The exporter will prepare the shipment and handover the goods and documents to their freight forwarder.
- The freight forwarder will consign the goods and the shipping documents will be handed over to the nominated bank.
- The nominated bank will then check all the documents against the letter of credit and, if all is in order, the nominated bank will collect the payment from the issuing bank on behalf of the exporter, and forward all the shipping and trade documents to the issuing bank.
- The importer’s account with the issuing bank will be debited for that amount.
- The issuing bank will release the documents to the importer so they can claim the goods and clear the shipment through customs.
Why You Should Use a Letter of Credit
It secures both parties equally and helps establish trust and reduce risk. Furthermore, a letter of credit may be used by the exporter to obtain trade financing against it, further helping with cash flow. The importer is also assured that they will receive the goods as described and arranged. At Euro Exim Bank, we use our position as a reputed international bank to help SMEs around the world access letters of credit and other trade finance instruments easily and economically. We are also able to issue digital letters of credit where possible.
