L/C Letter of Credit
L/C (Letter of Credit)
When concluding transactions, entrepreneurs have to decide what form of payment to choose. From a security point of view, a letter of credit is considered the best choice. It is recommended to use it especially in transactions from the higher-risk group. Therefore, its popularity is greater in foreign trade. Due to the associated costs, it is only profitable for larger orders, the total value of which exceeds 30,000. USD. Below we describe what a Letter of Credit (L / C) is.
What is a letter of credit?
To pisemny dokument, wiążący kupującego, sprzedawcę i bank. Ogranicza ryzyko związane z rozliczaniem transakcji. Zabezpiecza przed sytuacją, w której importer jest w danym momencie niewypłacalny. Chroni również przed jego nieuczciwością. Poprzez zawarcie akredytywy bank zobowiązuje się do wypłacenia określonej sumy eksporterowi.
It is a written document that binds the buyer, seller and bank. It reduces the risk associated with the settlement of transactions. It protects against a situation in which the importer is insolvent at a given moment. It also protects against his dishonesty. By concluding the letter of credit, the bank undertakes to pay a specified amount to the exporter.
It mainly consists in separating a certain amount of cash from the importer’s bank account. The bank reserves them to cover liabilities to the exporter. The bank may release the recipient of the goods from the obligation to allocate funds. Thanks to this, the importer does not have to freeze its funds. It all depends on the agreement between the individual parties.
In short, a letter of credit also provides a guarantee of payment for the goods and protects both parties against the risk of failure to meet the obligations agreed in the contract. It is the bank’s obligation towards the exporter, taken by the bank on behalf of the importer.
Bank letter of credit
The first is the importer’s bank , also known as the opening bank. It does not analyze the course of the transaction; it only decides whether to implement it based on the documents presented.
The second bank,, the intermediary bank,may have several functions:
- the advising bank acts as an intermediary between the opening bank and the exporter
- the negotiating bank checks the documents
- the confirming bank commits to or refuses to make a payment to the exporter.
Documentary credit, known in English as documentary credit or documentary letter of credit , is a conditional form of transaction settlement. It is able to eliminate the transaction risk for both the importer and the exporter.
Compared to documentary collection used in international transactions, a letter of credit is a more expensive form of payment.
How does a letter of credit work?
A letter of credit is always ordered by the buyer. Then the application is examined by the bank. It should be noted that he is not required to open a letter of credit. The final decision depends entirely on the individual assessment of the bank. The institution verifies, first of all, the credibility of the enterprise, the terms of the contract and whether the contract is feasible. The conditions for its opening are also set (the opening of a letter of credit lasts – depending on the bank – from 24 hours to 3 days).
The customer should be aware that banks are not responsible for the condition of the goods received by the buyer. They only check the compliance of the documents provided with the contract. From the moment the letter of credit is opened, the bank takes responsibility for the payment. The seller must provide the documents within a specified period. Their content must be consistent with the terms and conditions established prior to the opening of the letter of credit. Any deviation, such as a change in the nomenclature (e.g. the use of specialist vocabulary and colloquial language) may result in non-payment of funds.
The creditor’s branch closes the letter of credit within 3 days of receiving the instruction from the importer’s bank. The three-day deadline gives the creditor time to invoice the services already provided. In addition, it is worth noting that the letter of credit does not protect against all types of risk related to the course of the transaction. For example, it does not hedge against currency risk.
Not all banks in the world cooperate in the opening and confirmation of letters of credit. For international trade with China, many banks in China offer a letter of credit service. However, it is worth using the services provided by banks with branches in Poland, i.e. Bank of China and Industrial and Commercial Bank of China.
Who is the letter of credit recommended?
A letter of credit is recommended especially to exporters who:
- enter into their first contract with a new contractor
- enter a completely new or remote market
- have doubts as to the reliability and timely fulfillment of the contractor’s obligations
- make large deliveries
- adhere to the principle of safety above cost
Benefits for the importer:
- reduces the risk of receiving defective goods (with the requirement to provide quality certificates)
- specifies the list of documents required in the letter of credit (they are the basis for payment)
- ensures timely delivery (letter of credit setting the dates of shipments of goods)
- possibility of negotiating more favorable terms of the transaction (eg better prices, deferred payment terms)
- protection against unjustified payment of receivables. The amount is transferred only after the bank confirms that the documents comply with the terms of the letter of credit
Benefits for the exporter:
- reduces the risk of non-payment or delay
- prevents the contractor from withdrawing from the contract or refusing to pay after receipt of the goods
- eliminates the risk of changes by the importer
- guarantees the receipt of receivables from the bank (upon presentation of documents in accordance with the contract), even in the event of the importer’s insolvency
- early withdrawal possible with a discount
- allows you to make your sales offer more attractive or get a higher price for a good (service) by offering a trade credit, without fear of the risk of non-payment.
- makes it possible to authorize the intermediary bank to pay the beneficiary an advance before presenting the required documents (advance letters of credit)
Documents necessary for the letter of credit
Timely delivery of documents is as important as their content. A letter of credit is opened for a certain period. Regardless of whether it lasts a month or a quarter, the exporter must complete the documents within the specified time. It should also take into account that the bank needs several days to read the documentation. The bank is not obliged to make the payment after the deadline specified in the letter of credit. The most common documents included in the contract:
- commercial invoice,
- cargo specification (unless the invoice serves this role),
- documents confirming the quantity, condition, characteristics of the cargo (certificates, certificates),
- transport document relevant to the given situation (CMR or international consignment note, CIM or international air waybill, AWB, bill of lading, etc.),
- certificate of origin,
- insurance policy,
- health certificates,
- a bill of exchange issued by the exporter,
- other – which may result from specific regulations of the importer’s or exporter’s country.
It is worth noting that any discrepancies in the documents (other values, typos in the names) may lead to the suspension of the payment. Even if the errors are corrected, the bank may charge liquidated damages. So don’t be trivial.
Types of letters of credit
Letters of credit are divided into the length of the loan, payment method, payment to the seller, forms of settlement. In addition, there is a letter of credit:
- irrevocable ( irrevocable credit ) – is ultimately a binding obligation of the bank issuing the letter of credit to the beneficiary; the most common
- revocable credit ( revocable credit ) – under which the issuing bank reserves the right to cancel or amend the obligation
It is also possible to agree on a negotiated or confirmed version. What’s the difference?
- negotiation – the exporter’s bank ceases to be only an intermediary, it becomes the evaluating bank, which enables detection of errors in the documentation even before their actual delivery to the bank issuing the letter of credit
- confirmed letter of credit – the most expensive version of the letter of credit, the exporter’s bank has additional obligations, protects against the insolvency of a foreign contractor, the opening bank, as well as an unexpected one, depending on the political, economic and financial situation of the importer’s country.
Costs related to the letter of credit
A letter of credit is always a paid service. The costs of the letter of credit are higher than the costs of other methods of money transfer. It differs depending on the bank due to the amount of the commission and the minimum amount. The price is negotiable.
The fee for opening a letter of credit usually depends on its value, validity period or the number of documents subject to assessment. It is usually a certain percentage of the sum of funds, the value of which cannot be less than the minimum amount. Confirmation of a foreign letter of credit is usually around 0.15% – 0.3% of its value (minimum PLN 150) quarterly.
The issuing bank of a letter of credit may require certain collaterals. Their amount is even 100-110% of the value of the letter of credit. They are valid for a limited period of time. The most common security measures are as follows:
- deposit on the ordering party’s bank account
- bank guarantee
- promissory note, surety
- so-called collateral, such as credit plus deposit.
We would like to point out again that due to costs, a letter of credit is beneficial for orders exceeding PLN 30,000. USD.