LETTERS OF CREDIT

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What is a Letter of Credit

Today the Letter of Credit (LC) is still one of the most popular methods for settling trade transactions particularly those that are International. The reason for this is simple. The LC offers a structure to the payment terms that mean providing the supplier complies with the conditions of the LC they have a guarantee from the bank that they will be paid for the goods or services they are selling. The LC is governed by a set of rules better known as The Uniform Customs & Practice for Documentary Credits (shortened to UCP 600, this being the latest version) which are rules agreed by the International Chamber of Commerce and these apply to those finance institutions (usually banks) who issue LCs. 


So to summarise, the LC is just one method amongst others where a buyer uses a bank guarantee to assure their supplier that they will receive the payment for goods or services subject to certain terms and conditions with the LC having its own set of rules that banks around the world tend to adhere to.  


This seems simple enough however, the banking industry does not go out of its way to make things easy to understand or follow and this can start with the range of descriptions applied to the LC. 


In its simplest form ‘Letter of Credit’ to which can be added ‘Import’ or ‘Export’ or even ‘Domestic’ is an effective description however some choose to use other words which can confuse those who are new to international trade. These include, Documentary Letter of Credit, Irrevocable Documentary Letter of Credit, Import Letter of Credit, Confirmed Export Letter of Credit, Standby Letter of Credit, Red Clause Letter of Credit etc. 


Whilst nothing is wrong with these words to describe the LC, this is just the start as those in the know are fully aware with other technical terms associated with the LC can be really taxing for inexperienced user. It comes across as language and skill used by the ‘insiders’ and unfortunately that tends to be the banks. 


The banks frequently fall short when it comes to educating the user, who is normally their client. When did you last receive a free copy of UCP 600 from your bank. Many banks have them printed but few voluntarily give them away.  The lack of guidance and advice is not helpful and in a way can discourage the client who would clearly be better off moving to more secured terms of payment. Using less secured methods such as deposits with order and balance on shipment/despatch raises the risk profile of the trade transaction, particularly if the bank is providing loans to fund these payments. 


For the client the acronyms and phrases used are like having to learn a new language. The fear of appearing foolish if they get it wrong makes it difficult for the client to get comfortable with the concept and benefits of using secured terms and if the clients don’t get it, how can they sell the benefits to their suppliers. Using the LC does offer added benefits for all parties be this the risk weighted capital requirements for the banks for such instruments to identifying parties for AML purposes, KYC and transparency etc. so more needs to be done to get the client on side. 



More to come on this later.

Who are the parties to an LC

Assuming you are the buyer of goods and/or services then parties to the LC would be described as follows: 


The Bank’s Client = Buyer = Purchaser = Importer: The LC term = THE APPLICANT 


The Customers bank: The LC term is THE ISSUING BANK. Note the customer’s bank can also be THE NEGOTIATING BANK. This will be covered later


The ‘Customers Supplier: The LC term = THE BENEFICIARY 


The Supplier’s Bank – THE LC term can = THE ADVISING BANK, THE NEGOTIATING BANK, THE CONFIRMING BANK.* 


* Note Those references to the supplier’s bank above can in theory be either one bank that carries out all three functions or two banks or even three separate banks each carrying out their own clearly defined role. You could also have the NOMINATED BANK where the LC is availble for negotiation but in many cases it would be available with 'any bank'


All might seem a bit confusing already but if you as the buyer think in these terms: 


THE APPLICANT – This is you applying to your bank, (either electronically or in paper format) and the application sets out the terms of the letter credit. Those terms should be kept as simple and as short as possible. One reason for so many problems with LC’s is that people try to repeat an entire contractual agreement within the credit. The advice is ‘Do not do this’. Banks only deal in documents, not the underlying goods or services and your bank (THE ISSUING BANK) is not a party to the contract. The bank is acting as a guarantor for payment using a LC. The documents that you THE APPLICANT want THE BENEFICIARY to provide in order to get paid should be kept to those that are essential.  


As an example, for goods this may include some or all of the following: Invoices, Packing List, Certificate of Origin, Bills of Lading (or other forms of transport documents such as an Air Waybill), Inspection Certificate. The more documents you call for, the more they have to be cross referenced to each other to ensure they comply with the LC and that can lead to higher probability of discrepancies which will then delay payment etc. 


Other information that THE APPLICANT will be required to go into the APPLICATION will include the amount and currency of the payment, the Incoterms where applicable, the latest shipment date which is important if you are on-selling and have made commitments to your buyers, the place and date that the LC will expire (usually no more than thirty days after shipment), whether part shipments are allowed and hence partial drawings are permitted and will transhipments be permitted. The question of the banks costs, charges and who is responsible for what needs to be dealt with. To have some degree of control over the goods THE APPLICANT should limit the period after shipment that THE BENEFICIARY has to submit the documents called for under the LC. For goods by sent by sea 10 days is ideal but up to 21 might be acceptable.  


THE ISSUING BANK – As THE APPLICANT, this is your bank and they are willing to act as guarantor for the payment. This clearly makes a statement about you THE APPLICANT and your business. The bank is prepared to underwrite the payment risk to value of 100% so why would you ever look at paying deposits with order and with no guarantee of performance by your supplier. You then probably pay the balance on shipment on the back of copy documents. Yes it may simplify matters but without the LC you as the buyer are raising the risk profile of the transaction. Ask yourself one question - How many deposits you can afford to lose before it starts to hurt financially? It is an easy sell to the BENEFICIARY.  Within x number of days of placing the order, they receive an LC which guarantees them 100% of the amount due. No further financial risk on you as a buyer. They can use the as collateral to borrow more than enough working capital from their bank to process your order. Yes it may cost them but since when did you as the buyer become a bank and in essence provide your supplier with working capital on an unsecured basis. 


THE ADVISING BANK – This is the bank that passes on the LC to the BENEFICIARY. It may be the BENEFICIARY’S own bank or another unconnected bank albeit this is less likely with the requirements of KYC (Know Your Customer). 


THE NEGOTIATING BANK – This is the bank that will check the documents presented by the BENEFICIARY and assuming the documents and terms of the LC have been complied with, they can make the payment. If the documents contain discrepancies, they will normally advise all parties and assuming sufficient time is available, any discrepancies can be corrected by the BENEFICIARY. In some cases, the APPLICANT may waive the notified discrepancies and accept to pay notwithstanding. This is a judgemental decision  that only the APPLICANT can make as to accept means that some of the protection afforded by the LC has been given away.


THE CONFIRMING BANK – This is the bank which is normally but not always domiciled in the same country as the BENEFICIARY.  The CONFIRMING BANK is effectively underwriting the risk of ISSUING BANK (both financial and performance) and in doing so it is also taking away any potential country risk exposure.  Additional LC charges are levied for ‘adding’ the confirmation and these costs will vary but are largely driven by general market pricing. The fees are based inter-alia on the risk profile of the ISSUING BANK and the validity (the period up until expiry or beyond this date for LCs where payment is deferred). For example if the confirmation charge is 0.5% per quarter or part thereof and the LC has a validity of 180 days then the charge would be 1% calculated on the value of the LC. Further details on the costs, fees and charges and who pays what will follow later.  


The above covers the main parties and some aspects of the LC but in later sections we will drill down and give some sound reasoning as to why and what the APPLICANT should do to protect their interest and if you are a BENEFICIARY, we will deal with similar issues including your retention of title and getting paid plus much more.



What rules apply

Uniform Customs & Practice (UCP) 600 is the latest revision of the Uniform Customs and Practice that govern the operation of letters of credit and came into effect in July 2007  


The rules are made up of 39 articles and are a comprehensive and practical working aid to bankers, lawyers, importers, exporters, transport executives, educators and everyone involved in letter of credit transactions  


This revision of the Uniform Customs and Practice for Documentary Credits (commonly called “UCP”) is the sixth revision of the rules since they were first promulgated in 1933. It was the result of more than three years work by the International Chamber of Commerce’s (ICC) Commission on Banking Technique and Practice.  


ICC, which was established in 1919, had as its primary objective facilitating the flow of international trade at a time when nationalism and protectionism posed serious threats to the world trading system. It was in that spirit that the UCP were first introduced – to alleviate the confusion caused by individual countries promoting their own national rules on letter of credit practice. The objective, since attained, was to create a set of rules that would establish uniformity in that practice, so that practitioners would not have to cope with a plethora of often conflicting national regulations. The universal acceptance of the UCP by practitioners in countries with widely divergent economic and judicial systems is a testament to the rules’ success.  


It is important to note that the UCP represent the work of a private international organization, not a Governmental body and since its inception, ICC has insisted on the central role of self-regulation in business practice. These rules, formulated entirely by experts in the private sector, have validated that approach. The UCP remain the most successful set of private rules for trade ever developed.  


A separate set of rules can be used for Standby Letters of Credit. Again these are produced by the ICC and the current version is ISP 98, ICC Publication No. 590 We will deal with these in more detail in the Guarantees and Indemnities section

Documents & Payments

Details coming soon

Payment - When, where how

Details coming soon

What are the costs and who pays

In the section Fees Commisions and Charges we will list most of the LC fees, commissions and charges an Applicant or Beneficairy can expect when issuing or an LC or receiving an LC from a buyer. In the main these represent but a small percentage of the overall value of the transaction particularly if, as the APPLICANT, you are on-selling to your buyer. Of course it depends what calculation you what to use but it could either a percentage of the purchase price or the landed cost or your subsequent selling price. Think of it as being the cost for peace of mind and some protection for your money. Even though you may be doing the wise thing and using an LC and accepting the cost, it will not take away the potential risk of a fraud being perpetrated by a supplier who for example may have put bananas in a container when in fact you had purchased other food stuffs.  


The LC cannot eliminate all the risks of buying and selling but can go some way to mitigating many if the right documents are called for and the third parties to the transaction (inspection service providers, freight companies, freight forwarders with reliable agents etc.) involved have a good reputation and are trustworthy and reliable. It is important to have the right ‘team’ of people or ‘partners’ around you. The LC charges cover more than the actual transaction you also are buying reputational cover with your bank standing behind your business and the relevant trade.


We will list most of the LC fees, commissions and charges the APPLICANT  can expect when using an LC. In the main these represent but a small percentage of the overall value of the transaction particularly if, as the APPLICANT, you are on-selling to your buyer. Of course it depends what calculation you what to use but it could either a percentage of the purchase price or the landed cost or your subsequent selling price. 



LC - FAQs , TIPS & INFORMATION

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FAQs

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