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Letter of credits: the basics
At Bell Rock Financial we offer a range of solutions through our financial partners to help support the import and export of goods and services:
Buyer / applicant
Because the documentary credit is a conditional undertaking, payment is made on behalf of the buyer against documents, which may represent the goods and give the buyer rights to them.
Seller / beneficiary
Because the documentary credit is a bank undertaking, the seller can look to the bank for payment, instead of relying upon the ability or willingness of the buyer to pay..
Definition
A documentary credit is a (conditional) bank undertaking of payment. It is a written undertaking by a bank (issuing bank) given to the seller (beneficiary) at the request, and on the instructions of the buyer (applicant) to pay at sight or at a determinable future date up to a stated sum of money, within a prescribed time limit and against stipulated documents or other conditions. The issuing bank is putting out its credit and good name for the sake of the buyer.
Summary
Documentary credits therefore:
- Are an arrangement by banks for settling international commercial transactions.
- Provide a form of security for the parties involved.
- Ensure payment, provided that the terms and conditions of the letter of credit have been fulfilled.
- Mean that payment by such means is based on documents only, and not on merchandise or services involved.
- In general we offer unsecured Letters of Credit
Types of letters of credits
Under UCP 600 a letter of credit is revocable even if there is no indication to that effect.(Article 3)
Is a credit in which a second obligation is added to the letter of credit by another bank. (Article 8 UCP 600)
Payment is at sight, which means that the drafts and documents are honored, if in order, by making payment without delay.
The draft honored by accepting it for payment at a future date. Payment is delayed until the maturity of the draft.
Normally, this type of LC functions like a guarantee. This type of credit can be drawn against only upon performance of service or financial obligation default. It is a definite undertaking of the issuing bank. The standby letters of credit from Trade and Merchant Trust state that they are governed by UCP 600. If that is the case, should we mention ISP98.
Can be transferred by the original beneficiary to one or more other parties. It is normally used when the first beneficiary does not supply the merchandise himself, but is a middleman and wants to transfer all or part of his rights to the actual supplier. (Article 38 UCP 600)
Documentary, merchandise, commercial, trade. The majority of LCs issued are in payment for goods in shipment or current services performed. Payment is normally made against documents for goods shipped. (Article 2 UCP 600)
Bears only the obligation of the issuing bank. The beneficiary should look to the credit worthiness of only the issuing bank, and not to any intermediary. (Article 7 UCP 600)
Comparision of various methods of payment
| Method | Goods available | Time of payment | Risk to exporter | Risk to importer |
| Cash in advance | After payment | Before Shipment | Very Low | Maximum – relies on exporter to ship goods as ordered |
| Letter of credit *Confirmed *Unconfirmed (Advised) | After payment | When documents are available at shipment | Very low | Assured of quantity and quality of shipment if inspection report is required |
| Documentary collection dight Draft Documents against Payment | After payment | On presentation or draft to importer | If draft unpaid, goods must be returned or disposed of, usually at loss | Assured of quantity, also quality, if goods are inspected before shipment |
| Documentary collection time draft documents against acceptance | Before payment | On maturity of draft | Relies on importer to pay draft | Minimal – can check shipment for quantity and quality before payment |
| Cosignment | Before payment, exporter retains title until goods are sold or used | After use; inventory and warehousing cost to exporter | Substantial risk unless through foreign branch of subsidiary | Very low |
| Open account | Before payment | As agreed | Relies on importer to pay account as agreed — complete risk | Very low |
Letter of credit versus bank guarantee
- It is important to note that a bank guarantee is not the same as a letter of credit, although with both instruments the issuing bank accepts a customer’s liability if the customer defaults.
- With a guarantee, the seller’s claim goes first to the buyer, and if the buyer defaults, then the claim goes to the bank. With letters of credit, the seller’s claim goes first to the bank, not the buyer.
- Although the seller will likely get paid in both cases, letters of credit offer more assurance to sellers than guarantees generally do.
Bank guarantees
There are a few different types of Bank Guarantee
- Advanced payment guarantee: typically ensures the performance of a commercial contract
- Loan guarantee: promises to assume the debt obligation of the borrower if they face default.
- Performance guarantee: – ensures the full and due performance of the contract in line with the original contract.
- Deferred payment Guarantee: this is a promise for a payment which has been postponed.
- Shipping guarantee: a written guarantee which shows joint liability. Furthermore, it will be presented by the importer to the carrier in the event of goods arriving before the documents.
- Trade credit guarantee: this covers the providers of a good/ service against the risk of non (or late) payment.
To access a guarantee, applicants must demonstrate creditworthiness. Our underwriters would normally look at previous trading history, recent accounts, credit history, and liquidity. They would need to know how long the bank guarantee is required, the amount, currency, and beneficiary details. This is generally speaking of course; different guarantees will require different documentation. Moreover, the client might be asked for some security over the guarantee (e.g. liquid assets such as property or equipment it holds, and maybe a personal or directors guarantee).
Performance guarantees
- A Performance bond is a frequent occurrence: a contractor fails to deliver according to the terms of a given agreement. In breach of contract situations like these, the contractor may have no choice but to abandon the job, leaving the developer with an unfinished project and an incredible exposure to a variety of risks.
- In such situations, the provisions afforded by a performance guarantee (sometimes referred to as a performance bond) will activate in order to protect the developer against losses. Situations vary; the protections may come in the form of additional funding to the incumbent contractor, or it may become necessary to engage a new contractor to fix or complete the work of the incumbent.
- A performance guarantee protects the project developer from economic loss and is a standard risk mitigation tool for capital projects.