Letters of credit and how they can be used to reduce risk in international trade.
Importing and exporting involves risks. Exporters run the risk of buyers failing to pay for goods, while importers may risk paying but never receiving anything. Because of the distances involved, it may be difficult to resolve any disputes.
One way of reducing the risks is to use a letter of credit - sometime known as ‘documentary credit’. This can offer a guarantee to the seller that they will be paid, and the buyer can be sure that no payment will be made until they receive the goods.
There are several different types of letters of credit available to use, depending on the circumstances.
This guide explains what letters of credit are, how they work, and when you might consider using one. It looks at some of the drawbacks of using a letter of credit and explores some possible alternatives. It also explains the international rules that govern most letters of credit.
What is a letter of credit?
A letter of credit is basically a guarantee from a bank that a particular seller will receive a payment due from a particular buyer. The bank guarantees that the seller will receive a specified amount of money within a specified time. In return for guaranteeing the payment, the bank will require that strict terms are met. It will want to receive certain documents - for example shipping confirmation - as proof.
Why use a letter of credit?
Letters of credit are most commonly used when a buyer in one country purchases goods from a seller in another country. The seller may ask the buyer to provide a letter of credit to guarantee payment for the goods.
The main advantage of using a letter of credit is that it can give security to both the seller and the buyer.
Advantages for sellers
By asking for an appropriate letter of credit a seller is reassured that they will receive their money in full and on time. A letter of credit is one of the most secure methods of payment for exporters as long as they meet all the terms and conditions. The risk of non-payment is transferred from the seller to the bank (or banks).
Advantages for buyers
When a buyer uses a letter of credit they get a guarantee that the seller will honour their side of the deal and provide documentary proof of this.
Other things to consider
It’s important to be aware of the additional costs involved in using a letter of credit. Banks make charges for providing them, so it’s sensible to weigh up the costs against the security benefits.
If you’re an exporter you should be aware that you’ll only receive payment if you keep to the strict terms of the letter of credit. You’ll need to give documentary proof that you have supplied exactly what you contracted to supply. Using a letter of credit can sometimes cause delays and other administrative problems.
When to use a letter of credit
Although letters of credit can be useful, it’s often best to avoid using one for a transaction. They can sometimes result in expensive delays, bureaucracy and unexpected costs. As a general rule you should probably only consider opening a letter of credit as an importer if:
- your supplier insists on it
- national exchange controls require it
Exporters - deciding whether to ask for a letter of credit
Think carefully about whether or not you need to ask an overseas customer for a letter of credit. Some important things to consider include:
- Legal matters - does the country you’re exporting to require one?
- Costs - does the value of the order justify the bank charges and extra costs involved, and who pays these costs?
- The customer’s creditworthiness - do they have a track record with you?
- Risks associated with the country you’re exporting to - is it politically stable with a good reputation as an international trading partner?
- Normal trading practices - is it standard practice for exporters to use letters of credit when trading with that country, and/or in that particular commodity?
- Available advice and guidance - banks may recommend using of a letter of credit in certain trading situations regardless of other factors, while credit insurers sometimes insist on it.
Give some thought to alternative arrangements, such as credit insurance, export factoring or cash in advance terms.
If you do decide that a letter of credit is the best option you’ll need to consider which type of letter to use. A ‘confirmed and irrevocable’ letter of credit is the most secure type.
It’s wise to have a clear policy in your business about when to consider using a letter of credit. Reviewing your policy on a regular basis will help you avoid using them unnecessarily and possibly putting off would-be customers.
Types of letter of credit
There are five commonly used types of letter of credit. Each has different features and some are more secure than others. The most common types are:
Other types include:
Sometimes a letter of credit may combine two types, such as ‘confirmed’ and ‘irrevocable’.
Irrevocable and revocable letters of credit
A revocable letter of credit can be changed or cancelled by the bank that issued it at any time and for any reason.
An irrevocable letter of credit cannot be changed or cancelled unless everyone involved agrees. Irrevocable letters of credit provide more security than revocable ones.
Confirmed and unconfirmed letters of credit
When a buyer arranges a letter of credit they usually do so with their own bank, known as the issuing bank. The seller will usually want a bank in their country to check that the letter of credit is valid.
For extra security, the seller may require the letter of credit to be ‘confirmed’ by the bank that checks it. By confirming the letter of credit, the second bank agrees to guarantee payment even if the issuing bank fails to make it. So a confirmed letter of credit provides more security than an unconfirmed one.
Transferable letters of credit
A transferable letter of credit can be passed from one ‘beneficiary’ (person receiving payment) to others. They’re commonly used when intermediaries are involved in a transaction.
Standby letters of credit
A standby letter of credit is an assurance from a bank that a buyer is able to pay a seller. The seller doesn’t expect to have to draw on the letter of credit to get paid.
Revolving letters of credit
A single revolving letter of credit can cover several transactions between the same buyer and seller.
Back-to-back letters of credit
Back-to-back letters of credit may be used when an intermediary is involved but a transferable letter of credit is unsuitable.
Uniform customs and practice for documentary credit
To standardise terms and procedures and avoid misunderstandings, a set of international rules for letters of credit have been developed by the International Chamber of Commerce (ICC).
Most commercial letters of credit are governed by these rules, which are referred to as Uniform Customs and Practice for Documentary Credits (UCP). The current version of the rules is UCP 600, which came into effect on 1 July 2007.
The UCP standards give definitions of important terms that are used in letters of credit. When referring to letters of credit, banks and others involved in international trade will generally use the UCP definitions of key terms and phrases.
UCP also sets out general documentary requirements and standard practices for handling letters of credit.
The ICC publishes a number of guides on UCP 600. You can find available publications about UCP 600 on the ICC Bookshop website.
Using UCP 600 letters of credit
Because UCP 600 standards are internationally recognised it’s always best to use letters of credit that are covered by them. If you’re an importer you may well find that sellers require you to use UCP letters of credit.
If a letter of credit is subject to UCP it will state this somewhere on it. It might include a statement like ‘This letter of credit is subject to the latest version of Uniform Customs and Practice for Documentary Credits published and updated by the International Chamber of Commerce’.
Be aware that in some instances the definitions and procedures set out in the UCP standards may differ from the laws of a particular country.