/ By tjchinafreight ivy / Shipping

What is a letter of credit?

There is no shortage of complex paperwork and documentation in the maritime world. You may know the more important bill of lading and packing list etc. But there are other equally important ones. In this article, we'll learn more about a letter of credit, what it is, and how it works.

What is a letter of credit?

According to the International Chamber of Commerce, a letter of credit is:

What is a letter of credit?
What is a letter of credit?

“On behalf of the buyer (customer/importer), the bank undertakes to pay the seller (beneficiary/exporter) the specified amount in the agreed currency, provided that the seller submits the required documents within the predetermined period.”

In other words, a letter of credit is a way, and one of the most common, where an importer promises to pay its foreign seller. It acts as a formal, binding legal agreement. Additionally, shippers generally consider this to be one of the safest payment methods.

In every transaction, there are sellers and buyers. In the vast world of trade, there is no way to know if the person you are dealing with is reliable. Given that it takes a long time for the goods to arrive by sea, the importer needs to guarantee payment before the goods arrive. This guarantee comes in the form of a letter of credit.

How does a letter of credit work?

It serves as a regular instruction from the importer's bank to the bank guaranteeing advance payment to the exporter. However, this first requires both parties to meet certain requirements. Buyers usually set these terms and conditions, which usually include:

  • Port of departure and port of destination
  • Shipping method
  • Route
  • Product description, including technical description (if applicable)
  • Number of Products
  • Needed file
  • Consignee details
  • Notifying Party Details
  • Latest shipping date

Once the seller agrees to these terms, the buyer's bank (or issuing bank) proceeds to issue the letter of credit. This will be sent to the seller and his bank (designated bank). According to these conditions, the seller prepares his goods and documents. After shipment, the seller will bring the copy of the document to the designated bank for verification.

When the nominated bank verifies that the documents match those listed on the letter of credit, it pays the seller. Then it goes to the issuing bank with the documents. The issuing bank then certifies itself. Upon satisfaction, it will refund the amount paid to the seller to the nominated bank.

When complete, it notifies the buyer that the shipment is complete and that all documents are correct and in their possession. The buyer then pays the issuing bank, which signs the bill of lading to allow the goods to be released to the buyer.

/ By tjchinafreight ivy / International

Different types of letters of credit

What is a letter of credit?

A letter of credit is a guarantee or assurance to the seller that they will get paid on a large transaction. They are especially common in international or foreign exchange transactions. Think of them as a form of payment insurance provided by financial institutions or other accredited parties to the transaction. The earliest letters of credit were common in the 18th century and were called travelers' letters of credit. The most common contemporary letters of credit are commercial letters of credit, standby letters of credit, revocable letters of credit, irrevocable letters of credit, revolving letters of credit, and red-term letters of credit, although there are several others.

Commercial letter of credit
This is a standard letter of credit commonly used in international trade. It can also be called a "Documentary Credit" or "Import and Export Credit". 1 The bank acts as a neutral third party to release funds when all the conditions of the agreement are met.

Standby Letter of Credit
This type of letter of credit is different: it offers payment if something doesn't happen. 2 Standby letters of credit do not facilitate a transaction, but provide compensation in the event of a problem. A standby letter of credit is usually similar to a commercial letter of credit, but only pays if the payee (or "beneficiary") can prove they didn't get what was promised in the agreement. Standby letters of credit are a form of insurance that ensures you get paid, and they also guarantee that services will be performed satisfactorily. They can be used with negotiable letters of credit.

Irrevocable letter of credit.
This Letter of Credit may not be cancelled or amended without the consent of the beneficiary (Seller). This Letter of Credit reflects the Bank's (Issuer's) absolute liability to the other party.

Revocable Letter of Credit.
The bank (issuing bank) can cancel or amend this type of letter of credit at the customer's instruction without the prior consent of the beneficiary (seller). After the L/C is revoked, the Bank shall not assume any responsibility to the beneficiary.

Red Clause LC.
The seller may require prepayment of a letter of credit for an agreed amount prior to shipment of the goods and presentation of the required documents. This red clause is so called because it is usually printed in red on the document to draw attention to the "advance payment" clause of the letter of credit.

Revolving letter of credit
A revolving letter of credit can be used for multiple payments.
If buyers and sellers want to repeat business, they may not want to obtain a new letter of credit for each transaction (or each step in a series of transactions). This type of letter of credit allows a business to conduct multiple transactions using a single letter of credit before the letter of credit expires, and the validity period of the letter of credit may be three years or less.

Negotiable letter of credit
A transferable letter of credit can be transferred from one "beneficiary" (payee) to another. They are usually used when an intermediary is involved in a transaction.

Back to back
Back-to-back letters of credit can be used when an intermediary is involved but a negotiable letter of credit is not suitable.

What are the benefits of using a letter of credit?

A letter of credit places the risk of the transaction on the bank rather than the buyer or seller. They provide a secure payment method that ensures funds get where they need to be. Letters of credit also provide parties with the opportunity to incorporate safeguards, regulations or other quality control measures.

How to get a letter of credit?

Many banks offer letters of credit, so you can get one by contacting your bank's representative. Banks with dedicated international trade or business departments are likely to offer letters of credit. If your bank doesn't offer a letter of credit, it may point you to an institution that does.

/ By tjchinafreight ivy / International

Bank Guarantee vs. Letter of Credit

Bank guarantees are similar to letters of credit in that they both instill confidence in the transaction and the parties involved. The main difference, however, is that the letter of credit ensures that the transaction goes smoothly, while the bank guarantee reduces any losses that arise if the transaction does not go as planned.

Letter of Credit - Reduce Risk

A letter of credit is a financial institution's commitment to fulfill a buyer's financial obligation, thereby eliminating any risk that the buyer will not perform payment. Therefore, it is often used to reduce the risk of non-payment after delivery.

In addition, a letter of credit is issued to the buyer after the necessary due diligence has been carried out and sufficient collateral has been collected to cover the secured amount. The letter is then submitted to the seller as proof of the buyer's credit quality.

Types of Letters of Credit

Just like bank guarantees, letters of credit vary according to need. Here are some of the most commonly used letters of credit:

  • An irrevocable letter of credit ensures that the buyer is obligated to the seller.
  • The confirmed letter of credit is from the second bank, which guarantees the letter of credit when the credit of the first bank is in question. If the company or the issuing bank fails to meet its obligations, the confirming bank will ensure payment.
  • An import letter of credit allows importers to make immediate payments by giving them a short-term cash advance.
  • An export letter of credit lets the buyer's bank know that it must pay the seller, provided that all the conditions of the contract are met.
  • A revolving letter of credit allows customers to make withdrawals within a certain range within a certain period of time.

Bank Guarantee – Failure to perform contractual obligations

Bank guarantees help companies mitigate any risk arising from both sides of a transaction and play an important role in facilitating high-value transactions. The agreed-upon amount is called the guaranteed amount and will always benefit the beneficiary.

In venture capital, both parties are obligated to perform certain duties in order to successfully complete a transaction, and both parties often use bank guarantees as a way to demonstrate their creditworthiness and financial standing.

Also, if one party fails, the other party can invoke the bank guarantee and get the guaranteed amount by filing a claim with the lender. Unlike a LOC, a bank guarantee protects the parties involved.

Types of Bank Guarantees

Bank guarantees are just like any other type of financial instrument - they can take a variety of different forms. For example, banks provide direct guarantees in both domestic and foreign operations. Indirect guarantees are usually issued when the subject of the guarantee is a government agency or other public entity.

The most common types of guarantees include:

  • Shipping Guarantee: This guarantee is provided to the carrier for shipments that arrive before any documentation has been received.
  • Loan Guarantee: An institution that issues a loan guarantee promises to assume financial obligations in the event of a borrower default.
  • Advance Payment Guarantee: This guarantee is used to support the performance of the contract. Basically, this security is a form of security to repay the advance payment if the seller does not deliver the goods specified in the contract.
  • Confirmed Payment Guarantee: With this irrevocable obligation, the bank pays the beneficiary a specific amount on behalf of the customer by a specific date.

Summary: What is the difference between a bank guarantee and a letter of credit?

Letter of Credit (LC)
A letter of credit is a promise by a bank to pay the beneficiary after certain conditions are met.
Often used by merchants engaged in the import and export of goods.
Protects both sides of the transaction, but benefits the exporter.
Example: A letter of credit can be used to transport goods or complete services.

Bank Guarantees (BGs)
A bank guarantee is a promise by the bank to pay the beneficiary in the event that the counterparty does not fulfill its contractual obligations.
Typically used by contractors to bid on large projects, such as infrastructure projects.
Protects both parties to the transaction, but benefits the beneficiary (usually the importer).
Example: A bank guarantee is used when a buyer buys an item from a seller, then the seller is in financial difficulty and cannot pay.

/ By tjchinafreight ivy / International

Export business risks

In recent years, the risk and even bad debts in the import and export business have been increasing, which not only causes interest loss, but also increases the risk factor with the passage of time, which has a serious impact on the sustainable development of foreign trade enterprises. Therefore, the issue of risk has increasingly become a topic of concern. Under normal circumstances, the risk of export receipts mainly includes the following six situations:

01The risk of receiving foreign exchange due to the inconsistency of the delivery specifications and dates with the contract

The exporter did not deliver as stipulated in the contract or letter of credit.

1. The production plant is late for work, resulting in late delivery;
2. Replace the products specified in the contract with products of similar specifications;
3. The transaction price is low, and it is shoddy.

02 Risk of foreign exchange collection due to poor document quality

Although it is stipulated that the foreign exchange should be settled by letter of credit and shipped on time with high quality, but after the shipment, the documents submitted to the negotiating bank did not match the documents and documents, so that the letter of credit promoted the due protection.

At this time, even if the buyer agrees to pay, it pays the expensive international communication fee and the deduction for discrepancies in vain, and the time for collection of foreign exchange is greatly delayed, especially for the contract with a small amount, the 20% discount will lead to a loss.

03 Risks caused by trap clauses stipulated in the letter of credit

Some letters of credit stipulate that the customer inspection certificate is one of the main documents for negotiation.
The buyer will seize the seller's eagerness to ship, deliberately picky, but at the same time propose various payment possibilities to induce the company to ship. Once the goods are released to the buyer, the buyer is very likely to deliberately inspect the goods for discrepancies, delay payment, or even empty both money and goods.

The letter of credit stipulates that the shipping documents will expire abroad within 7 working days after the issuance of the shipping documents, etc. Neither the negotiating bank nor the beneficiary can guarantee such terms, and must be carefully verified. Once a trap clause appears, it should be notified to modify it in a timely manner.

04 There is no complete set of business management system

The export work involves all aspects, and the two ends are outside, which is prone to problems.

If the enterprise does not have a complete business management method, once a lawsuit occurs, it will cause a rational and unwinnable situation, especially for those enterprises that only focus on telephone contact.

Secondly, as the company's customer base is expanding every year, in order for the company to have a target in trade, it is necessary to establish a business file for each customer, including creditworthiness, trade volume, etc., and screen them year by year to reduce business risks.

05 Risks caused by operations contrary to the agency system

For export business, the real practice of the agency system is that the agent does not advance funds to the client, the profit and loss is borne by the client, and the agent only charges a certain agency fee.

In actual business operations now, this is not the case. One of the reasons is that he has few customers and his ability to collect foreign exchange is poor, and he has to strive to complete the target;

06 Risks arising from the use of D/P, D/A forward payment methods or consignment methods

The deferred payment method is a forward commercial payment method, and if the exporter accepts this method, it is equivalent to financing the importer.

Although the issuer voluntarily pays the deferred interest, on the surface it only needs the exporter to make advances and loans, but in essence, the customer waits for the arrival of the goods and checks the quantity of the goods. If the market changes and the sales are not smooth, the importer can apply for the bank to refuse to pay.

Some companies release goods to classmates and friends who do business abroad. I thought it was a relationship customer, and there was no problem of not being able to receive foreign exchange. In the event of poor market sales or customer problems, not only the money cannot be recovered, but the goods may not be recovered.