What is a letter of credit?
The letter of credit is one of the most widely used means of BtoB payment in the world of international trade.
It is a bank financial guarantee that allows the exporter to know that he will be paid on the condition that he sends the goods. For the importer, he has the assurance that he will receive the goods, in accordance with the purchase contract and the documentation related to the term defined by the contract.
This means of guaranteeing payments, which is very popular with international trade players, works directly with the banks. It is in fact the customer’s (buyer) bank that undertakes to pay the beneficiary, who is the seller, on delivery of the documents in conformity with the contract.
What guarantees does a letter of credit provide?
If you are an importer, a letter of credit is an assurance that your company will pay for the goods only if the exporter proves that he has sent the goods. It is a form of insurance that allows you to minimize your counterparty risk and protect you in case of attempted fraud by a supplier. The letter of credit also allows you in some cases to keep your liquidity. The buyer don’t have to make an initial payment or advance payment to prove good faith because his bank is committing herself on the company’s behalf.
For the exporter, the letter of credit protects against the risk of non-payment of the goods he has sent to his customer. As the payment is insured by the customer’s bank, the letter of credit protects the exporter against legal risks because the payment of the contract is assured as long as the delivery conditions previously agreed upon are respected.
The letter of credit is therefore a financial hedge for the buyer and seller in an international business transaction.
The different types of letters of credit:
- Revocable or Irrevocable:
In most cases, a letter of credit is irrevocable by default. When issued by the importer’s bank, it guarantees the exporter that he will be paid if he meets his contractual obligations. To cancel an irrevocable letter of credit, all parties to the transaction must agree.
A revocable letter of credit, on the other hand, gives the buyer or his bank the right to modify the terms of the contract. The seller is therefore only partially protected, which is why revocable letters of credit are no longer used.
- Revolving Letter of Credit:
A letter of credit is normally made for each international transaction. In case the importer buys several times from the same supplier, he can ask for the opening of a revolving letter of credit, allowing him to make several commercial transactions within a predetermined amount.
- Transferable letter of credit :
This type of letter of credit applies when there are several commercial actors in a transaction:
- The importer.
- A commercial intermediary: an intermediary seller or trader for example.
- The exporter.
The transferable letter of credit therefore protects the 3rd actor in the financial transaction.
- Confirmed or not confirmed :
Depending on whether a letter of credit is confirmed or not, the exporter who is always the beneficiary of the transaction will have more or less collateral.
When a letter of credit is confirmed, a second guarantee is obtained with another financial institution. It is generally used when there are doubts about the solvency of the bank issuing the first letter of credit. The seller therefore seeks a second guarantee to ensure that he will be paid.
If the letter of credit is not confirmed by a second bank, it is considered unconfirmed.
How does a letter of credit work?
- The importer and exporter decide to work together and an order is placed.
- The importer goes to his bank to set up a letter of credit. The cost of setting up a letter of credit is often taken by the importer and can vary from 1% to 8% in extreme cases when the buyer’s creditworthiness is low.The average cost is around 2.5% to 3% + documents movement fees. (without counting the expenses of exchange)
- The bank transmits the letter of credit to the exporter as a guarantee of payment.
- The exporter entrusts the goods to the carrier who provides him with the transport documents. The latter gives the documents to the bank issuing the letter of credit.
- After verification, the bank presents the bill of lading and acceptance to the importer.
- Payment is issued and the exporter receives payment from the bank.
It is important to note that this is a lengthy process. It takes an average of 5 to 10 business days to set up a letter of credit (acceptance) and about 10 days for the bank to receive and verify the contractual documents.
Letter of credit framework :
Advantages and disadvantages of letters of credit :
Advantages:
- The letter of credit protects both parties equally against counterparty risk.
- It is also an interesting cash flow tool for the buyer because in some cases, he does not commit cash until he receives the goods.
- It allows to explore new commercial territories with less risk and protects against external parties to the commercial transaction.
The disadvantages:
- The cost is a major drawback to the use of these products. The average cost is around 2.5% to 3% + document movement fees. (without counting the exchange fees)
- It is a product mainly reserved for large groups. The latter can bear the cost but also prove to the bank that they are solvent and have access to these products.
- The execution time is also a major drawback. It is necessary to count on average 25 working days for the realization of an operation of letter of credit end to end
Tulyp is a FinTech specialized in Trade Finance. The Tulyp solution supports international trade actors on their payment guarantees, financing, and liquidity issues. If you have any questions you can contact us, one of our experts will contact you within 24 hours.