Payments by letters of credit: scheme, advantages and disadvantages

2024 Author: Howard Calhoun | [email protected]. Last modified: 2023-12-17 10:16

Letter of credit form of payment acts as a non-cash instrument. It is a written obligation of the bank, whose client is the buyer (or importer), to pay a certain seller (or exporter) the specified amount. It also agreed on the dates and amounts of payment in accordance with the terms.

Concept and essence

Let's consider the essence of settlements by letters of credit and the scheme of interaction between participants.

Letter of credit - a form of payment in both foreign and domestic settlements. It is used in transactions that involve various types of increased risk (for example, contractor, contract performance, product quality, delay, non-payment) because it reduces them.

Settlement parties

Let's consider the main aspects of settlements by letters of credit and the schemes of interaction between them.

Among the main aspects of settlements, the following types are distinguished.

Principal (importer) - submits an order to open a letter of credit in his bank and funds to cover the paymentexporter. The importer has the right to claim compensation from his bank to cover losses resulting from negligence or omission on the part of the financial institution. The importer must cover the amounts paid to the exporter, as well as possible costs and commissions.

The importer's bank (opening bank) forms a letter of credit in accordance with the written order of the importer, in which he undertakes to independently pay for the documents submitted by the beneficiary of the letter of credit, if its conditions have been met. The bank does not analyze the course of the transaction, but makes a decision on payment or refusal based on the submitted documents.

Intermediary bank (consulting, negotiating, confirmation), which, depending on the terms of the letter of credit, can perform the functions:

1. Notifying bank - informs the beneficiary about the opening of a letter of credit and acts as an intermediary in the correspondence between the opening bank and the exporter. He is not obligated to pay the letter of credit.
2. Bank negotiation: notifies and checks compliance of documents, acts on behalf of the principal, that is, is the importer's bank.
3. A bank that confirms a letter of credit, which assumes an obligation towards the beneficiary.

The exporter has no obligations, submits documents in accordance with the letter of credit and pays for them.

Main types of letters of credit

Let's consider settlements by letters of credit, the scheme and types of this form of interaction.

Letters of credit divideaccording to various criteria. Some of the items listed below are widely used in international transactions.

Separation of letters of credit in terms of opening bank obligations:

• Appeal letter of credit: the bank reserves the right to cancel or modify its obligations without the consent of the beneficiary until the documents of the intermediary bank are recognized.
• Irrevocable letter of credit: it cannot be changed or canceled without the consent of all parties involved. The change is void if either party disagrees with it.

Separation of letter of credit by payment method:

• Cash letter of credit: payment is made immediately after the exporter submits documents.
• Letter of credit with deferred payment: the bank undertakes to make payment for a deferred period (for example, 30 days from the date of dispatch) upon presentation of documents in accordance with the terms of the letter of credit during its validity.
• A letter of credit relating to a due date that commits a bank to accept payments on non-working days. Once approved, the letter of credit expires and is replaced by a promissory note obligation.
• Letter of negotiation - the opening bank grants the intermediary bank the right to check the compliance of documents with the letter of credit and payment to the beneficiary.

Separation of the letter of credit due to the role of the intermediary bank:

• Confirmed letter of credit - a confirmation bank has been added to the letter of credit opened by the importer's bank.
• Unrecognized letter of credit - type of letter of credit,which is not confirmed by the intermediary bank, and payment for the exporter is made only by the debtor bank.

Other species

Other letters of credit can be of the following types:

• standby letter of credit (collateral) is a bank guarantee imposing an obligation to pay the required amount to the beneficiary if the payer has not made an advance within the agreed time between the parties or does not fulfill other obligations secured by the letter of credit;
• revolving letter of credit applies to successive recurring deliveries of the same product over a long period of time;
• letter of credit in a row - the buyer opens a letter of credit for imports for a specific beneficiary, and proceeds from the export letter of credit ensure payments on the import credit.

Benefits

Let's consider the advantages of settlements by letters of credit and the scheme of interaction between the parties.

Benefits for the seller or exporter:

• minimize the trade risk of the transaction, that is, the risk of refusal to accept the goods and lack of payment from the importer;
• allowable financing of the transaction by transferring a letter of credit to the supplier;
• ability to discount receivables to due date and secure payment on predetermined date.

Benefits for buyer or importer:

• minimization of transport risks;
• impossibility of breaking deadlines;
• protection against unjustified paymentdebt.

How the process works

Let's consider the possible options and the essence of settlements by letters of credit. The scheme looks like this:

1. Concluding a contact between the importer and exporter and creating a letter of credit as a form of payment for the goods.
2. The importer informs the bank about the opening of a letter of credit to the exporter and provides financial coverage.
3. The importer's bank notifies the exporter's bank (intermediary bank) of the opening of the letter of credit, instructing it to notify the exporter.
4. The intermediary bank checks the authenticity of the letter of credit notified by the importing bank and then passes it on to the exporter.
5. The exporter sends the goods and draws up documents in accordance with the terms of the letter of credit.
6. The exporter submits a package of documents to the bank in accordance with the terms of the letter of credit.
7. The exporter's bank checks the documents (number and type) and sends them to the importer's financial institution.
8. The importer's bank checks the correctness of the documents, if they are in order, it sends the payment to the exporter's bank and the documents to the importer.
9. Payment received is credited to the exporter.

Main elements of the settlement scheme using a letter of credit

The order to open a letter of credit must contain the following items:

• place and date of placing the order;
• beneficiary;
• Letter of credit amount;
• date and place of validity of the letter of credit;
• place of payment (opening bank or sending bank);
• payment type;
• partial deliveries (allowed, prohibited);
• Place of loading and destination;
• product description;
• quantity;
• price and its basis (according to Incoterms);
• special settlement terms;
• documents required for payment;
• term for shipment of goods;
• document submission time;
• bank charges;
• type of letter of credit;
• payer's account number;
• seal and signatures.

Settlement scheme from an exporter's point of view

Let's consider the procedure for settlements by letter of credit and the scheme of interaction on the part of the exporter.

Letter of credit is the preferred form of payment for the exporter because it is the obligation to pay the bank, not the importer. If the exporter complies with the terms of the letter of credit, he will receive payment regardless of the situation and the financial condition of the importer. The exporter receives payment after delivery and submission of documents to the bank.

The letter of credit protects the exporter from withdrawing from the deal or refusing to accept the goods. This allows the exporter to obtain a loan to finance the production of goods, which is secured by a letter of credit.

It is possible to use forfaiting and prepayment in case of deferred payment.

Letter of credit is an advantageous form of payment for the exporter when he meets all the conditions. If the exporter submits documents in which contradictorydata or deficiencies are found, for example, the absence of a set of bills of lading, the necessary confirmations in the documents issued on request, or the contamination of the bills of lading, then the payment to the exporter will be withheld. Other mistakes made by the exporter when submitting documents include:

• erroneous labeling of documents;
• incorrect marking of the place of loading and destination;
• non-compliance with letter of credit;
• description of goods in documents;
• no additional documents appearing in the text.

Letter of credit is a time-consuming form of payment not only due to the need for careful preparation of the relevant documents, but also requires a detailed review of the terms of the letter of credit, the contract and the consistency between the buyer and the seller, as well as checking the provisions in terms of information and inconsistencies.

Payment scheme from the point of view of the importer

Let's consider settlements by letters of credit and the scheme of interaction in relation to the importer.

Using a letter of credit, the importer requires the exporter to provide the relevant documents and fulfill all the conditions of the letter of credit. Choosing the right documents and terms of delivery of goods, the importer regulates the course of the transaction. By setting the terms of the letter of credit, the importer has a guarantee of the proper performance of the contract, but it does not protect him from the withdrawal of the contract by the exporter.

A letter of credit sometimes requires the importer to allocate financial resources before concluding an agreement - an advance payment. However, this is notconditions the payment to the exporter. The acceptance by the importer of a letter of credit as a form of payment puts him in a better position than in the case of an unconditional transfer of payment before the execution of the order. An unfavorable aspect of the use of letters of credit as a form of payment by the importer is the involvement of its own financial resources before delivery, in the absence of a contract performance guarantee from the exporter. Some banks require the importer to pay more than the amount stated in the letter of credit in order to secure differences in exchange rates. You can pay your bill with a line of credit, but the bank must accept this form of payment.

Documentary payment form: areas of application

Let's consider the settlement scheme for a documentary letter of credit.

It includes a conditional, irrevocable documentary form of payment that ensures the interests of both parties to the transaction. A letter of credit is an obligation of the bank.

A documentary letter of credit in foreign trade is a written obligation of the importer's bank to pay the exporter's receivables in exchange for providing documents on the delivery of goods. In such calculations, the customer is an importer who makes a request to his bank to open a letter of credit for the exporter.

The advantages of the documentary letter of credit settlement scheme are as follows:

• Transparent rules and a sense of security. By opening a letter of credit at the request of the importer (buyer), the bank undertakes topay the beneficiary (exporter, seller) a certain amount. The beneficiary must fulfill all the conditions of the letter of credit, that is, at the specified time, send the goods or perform the service and provide the bank with the necessary commercial documents in accordance with the terms of the letter of credit. The obligation of the bank opening the letter of credit becomes payable on the date arising from the terms of the document.
• Ensuring the security of the transaction. The importer is confident that payment will be made only on the basis of documents confirming the proper execution of the commercial contract in accordance with the terms of the letter of credit.
• Risk minimization. The procedure allows minimizing the risk arising from purchase and sale transactions.
• Flexibility. You can customize the conditions according to the specifics of the transaction and the ability to make changes during its validity.
• Wide range of different types and forms: ordinary letters of credit, standby letters of credit, import and export letters of credit, letters of credit in domestic trade.

Documentary form recommended for companies:

• specializing in domestic or foreign trade;
• suppliers (exporters) and recipients (payers).

This form of settlement is used as a conditional under a commercial transaction.

A documentary credit settlement scheme is a type of payment settlement that can eliminate the operational risk of both parties to the contract. This fact can limit the risk of collection and the risk of paying the exporter, since he receives the funds on presentationdocuments corresponding to the letter of credit. The importer, on the other hand, can significantly reduce their product and quality risk by requesting that the documents include detailed specifications relating to the goods they purchase. If the letter of credit is confirmed by a local bank, the country risk can also be reduced.

Among the forms of documentary letters of credit are:

• Revocable letter of credit. The settlement scheme for it is as follows: these settlements can be changed or canceled by the opening bank at any time without prior notice to the beneficiary, sometimes even against his will, until the documents are accepted.
• Irrevocable letter of credit - the obligation of the bank to pay if the exporter must provide the necessary documents within the prescribed period. Changes to the terms can only take place with the consent of all parties to the transaction. Only this type of letter of credit fully ensures the interests of the exporter.

What documents are used in the calculations

Let's consider the workflow used. The letter of credit settlement scheme includes:

• commercial account;
• insurance documents;
• certificate of origin;
• marine bill of lading;
• receipt;
• duplicate railway bill of lading;
• air waybill;
• car invoice.

Settlement scheme taking into account the transport company

International trade is constantly associated with different types of risk. The merchant worries whether the customer will pay the requiredamount, the customer is worried about whether the seller will send the goods. Besides, neither of them is willing to put their own business at additional risk.

This disagreement was the prerequisite for the emergence of an instrument that guarantees both parties the fulfillment of contractual obligations.

The transport company plays a significant role in the settlement scheme of a documentary letter of credit.

Letters of credit are used for the import of all types of products when using transport companies.

The main advantage of a bank letter of credit will be that it provides a guarantee of delivery and payment for goods. This requires the participation of a third party, which will monitor the fulfillment of the terms of the transaction for both the manufacturer and the client. The rule is that the guarantor is an international banking organization. Simultaneously attracted banking structures - banks of the sender and client states - are also widely used in international practice.

Conclusion

Under the letter of credit understand the written obligation of the bank to pay a certain amount for documents submitted in a timely manner in accordance with the agreed terms and conditions. This is the most common form of international and national settlements, ensuring the interests of all parties to the contract.