Letters of credit
A letter of credit or documentary credit is a payment mechanism used in international transactions to give added security to both the exporter and the importer.
Documentary credit is used to ensure that exporters are paid for the goods they sell and that importers pay for the goods they receive, provided certain conditions are met.
The exporter collects payment for his goods, as agreed with the importer, who has arranged for his bank to make payment upon presentation of the required documentation. The importer will pay for the goods once it is accredited that the conditions agreed with the exporter have been met. And the exporter will have arranged with his bank to collect payment on presentation of the documentation accrediting that the goods have been shipped according to the agreed conditions.
The importer will first ask his bank to issue a letter of credit, and then notify the exporter and inform him what documents have to be presented. The exporter then sends the goods to the agreed location under the agreed conditions, and simultaneously instructs his bank to send the documents that prove the goods have been shipped according to the agreed terms to the importer’s bank. Finally, once the correct documents have been received, the importer’s bank will make the payment.
The documentation when making or collecting payment, in the case of the importer and exporter, respectively, is crucial. This documentation must be accurate and be as specified in the letter of credit. It is usually the beneficiary that prepares the necessary documentation, according to the terms of the agreement. The beneficiary can be sure of collecting the payment if he submits the necessary documents in the appropriate form on time.
The importer can make sure that the shipped and invoiced goods are as ordered, by either going directly to the off-loading point and checking the goods in person or by hiring an independent third party to carry out the inspection; this third party may be a trusted individual or a specialist certification agency. Therefore, one of the documents usually required is the physical inspection certificate for the goods, which must be verified either by the importer or by a third party.
Types of letters of credit
Letters of credit come in various forms:
- Revocable or irrevocable: once issued a revocable letter of credit can be modified or cancelled prior to payment by the importer’s giving the relevant instructions to his bank, making it less secure for the beneficiary. An irrevocable letter of credit, on the other hand, cannot be cancelled or modified by the issuer, such that the beneficiary is guaranteed payment provided the necessary documents are presented.
- Confirmed or unconfirmed: irrevocable letters of credit can also be confirmed or directly guaranteed, either by the issuing credit institution itself or by a third-party, usually from the beneficiary’s country as this offers the beneficiary greater solvency or reliability. Unconfirmed letters of credit do not have these additional guarantees, however.
- Sight or deferred letter of credit: a letter of credit at sight is paid as soon as the required documents are presented. In the case of a deferred or time letter of credit a delay is allowed after the necessary documents have been presented before payment is made.
- Divisible or indivisible: a divisible letter of credit will allow the beneficiary to draw part of the credit, as shipments are progressively made. It is also possible to open documentary credit lines allowing the beneficiary to draw credit up to a given limit as shipments are made, as defined in the terms and conditions of the agreement, and provided the necessary documentation is submitted.
- Transferable or non-transferable: a transferable letter of credit allows the beneficiary to instruct the paying bank to pay some or all of the sum of money to another individual, who must be identified beforehand. Letters of credit must expressly indicate whether they are transferable or non-transferable.