What are the advantages of using letters of credit in global trade?

The difference between an LC and a Guarantee, both of which are issued by a bank, in favour of a beneficiary at the request of an applicant, is that the latter is a default instrument whist the LC is a method of payment. The likehood of a drawing (claim) under the LC is most probable, as it represents the financial settlement of a trade transaction. Whilst the guarantee is or will only be claimed against if the applicant fails to perform in terms of a requirement they are required to do in terms of the underlying contract between the two parties.

The banks do not "verify" the documents, they check that the data shown in them appears to comply with requirements in thatLC and the rules.

La lettre de crédit est un instrument de paiement émis par une institution financière habilitée à le faire (banque émettrice) sous ordre de l’acheteur (donneur d’ordre) en faveur du vendeur (bénéficiaire). Cet instrument de paiement est émis pour un montant, une durée et des conditions déterminées à l’avance. Le paiement se déclenchera lorsque les documents présentés par le bénéficiaire seront conformes aux termes et aux conditions de la LC ainsi qu’aux règles et usances.

Letters of credit (LCs) are a popular payment method in international trade. They provide security for both the buyer and the seller, and can help establish trust between parties involved in a transaction 1. Here are some advantages of using LCs: Security: LCs provide a guarantee to the seller that they will receive payment as long as they meet the terms of the LC. This reduces the risk of non-payment and helps protect the seller’s cash flow 12. Customizable: LCs can be customized to meet the specific needs of the buyer and seller. This allows for flexibility in the terms of the transaction 3. Creditworthiness: LCs can provide proof of the buyer’s creditworthiness, which can be important when dealing with new or unknown customers 2.

It's easy for us to verify that the buyer and seller are genuine. It is a secure and safe transaction on both sides. As far as risk factored is concerned, it is under their control, and if any other issues arise, they are dealt with legally. In addition, they will gain transaction time prior to the confirmation of an order.

-Beneficiary (Exporter) only can minimise the risks presenting the documentation required in time & form, found in accordance with the L/C terms and conditions without any discrepancy and that his bank add the Confirmation, thus will allow the Beneficiary to avoid the Applicant’s (Importer) commercial risk, Issuing Bank risk and Applicant’s Country Risk. -L/Cs are payment method with contractual obligations among banks (Issuing, Negotiating and/or Confirming banks), banks review documents not goods and accept their obligations when all the terms & conditions are fulfilled. -L/Cs are requested by Exporters when they do not have a long commercial relationship with importers and/or importers are located in risky countries.

Ideally the Beneficiary will want the LC available in their country, payable at SIGHT against full set of B/Ls, T/T reimbursement allowed. If Sovereign and Counterparty risk a concern then they can request the LC must carry the Confirmation or Irrevocable Reimbursement Undertaking of an acceptable bank ( which they regard eliminates these risks).

The contractual relationship under the letter of credit that exists between the bank(s) and the beneficiary, namely, a conditional promise to pay or incur a deferred payment undertaking by the issuing or confirming bank is predicated on presentation of facially compliant documents. However, the bank(s) are not in a position to “ensure that both parties fulfil their obligations”. The letter of credit is a contract between the issuing and confirming bank (if any) and the beneficiary but at a principal level, the applicant is not a party to it. Rather, the applicant’s contractual relationship with the issuing bank is embodied and defined under a separate agreement and indemnity.

Risk mitigation: Letters of credit provide a level of security for both the buyer and the seller. The buyer is assured that the goods will be delivered as per the agreed terms, while the seller is guaranteed payment upon meeting the conditions of the letter of credit. Overall, using letters of credit in global trade can help reduce risk, enhance credibility, provide financing options, ensure regulatory compliance, and offer flexibility in trade transactions.

Using letters of credit in global trade offers several advantages. Firstly, it provides a secure method of payment for both the buyer and the seller, reducing the risk of non-payment or non-delivery. Additionally, letters of credit can facilitate trust between parties who may not have established a longstanding relationship. They also help in streamlining the trade process by ensuring compliance with agreed-upon terms and conditions. The involvement of banks adds an extra layer of verification, making transactions more transparent. Overall, letters of credit contribute to risk mitigation, smoother transactions, and increased confidence in international trade.

It’s worth emphasising that a confirming bank’s obligation to the beneficiary is primary and not secondary or contingent on a failure of the issuing bank to honour. The confirmation not only potentially protects against “legal/political obstacles” but more importantly, against sovereign and institutional credit risk.

The current ICC rules which govern these instruments, the latest being UCP 600, no longer provide for the provision of revocable LCs, hence all LCs now issued under these set of rules are irrevocable at time of issue. Other types of LCs that can be issued are Revolving LCs where the initial monetary value of the Credit is reinstated automatically. Then you can also get a Standby LC which is only drawn against upon default of non payment by the buyer on goods supplied by the seller on an open account arrangement.

While I have never had to use a LC, in the future I may need to, and I want to ensure that funds are processed correctly and in a professional manner. A LC would give me flexibility to make smart business purchases, and not have to hassle with middlemen or etc. Knowing I can trust my bank and the seller bank to handle large transactions puts my mind at ease.

The last sentence is grossly incorrect! The buyer can do no such thing. Banks engaged in an LC transaction deal only with documents and there is connection then to what might be happening with the goods in transit or even if the goods are correct as ordered.

Banks deal only in documents and not in goods. Further bank’s role in this transaction shall begin when a comply presentation is made . Lastly LC cancellation has to be agreed mutually by both parties buyer & seller no individual party to it can take a call at its own .

Whilst there are benefits as described above which is of great importance for the buyer. The buyer (applicant) nor their bank ( the issuing bank) can cancel or modify the LC without the consent of the Beneficiary, as alluded above.

In my experience, it is very important when drafting letters of credit to include all necessary clauses (beyond the routine ones) to ensure that the quantity and quality of the goods purchased are in line with previous negotiations. These depend on the type and characteristics of the goods being imported.

In precise words, letter of credit allows buyers / importers to: - Mitigate importing transactions most risks (quality, quantity, manufacturing, transportation, credit, foreign currency, legal, political and unforeseen risks). -Payment under letter of credit is affected in more convenient method, comparing with other payment methods (like, open account, cash in advance or documentary collections for example). - Enabling buyers / importers to access some banking finance.

"buyers can minimize losses in case of non-delivery, damage, or fraud by the sellers by either claiming the funds from the banks or canceling or modifying the LC if possible." This is a wrong statement. In my experience, the almost only way to minimize buyers' losses is to include an insurance policy covering CIF costs plus an extra amount for eventual adverse events as an item in your required documents list.

The ability to secure a letter of credit issuance facility often enhances the credit risk perception of the applicant and adds financial credibility in the eyes of the beneficiary. This is an important consideration especially where trade flows from developed economies to less developed economies and setting a precedent to potentially conduct subsequent transactions on open account basis and outwith letters of credit.

Many businesses, particularly those relatively new to exporting, can find letters of credit hard to comply with, and the failure rate can be high. This can push the seller into an effectively open account transaction

As LCs can be issued on a deferred payment basis, i.e. supplier's credit granted.( example - 60days after shipment date) It enabes the nominated bank to discount its deferred payment undertaking given to the beneficiary ( supplier) against a complying presentation, thereby providing an additional financial service and generation of additional income.