What is a Letter of Credit – Definition, Types, Process and Benefits

Within the international means of payment, the Letter of Credit is an instrument through which the Issuing Bank, at the request of the importing client (payer), undertakes to pay an exporter abroad (beneficiary) a sum of money for the purchase of merchandise determined against the due presentation of documents within the agreed terms and within a specific term. The Letter of Credit for many companies is considered the safest means of payment.

The Advantages it has for the Importer, Our team says, gives the buyer peace of mind to pay for the merchandise traded. The Exporter’s Advantage offers a secure collection method by having the commitment of the Issuing Bank and the security of adding a responsibility from another bank to confirm the operation. 

How Can They Be So Sure That The Importer And The Exporter That The Other Will Comply? 

The main advantage of the Letter of Credit or Documentary Credit is that the Banks act as an intermediary as in other payment methods, but by agreeing to issue a Letter of Credit in the name of their client (importer) in a certain way endorses it and adds your payment commitment. If the importer cannot pay, the issuing Bank is obliged to assume the payment.

Process

By the Purchase Contract, the importer requests from its Bank the issuance of a Letter of Credit; once the credit risk of its the client has been evaluated, the Bank will issue the financial instrument, instructing a Correspondent Bank located in the plaza ( country) of the beneficiary (exporter) to pay and honor bills (if necessary) upon expiration after the exporter presents the documents evidencing the shipment (invoice, bill of lading, packing list, certificates, among others). The exporter must thoroughly study the Letter of Credit once it is received to comply with its conditions.

What is a Letter of Credit?

What is a Letter of Credit

 

Differences between Documentary Credit and Letter of Credit

Letter of credit; It is the one granted by the issuing Bank to its client once its payment capacity has been verified and partly taking the shipping documents as collateral.

Letter of credit; is the one that before the opening of the Documentary Credit, the Bank of the importer issues and sends to the correspondent in the country (place) of the exporter with the instructions referring to the documentation, deadlines, deliveries, merchandise, among others that must be met so that the payment becomes effective, the correspondent notifies the exporter about the arrival of the instructions and also confirms the authenticity of the document presented by the exporter before proceeding to the payment or acceptance of letters if it is a deferred payment.

As additional information, deferred payment is vital to enter new markets because the exporter offers commercial advantages. The Importer can sell the merchandise and pay for it; in a nutshell, the exporter’s deferred payment finances the Importer’s shipment.

How to fill out an Application for Opening a Letter of Credit?

The request for a letter of credit must be duly filled in legible letters, remember the maximum shipment date of the merchandise if the Letter of Credit is “Confirmed” or “Not Confirmed,” the company’s account number, the description of the merchandise in Spanish and English, the maximum validity date, type of Incoterms, the additional conditions, the ultimate date of presentation of documents.

Take into account that the Letter of Credit is built based on the Purchase Order, the same as that made by the Importer and Exporter.

Types of Documentary Credit

The Documentary Credits can be divided into different categories according to other criteria, they are:

  • Revocable
  • Way to pay
  • Payment Commitment
  • Others

 Extending information on the Criteria

For its revocability.

1) Irrevocable, cannot be modified or canceled without the consent of all the parties involved: Originator (Importer), Issuing Bank (Importer’s Side), Advising or Confirmed Bank (Exporter’s Bank), and Beneficiary (Exporter) Take note # # The letter of credit if it is irrevocable constitutes for the issuing Bank a commitment that assumes on behalf of the Importer or payer to pay, negotiate or accept letters as long as the terms and conditions are given in the Documentary Credit ## are fulfilled.

By your Payment Method.

1) At sight, 

Against documents; Payment is made in the boxes of the Issuing Bank or Adviser / Confirmer against presentation of shipping documents provided that the agreed terms have been fully fulfilled (dates, documents, instructions)

With Advance Payment; The payment is made totally or partially before shipment and against a simple receipt confirmed by the exporter and the written promise to return the money if the load is not made. (Green Clause)

2) Term

Acceptance; Payment is made within a specified period, from a specific date (usually shipping) against the presentation of the shipping documents and the letter or letters drawn by the Issuing Bank (Importer) or the Notifying Bank (Exporter )

Deferred Payment; Payment is made within a certain period, from a specific date that is usually the date of shipment; in this case, no letters are used; the Importer more uses this modality. 

3) For the Payment Commitment,

Notified, in the case, the Notifying Bank (Exporter) only reports the Beneficiary (Exporter) of issuing the Documentary Letter of Credit in its favor. Do not add any commitment only to carefully review the documents and verify the authenticity and conformity of the credit documents.

Confirmed, it gives the exporter double payment security; in what way? Since, when adding the confirmation, the Confirming Bank, usually the Advising Bank, jointly assumes with the Issuing Bank (Importing Bank) the commitment to pay or negotiate letters with a defined term against the presentation of shipping documents the terms Conditions are compliant. That is why properly reviewing the documents is vital in a negotiation with a Letter of Credit. If the Importing Bank fails to pay, the Confirming Bank assumes the payment to the exporter.

Others

1) Revolving or Revolving Credit; it can be partially or renewed until the expiration period allows it (it can be in amount or on time). The important thing is that this type of credit prevents the Importer from having to issue new letters of credit for each shipment, being more dynamic in the Documentary procedure and reducing its costs, avoiding the costs of publishing a letter of credit. It is the most appropriate modality when making partial shipments.

2) Transferable Credit; It is used when the exporter is not the manufacturer but only an intermediary; this modality, at the beneficiary’s request (Exporter), the Advising / Confirming Bank can issue a national Letter of Credit in favor of a second beneficiary. For an amount less than the figure In the original Letter of Credit, the difference is the exporter’s profit margin; it is a way to prevent the producer from contacting the Importer.

3) Back to Back Credit; It is when the Letter of Credit of which the exporter is a beneficiary is not transferable, and it does not comply with the contract request, it subcontracts a supplier and offers its credit as a guarantee to the Advising Bank for the issuance of a second credit.

4) Stand By Credit; it is an irrevocable commitment assumed by the Bank on behalf of the payer (Importer) to pay a certain amount to a Beneficiary; if the terms of the letter of credit were not fulfilled, it is generally used as a bank guarantee to support commercial credits and Financial Tenders or public tenders.