There are many international payment methods that allow importers and suppliers to make payments. However, there are still several risks and concerns associated with paying a supplier before receiving the goods. Among the safest payment methods in international trade transactions is payment via a letter of credit.
A letter of credit facilitates the purchase process from suppliers, whether local or international, and allows for better credit terms, thus providing protection for both parties in the import and export process.
Ensuring the security of payments in international trade and protecting them from risks
Payment security is essential in international trade to protect both buyers and sellers from risk and fraud, build trust, and foster long-term business relationships. Using secure payment mechanisms, such as letters of credit, along with a bill of lading, mitigates the risks of non-payment or non-delivery.
The Enron scandal also highlights the importance of these mechanisms, as the lack of payment security contributed to its fraudulent activities.
To ensure payment security, several measures must be followed, such as:
- Clearly define the payment terms.
- Use secure payment methods.
- Conduct a comprehensive feasibility study for business partners.
- Monitoring the financial status and reputation of business partners.
- Review international trade regulations.
Letter of Credit (L/C)
A letter of credit is a guarantee from a bank to a seller, whereby the bank undertakes to pay a specified amount to the beneficiary upon presentation of documents conforming to the agreed terms. It also guarantees the importer that payment will only be made upon presentation of the correct documents proving receipt of the goods according to the agreed specifications.
This method is considered one of the most important payment methods in international trade transactions. Letters of credit are widely used in import and export to secure payment and guarantee the receipt of goods according to the terms agreed upon by the parties.
Key parties in a letter of credit
A letter of credit is a financing method used in international trade to protect the rights of various parties. This system involves four main parties:
- The buyer is the one who requests the opening of a letter of credit from the bank. The letter of credit is a contract between the buyer and the issuing bank, in which the buyer agrees on the payment terms he requests from the seller.
- The issuing bank is the bank that receives the buyer's request to open a letter of credit. After reviewing the request and obtaining the buyer's approval of the specified terms, the bank opens the letter of credit and sends it to the beneficiary (seller), either directly in the case of a simple letter of credit, or to a correspondent bank in the case of a joint letter of credit.
- The beneficiary (seller) is the party selling the goods or providing the service. The beneficiary fulfills the terms of the letter of credit and submits the required documents to the bank to receive the funds.
- The correspondent bank is the bank that participates in executing the letter of credit if more than one bank is involved. The correspondent bank informs the beneficiary of the terms of the letter of credit.
Documents required for a Letter of Credit (L/C):
Although the documents required for a letter of credit may vary according to the commercial laws of different countries, there is a set of common documents that are usually used in this type of transaction to ensure that the business process runs smoothly and securely.
Essential documents for a letter of credit:
- Draft: Primary document Which contains the details of the agreement between the parties.
- Commercial invoiceA document detailing the financial aspects of the transaction.
- Customs invoice: Used to complete customs procedures when exporting or importing goods.
- bill of lading: A basic transport document proving that the goods have been loaded onto the chosen means of transport.
- Air waybill: Used if the shipment is by air.
- Insurance policy or certificate: to guarantee Cargo insurance Against risks during shipping.
- Packing list: Shows the contents and specifications of the shipment.
- Certificate of origin for goods: Shows the country of origin of the exported goods.
- Goods inspection certificate: Proves that the goods have been inspected by an authorized body.
Steps for a letter of credit:
1. Agreement between the exporter and the importer
Initially, the exporter and importer agree on all aspects of the transaction. The exporter then issues a pro forma invoice to the importer detailing the goods required.
2. Submitting an application to open a letter of credit
The importer goes to their bank to open a letter of credit based on the pro forma invoice provided by the exporter. In this application, the importer must specify the details of the goods required.
3. Submit the required documents
To successfully execute a letter of credit, the importer or exporter must submit the required documents according to the terms of the credit. These documents serve as proof of proper contract execution and vary depending on the type of transaction, but they are essential to ensuring the transaction's completion. Accurate and timely submission of the documents guarantees that all parties receive their dues and prevents any delays or legal issues in the business transaction.
4. Reviewing the documents from the bank
The importer fills out a special letter of credit form at the bank. A copy of the form, along with a copy of the pro forma invoice, is submitted to the Ministry of Foreign Trade. The bank retains a copy of the form in its letter of credit file.
5. Approval to open the credit
After reviewing the documents, the bank agrees to open the letter of credit, determines the method of coverage (how the amount will be paid), and details the expenses and commissions, such as SWIFT charges and credit opening fees.
6. Notify the issuing bank
The importer's bank informs the exporter's bank in the supplier's country that a letter of credit has been opened in favor of the supplier. The bank then sends the exporter the text of the letter of credit, its terms and conditions, and the required documents.
7. Shipping goods and preparing documents
After the goods are prepared, the exporter ships them according to the letter of credit. The exporter receives the bill of lading and the required certificates as per the terms of the letter of credit.
8. Review the documents at the importer's bank
After the documents are sent from the issuing bank to the importer's bank, the importer's bank carefully reviews them to ensure they comply with the terms of the letter of credit. If they comply, payment is made to the issuing bank.
9. Payment and receipt of goods
After paying the amount to the supplier, the importer goes to customs to receive the goods after submitting the required documents such as the bill of lading.
Types of letters of credit:
Irrevocable and revocable letter of credit:
An irrevocable letter of credit is a written undertaking that guarantees the credit cannot be amended or cancelled except with the consent of the beneficiary and the confirming bank (if any). This type of credit has the following advantages:
- Irrevocable even if the credit does not state that it is irrevocable.
- It cannot be cancelled by any party without the beneficiary's consent.
The absence of the concept of revocability, according to the rules of the International Chamber of Commerce, does not include a revocable letter of credit unless it is expressly included.
The danger of revocable letters of credit: Although most letters of credit in international trade are irrevocable, revocable ones can sometimes occur. Caution is advised when dealing with them, as they can be canceled at any time without the beneficiary's consent.
A confirmed letter of credit is a joint undertaking between the confirming bank and the issuing bank, whereby both banks commit to fulfilling their obligations to the beneficiary. This type of credit is used when there are concerns about the issuing bank's ability to meet its obligations or risks in the country where the issuing bank is located. This type of credit typically includes a specific condition in the pro forma invoice or sales contract.
3. Letter of credit with silent confirmation:
A letter of credit with silent confirmation requires a special arrangement between the bank and the beneficiary without the issuing bank's knowledge. This type is more expensive due to the higher risk, as there can be an explicit agreement between the bank and the beneficiary without the issuing bank's involvement.
A revolving letter of credit is a type of credit that allows the credit to be recovered after each shipment. It includes two main types:
- Revolving cumulative credit: Any unused amount is rolled over to the next month.
- Non-cumulative revolving credit: Renewed monthly. This type is used to reduce administrative workload in recurring transactions with the same supplier.
5. Letter of credit with red and green clauses
A letter of credit with red or green clauses contains special provisions that allow the seller to rely on credit before the goods are shipped. The terms of the letter of credit differ in color.
- Red condition: can be uninsured or clean and means that the required documents do not contain evidence of the goods.
- The guaranteed red clause: allows the seller to obtain an advance payment against the submission of shipping documents.
- Green condition: Prepayment is allowed with the provision of goods storage in the bank's name to guarantee payment.
6. Transferable Letter of Credit
A transferable letter of credit allows the seller (first beneficiary) to transfer the credit, in whole or in part, to a third party (second beneficiary). The letter of credit must clearly state that it is transferable and that the transfer is made in accordance with the terms of the letter of credit.
- The balance can be partially transferred to more than one second beneficiary.
- The transferred balance cannot be transferred to another beneficiary.
- The insurance coverage can be modified to provide the coverage amount stipulated in the credit.
7. Back-to-back letter of credit
A back-to-back letter of credit is used between intermediaries who work between the source and the final buyer, where two separate letters of credit are used:
- Key credit: in favor of the intermediary.
- Sequential Letter of Credit: In favor of the supplier. Caution should be exercised when using this type of letter of credit due to the potential for disagreements in interpreting the terms between banks.
A standby letter of credit is a type of bank guarantee that sometimes resembles a financial guarantee, but differs in terminology and execution. It is the most common type of letter of credit in the United States. This type of guarantee ensures performance in case of default and provides security against non-performance in contracts.
Types of standby letters of credit
There are several types of standby letters of credit, which are used in different situations such as:
- Performance: Ensuring compliance with contractual obligations.
- Prepayment: Guarantee of payment of an advance payment or deposit upon signing the contract.
- Bid Guarantee: Guarantees that the bid will not be withdrawn or changed before the tender is awarded.
- Anti-deposit: Issued by one bank in favor of another to support the issuance of a guarantee or undertaking.
- Financial: Supports the obligation to pay or repay.
- Insurance: Reinforces the applicant's commitment with respect to insurance or reinsurance activity.
- Direct payment: This is considered the primary method of payment.
- Commercial: Guarantees payment for outstanding goods or services.
Steps for payment via Letter of Credit (L/C):
The documentary credit process involves simple and straightforward steps. While importers or exporters may initially perceive it as complex, it becomes a routine procedure after the first attempt, handled by a bank employee. The steps are as follows:
1. After the deal is finalized between the exporter and the importer, the exporter prepares a proforma invoice, signed and stamped by the company, in favor of the importer. This invoice allows the importer to go to the bank to open a letter of credit. The proforma invoice contains the agreed-upon specifications and terms, upon which the bank opens the letter of credit.
2. After that, the importer’s bank (which opens the letter of credit) contacts the exporter’s bank to inform it of the client’s desire to open the letter of credit in accordance with the agreed terms.
3. After the letter of credit is opened, the exporter prepares the shipment according to the agreed specifications and arranges with a shipping company to transport the goods to the importer’s port.
4. The exporter prepares the required documents and delivers them to the bank, which in turn sends them by mail to the importer’s bank, so that the latter receives the documents and completes the necessary procedures.
Advantages and disadvantages of documentary credit
Features | Disadvantages |
|---|---|
| A. Reducing risks: | 1. High costs |
| It helps reduce the risks associated with international trade, as it guarantees the importer payment after confirming receipt of documents or goods as agreed. | A letter of credit requires payment of fees from both the buyer and the seller, such as the costs of issuing the letter, bank fees, and confirmation fees, which can be high for small transactions. |
| B. Payment security: | 2. Risks associated with documents |
| It provides suppliers with a guarantee of payment through a trusted financial institution, eliminating the risk of non-payment or delay. | The documents must fully comply with the terms specified in the letter of credit. Even a minor error in the documents may result in payment being refused or delayed. |
| C. Flexibility: | 3. The complexities of trade in countries with underdeveloped banking systems |
| A letter of credit can be customized to suit the specific needs of the transaction, whether payment is on demand or deferred. | Traders may find it difficult to execute letters of credit in countries with underdeveloped banking systems, which adds complications to business operations. |
Conclusion
A letter of credit is a vital tool between importers and exporters in international trade, providing payment guarantees and mitigating the risks associated with cross-border transactions. It helps importers ensure the delivery of agreed-upon goods or services, while providing exporters with confirmation of payment upon fulfillment of specified conditions. This mechanism fosters trust between trading parties, facilitating trade operations and protecting the rights of all involved in the transaction.