One of the most important considerations when it comes to international trade is how you are going to get paid for your exports. While relying on cash upfront may eliminate the risk of non-payment, it limits your universe of potential customers as it can cause cash flow and other problems for buyers.
There are five primary methods of payment in international trade that range from most to least secure: cash in advance, letter of credit, documentary collection or draft, open account and consignment. Of course, the most secure method for the exporter is the least secure for the importer and vice versa. The key is to strike the right balance for both sides. This article focuses on Letters of Credit (LCs) in international trade.
A letter of credit, also referred to as a documentary credit, is a contractual agreement whereby the issuing bank (importer's bank), acting on behalf of the customer (the importer or buyer), promises to make payment to the beneficiary or exporter against the receipt of strictly complying stipulated documents. The issuing bank will typically use intermediary banks to facilitate the transaction and make payment to the exporter.
The LC is a separate contract from the sales contract on which it is based; therefore, banks are not concerned with the quality of the underlying goods or whether each party fulfills the terms of the sales contract.
The bank's obligation to pay is solely conditioned upon the seller's compliance with the terms and conditions of the LC. In LC transactions, banks deal in documents only, not goods.
LCs are most often used in higher-risk situations or new trade relationships where exporters want greater security but still need to remain competitive. They can be arranged easily for one-time transactions between the exporter and importer or used for an ongoing series of transactions.
A letter of credit may be irrevocable, which means that it cannot change unless both parties agree; or, it can be revocable, in which case either party may unilaterally make changes. Under current international banking rules (UCP 600), all LCs are considered irrevocable unless explicitly stated otherwise. Revocable LCs are rare and generally not recommended.
LCs are one of the most versatile and secure instruments available to international traders. Since LCs are credit instruments, the importer's credit with their bank is used to obtain an LC. The importer pays the bank a fee to render this service. An LC is useful when reliable credit information about a foreign buyer is difficult to obtain or if the foreign buyer's credit is unacceptable, but the exporter is satisfied with the creditworthiness of the importer's bank.
This method also protects the importer because the documents required to trigger payment provide evidence that goods have been shipped as agreed. However, because LCs open up the potential for discrepancies, which may negate payment to the exporter, documents should be prepared by trained professionals.
Discrepant documents—literally not having an "i dotted and t crossed"—may negate the bank's payment obligation. That's why many export companies use export documentation and compliance software like Shipping Solutions to ensure their export paperwork is accurate and complete.
A greater degree of protection is afforded to the exporter when an LC issued by a foreign bank (the importer's issuing bank) is confirmed by a U.S. bank.
The exporter asks its customer to have the issuing bank authorize a bank in the exporter's country to confirm (this bank is typically the advising bank, which then becomes the confirming bank). Confirmation means that the U.S. bank adds its engagement to pay the exporter to that of the foreign bank. With a confirmed LC, the confirming bank pays the exporter once the documents comply, even before it receives reimbursement from the issuing bank. This significantly reduces risk.
Exporters should consider getting confirmed LCs if they are concerned about the credit standing of the foreign bank or when they are operating in a high-risk market where political upheaval, economic collapse, devaluation or exchange controls could put the payment at risk. Exporters should also consider getting confirmed LCs when importers are asking for extended payment terms.
There are typically seven steps that occur to get paid using a letter of credit:
While an LC usually involves the exporter, importer and both parties' banks, these four principals can be referred to by different names:
Letters of credit can take different forms:
To get paid under a letter of credit, exporters should expect to prepare and submit documentation, such as:
Accuracy and consistency are critical. Even minor discrepancies in the export paperwork can result in delayed or denied payment. Shipping Solutions export documentation software not only helps companies more quickly prepare their paperwork, it helps improve the accuracy of the documents by eliminating redundant data entry. The less data entry you do, the lower the chance of making mistakes. Register now for a free online demo of the Shipping Solutions software. There is no obligation.
If you’re considering letters of credit for your exports, keep these things in mind:
Make sure you're using the right export documents. Download the free Beginner's Guide to Export Forms to simplify your process.
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This article is taken in large part from the Trade Finance Guide: A Quick Reference for U.S. Exporters, which you can download for free by clicking the link below.