The letter of credit form of payments acts as a non-cash instrument. It is a written obligation of the bank, whose customer is the buyer (or importer), to pay the specified amount to the seller (or exporter). It also agreed on the dates and sizes of payment in accordance with the terms.
Concept and essence
Consider the nature of settlements by letters of credit and the scheme of interaction between participants.
Letter of credit - a form of payment in both foreign and domestic payments. It is used in transactions that are accompanied by various types of increased risk (for example, related to the contractor, proper execution of the contract, product quality, delay, lack of payment), since it reduces them.
Parties settlement
Consider the main aspects of settlements by letters of credit and the interaction schemes between them.
Among the main aspects of the calculations, the following types are distinguished.
Principal (importer) - submits an order to open a letter of credit in his bank and funds to cover the payment to the exporter. The importer has the right to demand compensation from his bank in order to cover losses resulting from negligence or omission on the part of a financial institution. The importer must cover the amounts paid to the exporter, as well as possible costs and commissions.
The importer’s bank (opening bank) forms a letter of credit in accordance with the written order of the importer, in which he undertakes to independently pay for the documents submitted by the beneficiary of the letter of credit, if its conditions have been met. The Bank does not analyze the progress of the transaction, but makes a decision on payment or refusal based on the submitted documents.
Intermediary bank (consulting, negotiation, confirmation), which, depending on the conditions of the letter of credit, can perform the functions of:
- Notifying Bank - informs the beneficiary of the opening of the letter of credit and acts as an intermediary in the correspondence between the opening bank and the exporter. He is not required to pay a letter of credit.
- Conducting bank negotiations: notifies and verifies the compliance of documents, acts on behalf of the principal, that is, it is the bank of the importer.
- Bank confirming a letter of credit, which assumes an obligation towards the beneficiary.
The exporter has no obligations, submits documents in accordance with the letter of credit and pays for them.
The main types of letters of credit
Consider the calculations of letters of credit, the scheme and types of this form of interaction.
Letters of credit are divided according to various criteria. Some of the following are widely used in international transactions.
Separation of letters of credit in terms of bank opening obligations:
- Letter of Appeal: the bank reserves the right to cancel or change its obligations without the consent of the beneficiary until the documents of the intermediary bank are recognized.
- Irrevocable letter of credit: it cannot be changed or canceled without the consent of all parties involved. A change is invalid if either party disagrees with it.
Splitting a letter of credit by payment method:
- Cash letter of credit: payment is made immediately after the exporter submits the documents.
- Letter of credit with deferred payment: the bank undertakes to make payment for a deferred period (for example, 30 days from the date of sending) upon submission of documents in accordance with the terms of the letter of credit during its validity period.
- Letter of credit relating to the date of deferred payment, which obliges the bank to accept payments on non-working days. After approval, the letter of credit expires, and its place is taken by the obligation on the bill.
- Negotiation letter - the opening bank gives the intermediary bank the right to verify the compliance of documents with the letter of credit and payment to the beneficiary.
Splitting a letter of credit in connection with the role of an intermediary bank:
- Confirmed letter of credit - a bank carrying out confirmation has been added to the letter of credit opened by the importer’s bank.
- Unrecognized letter of credit - a type of letter of credit that has not been confirmed by an intermediary bank, and payment for an exporter is made only by a debtor bank.
Other types
Other letters of credit may be of the following types:
- standby letter of credit (security) is a bank guarantee imposing an obligation to pay the necessary amount to the beneficiary if the payer has not made an advance payment within the agreed period between the parties or does not fulfill other obligations secured by the letter of credit;
- revolving letter of credit applies to sequentially repeated deliveries of one product over a long period of time;
- letter of credit - the buyer for the specific beneficiary opens a letter of credit for import, and proceeds from the export letter of credit provide payments on the import loan.
Benefits
Consider the benefits of settlements by letters of credit and patterns of interaction between the parties.
Advantages for seller or exporter:
- minimize the trade risk of the transaction, that is, the risk of refusal to accept the goods and lack of payment from the importer;
- eligible financing of the transaction by transferring a letter of credit to the supplier;
- the possibility of discounting receivables before the payment deadline and ensuring payment on a date specified in advance.
Benefits for buyer or importer:
- minimization of transport risks;
- the impossibility of violating the deadlines;
- protection against unjustified payment of debts.
How is the process going
Consider the possible options and the essence of settlements by letters of credit. The scheme is as follows:
- Making a contact between the importer and the exporter and creating a letter of credit as a form of payment for the goods.
- The importer informs the bank about the opening of the letter of credit to the exporter and provides financial coverage.
- The importer's bank notifies the exporter's bank (intermediary bank) of the opening of the letter of credit, instructing him to notify the exporter.
- The intermediary bank checks the authenticity of the letter of credit, which the importer bank has notified of, and then transfers it to the exporter.
- The exporter sends the goods and draws up documents in accordance with the terms of the letter of credit.
- The exporter submits to the bank a package of documents in accordance with the terms of the letter of credit.
- The exporter’s bank checks the documents (number and type) and sends them to the importer’s financial institution.
- The importer’s bank checks the correctness of the documents, if they are in order, it sends the payment to the exporter’s bank and the documents to the importer.
- The payment received is credited to the exporter.
The main elements of the scheme of settlements using a letter of credit
An order for opening a letter of credit should contain the following items:
- place and date of placing the order;
- beneficiary;
- letter of credit amount;
- date and place of validity of the letter of credit;
- place of payment (opening bank or sending bank);
- type of payment;
- partial deliveries (allowed, prohibited);
- place of loading and destination;
- product description;
- quantity;
- price and its basis (according to Incoterms);
- special settlement conditions;
- Documents required for payment;
- period of shipment of goods;
- document submission time;
- expenses for bank commissions;
- type of letter of credit;
- payer account number;
- stamp and signatures.
Calculation scheme from the point of view of the exporter
Consider the procedure for settlements by letter of credit and the scheme of interaction by the exporter.
A letter of credit is the preferred form of payment for the exporter, because it is an obligation to pay the bank, not the importer. If the exporter fulfills the conditions of the letter of credit, he will receive payment regardless of the situation and financial condition of the importer. The exporter receives payment after delivery and submission of documents to the bank.
A letter of credit protects the exporter from withdrawing from a transaction or refusing to accept goods. This allows the exporter to obtain a loan to finance the production of goods, which is secured by a letter of credit.
It is possible to use forfeiting and prepayment in case of deferred payment.
A letter of credit is a profitable form of payment for an exporter when he fulfills all the conditions. If the exporter submits documents in which conflicting data is found or deficiencies are found, for example, the absence of a set of bills of lading, the necessary confirmations in documents issued upon request, or contamination of bills of lading, then payment to the exporter will be withheld. Other errors made by the exporter when submitting documents include:
- erroneous marking of documents;
- incorrect marking of the place of loading and destination;
- non-compliance with the letter of credit;
- description of goods in documents;
- lack of additional documents appearing in the text.
A letter of credit is a labor-intensive form of payment not only because of the need to carefully prepare the relevant documents, but also requires a detailed review of the terms of the letter of credit, the contract and the consistency between the buyer and seller, as well as checking the provisions in terms of information and the presence of contradictions.
The scheme of calculations from the point of view of the importer
Consider the calculations by letters of credit and the interaction scheme in relation to the importer.
Using a letter of credit, the importer requires the exporter to provide the relevant documents and fulfill all the conditions of the letter of credit. Choosing the right documents and terms of delivery of goods, the importer regulates the course of the transaction. By setting the terms of the letter of credit, the importer has a guarantee of the proper execution of the contract, however, he does not protect him from the withdrawal of the contract by the exporter.
A letter of credit sometimes requires the importer to allocate financial resources before concluding a contract - an advance payment. However, this does not stipulate payment to the exporter. The acceptance by the importer of the letter of credit as a form of payment puts it in a more favorable position than in the case of unconditional transfer of the payment before order execution. An unfavorable aspect of the use of letters of credit as a form of payment by the importer is the attraction of their own financial resources before delivery, in the absence of a guarantee of the contract from the exporter. Some banks require the importer to pay an amount in excess of the amount indicated on the letter of credit in order to ensure differences in exchange rates. You can pay your bill with a credit line, but the bank must accept this form of payment.
Documentary Settlement Form: Applications
Consider the settlement scheme for a documentary letter of credit.
It includes a conditional, irrevocable documentary form of payment that ensures the interests of both parties to the transaction. A letter of credit is a liability of the bank.
A documentary letter of credit in foreign trade is a written obligation of the importer's bank to pay the exporter's receivables in exchange for providing documents on the delivery of goods. In such calculations, the customer is an importer who makes a request to his bank to open a letter of credit for the exporter.
The advantages of a settlement scheme using a documentary letter of credit are as follows:
- Transparent rules and a sense of security. By opening a letter of credit at the request of the importer (buyer), the bank undertakes to pay a certain amount to the beneficiary (exporter, seller). The beneficiary must fulfill all the conditions of the letter of credit, that is, at the indicated time to send the goods or perform the service and provide the bank with the necessary commercial documents in accordance with the terms of the letter of credit. The obligation of the bank opening the letter of credit becomes payable on the date arising from the terms of the document.
- Securing the transaction. The importer is confident that payment will be made only on the basis of documents confirming the proper execution of the commercial contract in accordance with the terms of the letter of credit.
- Minimization of risk. The procedure allows to minimize the risk arising from sales transactions.
- Flexibility. You can adjust the conditions in accordance with the specifics of the transaction and the ability to make changes during its term.
- A wide range of different types and forms: letters of credit ordinary, standby, import and export, letters of credit in domestic trade.
The documentary form is recommended for companies:
- specializing in domestic or foreign trade;
- to suppliers (exporters) and recipients (payers).
This form of settlement is used as a conditional on a commercial transaction.
The settlement scheme using a documentary letter of credit is a type of payment settlement, the application of which can eliminate the operational risk of both parties to the contract. This fact may limit the risk of collection and the risk of payment to the exporter, since he receives funds when submitting documents relevant to the letter of credit. The importer, on the other hand, can significantly reduce its product risk and quality risk by requesting the inclusion in the documents of a detailed specification regarding the goods being purchased. If the letter of credit is confirmed by a local bank, the country's risk can also be reduced.
Among the forms of documentary letters of credit are:
- Revocable letter of credit. The settlement scheme for it is as follows: these calculations can be changed or canceled by the opening bank at any time without prior notice to the beneficiary, sometimes even against his will, until the documents are accepted.
- Irrevocable letter of credit - the obligation of the bank to pay if the exporter must provide the necessary documents in a timely manner. Changes to the conditions may take place only with the consent of all parties to the transaction. Only this type of letter of credit fully protects the interests of the exporter.
What documents are used in the calculations
Consider the workflow used. The settlement scheme for the letter of credit includes:
- commercial invoice;
- insurance documents;
- certificate of origin;
- sea bill of lading;
- receipt;
- duplicate railway bill;
- air waybill;
- car consignment note.
Settlement scheme taking into account the transport company
International trade is constantly associated with different types of risk. The merchant is worried whether the customer will pay the required amount, the customer is worried whether the seller will send the goods. In addition, any of them does not want to expose their own business to additional risk.
This disagreement served as a prerequisite for the emergence of a tool guaranteeing the fulfillment of contractual obligations by both parties.
In the settlement scheme for a documentary letter of credit, the transport company plays a significant role.
Letters of credit are used for the import of all types of products when using transport companies.
The main advantage of a bank letter of credit will be that it provides a guarantee of delivery and payment of goods. This requires the participation of a third party, which will monitor the implementation of the terms of the transaction for both the manufacturer and the client. The rule is that the guarantor is an international banking organization. At the same time, attracted banking structures - the banks of the sending and client states - are also widely used in international practice.
Conclusion
A letter of credit means a written obligation of a bank to pay a certain amount for documents submitted in a timely manner in accordance with the agreed terms and conditions. This is the most common form of international and national settlements, ensuring the interests of all parties to the contract.