letter of credits

8/2/2019 Letter of Credits

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International Trade Finance

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International trade finance involves commercial transactions between buyersand sellers in different countries. It presents a number of difficulties for thefirms involved.


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International Trade - Risks

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Types of Payments in International Trade

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Types of

Payment

Methods of Payment

Payment inAdvance

The buyer agrees on a price for the goods and makes the payment to the seller beforethe goods are shipped. This method is typically used where the buyer can negotiate asignificant cash discount for taking on the trade risk. It could also be possible that thebuyer is unable or unwilling to open a letter of credit.

OpenAccountTrading

This method of payment involves an agreement between the seller and the buyer

whereby the goods are shipped to the buyer and the buyer makes the payment at apredetermined date in the future. In this case, it is the seller who is taking on all thetrade risk. We will discuss open account trading in more detail at a later stage in thistutorial.

Clean

Payments Clean Payments are the means of forwarding funds overseas. These can be made by:

1. Telegraphic Transfer - a message forwarded electronically to an overseas branchor a correspondent bank, instructing it to pay a named party (beneficiary) a specifiedsum of money by order of the remitter (applicant).

2. Draft - similar to a bank check but drawn on an overseas bank. Payment is made tothe payee after adequate verification of identity.


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Open Account Trading

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Despite all the technological developments that have occurred in the pastdecade, nothing seems to be able to stop the growing popularity of openaccount trading.

Open account trading works as follows.A company sells goods to another. It then sends the buyer an invoice, and indue course (usually within 30 days) it receives payment.

Open account trading allows settlement to be achieved at a lower cost because credit lines will not be used to underwrite transactions. The savingsthat companies make will depend on the number of transactions, the level ofautomation, and so on.


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Open Account Trading

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However, open account trading presents an administrative burden for traders,because it entails taking data from multiple sources, consolidating it andmatching commercial invoices/bills of lading against purchase orders. Thismanual process is both time-consuming and subject to error. With an L/C, theissuing bank handles this administration in return for a fee. Many companiesmay choose to outsource this work to banks, because of their expertise in theadministration of trade documentation, and the fact that they have invested in

the technology and have the geographic coverage to facilitate global trade.

Open account trading leaves the seller fully exposed to non-payment or defaulton the part of buyers. Sellers may have to look at receivables financing orfactoring to manage their working capital demands. The cost of capital can be

disproportionately high for small suppliers, even offsetting the savings madethrough the elimination of L/C fees. Therefore, there will probably always be aneed for L/Cs in many cases.


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Letter of Credit (LC)

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Letter of credit is a widely popular commercial instrument used as a meansof financing international business transactions.

A letter of credit is a contract under which a bank agrees to pay the seller inconnection with the export of specific goods.The credit is issued at the requestof the buyer (the applicant) in favour of the seller (the beneficiary)

It facilitates trade by providing payment against presentation of documentsrelating to the transaction as specified in the credit

The transaction of LC take place through SWIFT ( Society for WorldwideInter-Bank Financial Telecommunication) network.


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Role of ICC & International Banks in LC

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International Chamber of Commerce (ICC) has the primary objective to facilitate

and ease flow of international trade. It plays a major role in preparation andpromotion of uniform practices all over the world.

In order for letters of credit to become widely acceptable, cooperation between

banks in different countries was required. Internationally agreed standardprocedures were therefore drawn up by the ICC which became know as the Uniform

Customs & Practice for Documentary Credits (UCP), or UCP600.

When an LC is opened, it is subject to UCP and this is disclosed in the documents.

Letters of credit therefore provide a strong degree of security and confidence ininternational trade because of the consistency of the rules across the world

The purpose of banks as intermediaries is to reduce the trade risks that both the

buyer and the seller face in open market trading. Banks undertake this intermediary

role in return for a fee, usually paid for by the buyer. A large part of this fee is tocompensate the bank for accepting an obligation to pay the seller regardless of the

financial standing of the buyer. Charges are usually set at a certain percentage of the

value of the letter of credit and are usually less than 1%.


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Regulatory Requirements

Trade Control Requirements i.e. Foreign Trade Policy

Exchange Control Requirements i.e. RBI & FEMA

Uniform Customs & Practices for Documentary Credits ( UCPDC)

i.e ICC is engaged in formulation of business policy and mechanics of trade andvarious other relevant international trade practices. The guidelines are acceptedto facilitate trade & payment through LC.

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Letters of Credit - Primary Function

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The primary function of letters of credit is the provision of a method ofpayment in international trade.

Therefore, letters of credit serve as:1. A compromise between the opposing wishes of the seller's desire forpayment in advance and the buyer's preference for making payment only onreceipt of the goods

2. A form of insurance for both the seller and the buyer that greatly reduces

the credit risk for each, while not sacrificing the length of time for payment tobe made


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LC LIFE CYCLE

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Aspects of the LC & bill transaction works in the following manner: The importer (opener) has concluded a purchase order for buying of certain goods with his overseas

supplier who wants payment by a LC. The importer asks his bank to open a LC in favour of hisoverseas suppliers

After the request from the supplier and considering the proposal,his bank opens a LC in favor ofsupplier ( exporter)

The advising bank ( an intermediary bank in the exporters country) receives credit from the opening

bank and after satisfying itself about the authenticity of the credit it forwards the same to thebeneficiary

After receiving the credit from the advising bank , the exporter checks it to ensure that it confirms to

the terms of sale contract and if necessary , ask the importer to effect amendments to the credit andthen proceeds to effect the shipment of goods

After the shipment is effected the exporter prepares the documents and draws his bill under the LCfor obtaining payment from the negotiating bank

After getting the documents and bill from exporter, the negotiating bank checks them with the LC andif in order, negotiates the bill and pays to the exporter

The opening bank ( importers bank) receives the bill and documents from the negotiating bank (

exporters bank) checks them and if found in order, reimburses, if reimbursement is obtained already ,confirms it to the negotiating bank. The opening bank presents the bill for acceptance / payment tothe opener ( importer)

The importer ( opener) receives the bill , checks the documents and then accepts / pays the bill. Onacceptance / payment , he gets the shipping documents covering the goods purchased by him.

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Letter of Credit - Participants

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Applicant (Opener) : Applicant is normally a buyer of the goods, whohas to make payment to beneficiary.LC is initiated and issued at his request

and on the basis of his instructions

Issuing Bank (Opening Bank) : Issuing bank is one which issues theCredit. i.e. it is the bank that creates a letter of credit and undertakes to make

payment

Advising Bank : Advising bank communicates with the beneficiary aboutthe LC. It is normally situated in the country / place of Beneficiary. The

Advising Bank may be correspondent bank of the issuing bank or could bespecifically notified by the Beneficiary. The Advising Bank primarily performsthe function of an informer. The only assurance implied is that the LC isgenuine


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Letter of Credit Participants (contd)

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Beneficiary : Beneficiary is normally a seller of the goods, who hasto receive payment from the applicant. If he transfers the credit toanother party, then he is referred to as the First or Original Beneficiary

Confirming Bank : Confirming Bank adds its guarantee to the LCopened by another bank, thereby undertaking the responsibility of

payment/ negotiation/acceptance under the credit, in addition to thatof the issuing bank. A Confirming Bank is required where the exporterfeels more comfortable dealing with a local bank.

Negotiating Bank : Negotiation is the process of giving value to

the documents. The negotiating bank is one with whom thedocuments may be negotiated. The LC may either specify theNegotiating bank ( restricted negotiation) or the exporter may be freeto negotiate through any Bank ( unrestricted negotiation)


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Letter of Credit Participants (contd)

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Reimbursing Bank : Reimbursing Bank is the bank authorized tohonor the reimbursement claim in settlement of negotiation /acceptance / payment lodged with it by the negotiation bank. It isnormally the bank with which issuing bank has an account, from whichpayment is to be made. This role may also be played by the issuingbank itself.

Second Beneficiary : Second beneficiary is the person in whosename the first or original beneficiary to credit has transferred the credit

designated as transferable. The rights of the transferee are subject toterms of transfer.


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Types of Letter of Credit

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Irrevocable LCIrrevocable LC is a undertaking given by the Issuing bank and cannot becancelled or amended without the consent of all the parties to LC,particularly the beneficiary. From on exporters point of view this is morefavourable. This nature has enabled building up an elaborate commercial

system on the basis of irrevocable bankers credit.

Confirmed LC

In a Confirmed LC, another bank (usually a Bank known to the

beneficiary), adds its confirmation/guarantee. It is a double guarantee & ismore favorable to beneficiary. This is generally desired by the Beneficiaryso that his risk becomes localized and he can deal easily with a local bankrather than deal with a bank abroad. This type of LC is costlier to theparties concerned.


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Types of Letter of Credit (contd)

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Transferable Letter of Credit

It is a credit which can be transferred by the original Beneficiary in favorof a second beneficiary or several second beneficiaries, such that creditcan be transferred only once i.e from the first beneficiary to a secondbeneficiary and not (thereafter) from the Second beneficiary to thirdbeneficiary & subject only to the original terms and conditions

Sight credits & Usance Credit (deferred payment credits )

Sight credit states that payment be made by the issuing bank at sight i.e. -on demand/ presentation. Usance credit drafts calls for payment againstdrafts calling for payment at a future date. This allows the buyers to

arrange for selling & arranging funds to reimburse the issuer


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Back to Back Letter of CreditBackto BackLC is an LC based on the security of another LC. It is also

called as Countervailing Credit. This is useful when an LC is opened bythe ultimate buyer in favor of a particular beneficiary, who may not be theactual supplier or manufacturer . He will open another credit with nearidentical terms in favor of the actual supplier / manufacturer offering themain credit opened in his favor as security and will be able to obtainreimbursement by presenting the documents received under back-to-backcredit under the main LC.

Types of Letter of Credit (contd)


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Role & Responsibility of an Issuing Bank

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To determine that the transaction falls within the scope of the banks policiesand procedures

That the transaction falls within the clients usual mode of business and withinits given credit facility

Act accordingly to any Government regulations that may apply to that branchof the bank or the bank as a whole

Complete regular due diligence on the client

That the transaction is issued in a workable form

To determine compliance of any presentation of documents and honourwhere such complying presentation is made, or to refuse according to article 16and

To educate and inform the client of best practices and changes in international

procedures


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Role & Responsibility of an Applicant

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Complete regular due diligence on their client

Recognise that the UCP will not offer any protection and therefore the LCterms and conditions must fulfill that need

To provide the bank with clear and unambiguous instructions on the LCapplication form

To recognise that once issued the credit cannot be amended or cancelled withoutthe agreement of the beneficiary and confirming bank, if any.

To recognise that any instructions given post issuance of the credit i.e. to amend

or to waive discrepancies , may be disregarded by the bank and

To remain cognisant of best practices and changes in international procedures i.e.UCP & Incoterms.


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Risks IssuanceJP to check

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Applicable UCP 600 rules

Sub-Article 14 (a)

A nominated bank acting on its nomination , a confirming bank , if any, and

the issuing bank must examine a presentation to determine , on the basis ofthe documents alone, whether or not the documents appear on their face toconstitute a complying presentation

Applicant : the documents must speak for the goods


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Advantages/Disadvantages of an LC

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Seller

Advantages:

Safe method of payment

Cannot be amended without the Sellerspermission

Provides double guarantee (issuing bank

and confirming bankAdvice & assistance can be receivedfrom any major banks since the terms&conditions are internationally set

Disadvantages

Even a small discrepancy in the supportingdocumentation can cause delay in receiptof sale consideration

Revocable LC can be cancelled/amendedwithout sellers permission

Lot of associated risks. ExCountry/political risk

Seller has to finance the credit (soprovided to buyer)

Buyer

Advantages:

Buyer protects his position based ondetailed and accurate documentationfrom the seller

Based on the shipping dates (provided

by seller,) the buyer can ensure thatthe payment is not released till thegoods are shipped

Buyer obtains short term credit frombanks because of the time gap inpayment for goods

DisadvantagesBuyer has to incur additional cost ofraising LC

Mismatch between payment made andreceipt of goods

Because of LC facility, Buyers bank mayreduce credit facility, till the LC is paid.

In an Irrecoverable LC, if the buyercannot cancel/amend the LC without

everyone consent.


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Necessary information on an LC

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WHO?

1. Name of the buyer

2. Name and address of the seller3. Name and address of the advising bank (usually chosen by the issuingbank)

4. Name of the person(s) on whom any of the following paymentmechanisms are to be drawn:

a) bill of exchange

b) draft

c) check

WHAT?

1. Amount and currency (ISO currency code) of the credit

2. Amount of the letter of credit in words and figures

3. The buyer must specify the:a) exact total amount

b) maximum amount

c) approximate amount

4. Details of the documents required

5. Quantity and description of the goods

6. Place, destination, latest date, and terms of shipment

7. Additional instructions if any

HOW?

1. Types of letters of credit: Revocable/Irrevocable

2. Whether the letter of credit is settled by - paymentacceptance/negotiation

3. How the letter of credit is to be advisedby (air) mail or otherwise

4. Whether partial shipment or transshipment is allowed

5. Whether the letter of credit is to be transferable

WHEN?

1. Expiry date (last date for receipt of documents)

2. Period of time after the issuance date of the transport document(s)within which the document(s) must be presented

Information onan LC


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Incoterms 2010

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Sr. Group Code INCO TERMS 2010

1 E EXW Ex-works

2 F FCA Free Carrier

FAS Free Alongside Ship

FOB Free on Board

3 C CIF Cost , Insurance & Freight

CPT Carriage Paid To

CIP Carriage & Insurance Paid To

CFR Cost & Freight

4 D DDP Delivered Duty Paid

DAT Delivered At Terminal (NEW)

DAP Delivered At Place (NEW)


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Documents requested in an LC

Commercial Invoice

Packing list

Transport documents such as Bill of lading ( SEA mode ) or

Airway Bill ( Air mode)

Insurance Certificate , if applicable i.e CIF

Inspection / Test Certificate

Certificate of Origin ( issued by Chamber of Commerce)

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General documentary credit conditions - If the credit stipulates a latest date of dispatch: were the goods shipped in time?

Can the deadline for presenting the documents to the bank be met?(Under UCP 600 Art. 14 c this is 21 days after

the date of shipment, unless the credit states otherwise and an original transport document is required)

Are all documents presented in the prescribed number (originals and copies)?

Does the invoice amount match the credit amount, i.e. is it not higher or lower or within the permitted tolerances?(UCP 600 Art. 30)

Is the supplied quantity consistent with the credit? (UCP 600 Art. 30)

Are the terms of delivery (e.g. INCOTERMS 2010) consistent with the credit?

Does the credit prohibit partial shipments?

Does the credit prohibit transshipment?

Are the markings, weights, quantity, type and dimensions of the packages consistent throughout the documents?

Are the descriptions of goods, services and performance consistent throughout the documents?.

If documents are required to be presented in a particular language: Is this document obtainable in the required

language?25


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Amendment of a letter of Credit The process for amending an LC is as follows

Seller requests a modification or amendment of any questionable terms in theLC

If the terms are agreed upon, Buyer issues order to his or her (buyers) bank to

make an amendment to the terms of the LC

Buyers bank notifies sellers bank of amendment thru the advising bank

Sellers bank notifies seller of amendment.

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Advantages & Disadvantages

Advantages Advantages

1. Importer is assured that , for the Exporter to be paid, all

terms & conditions of the LC must be met

2. Ability to negotiate more favorable trade terms with the

Exporter when payment by LC is offered

1. An undertaking from the issuing bank that you will

receive payment under the LC provided that you meet

all terms & conditions of the LC.

2. Shifts credit risk from the Importer to the issuing bank3. Not obliged to ship against LC that is not issued as

agreed.

Disadvantages Disadvantages

1. LC assures correct documents but not necessarily correct

goods.2. Ties up line of credit.

1. Documents must be prepared in strict compliance with

the requirements stipulated in the LC. Non-complianceleaves Exporter exposed to risk of non-payment

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The LC provide a relatively risk-free environment to both importer & exporter.

EXPORTIMPORT


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Articles, Application format & LC swift copy

UCP - 600

Appl LC format

SWIFT Message format

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http://ucp%20-%20600.pdf/http://appl%20lc%20format.doc/http://lc%20format.doc/http://lc%20format.doc/http://appl%20lc%20format.doc/http://ucp%20-%20600.pdf/http://ucp%20-%20600.pdf/http://ucp%20-%20600.pdf/http://ucp%20-%20600.pdf/


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Precautions for Exporters & Importers :The documentary letter of credit (credit) is an important and well-

established instrument for securing payments in international trade.However, to ensure smooth processing it is vital for exporters /beneficiaries

to fulfill the terms and conditions of the credit exactly and to present

complying documents to the bank.

Even minor discrepancies or errors can result in the honoring of the

documents being delayed or prevented altogether. It is always important to

check the credit very carefully as soon as customers receive it to ensure that

it conforms to the underlying contract and that the terms and conditions

can be met.

If necessary it is possible to have the credit amended accordingly. Banks

have to educate their customers in this regard.29


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International Trade Financial Risk Mitigation

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Factoring - is a receivable management service encompassing finance, creditprotection, collection and sales ledger management for exports on open

account terms. They provide financing upto 90-95%.

Forfaiting - is the discounting of international trade receivable on a 100%"without recourse" basis. It is a form of suppliers credit involving the sale orpurchase of receivables falling due at some future date. The exporter is, of

course, responsible for the validity of his order and execution thereof, butonce documentation has been delivered and accepted and discounting is done,there is absolutely no recourse to the Exporter, with the exception of anunderlying fraudulent transaction. Forfaiting effectively transforms a credit saleinto a cash sale.

Securing terms of payment (L/C)

Acquiring insurance backed financial packages


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Characteristics Forfaiting/Factoring

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Forfaiting Factoring

100% financing without recourse to the seller. Upto 90% financing

Importer's obligation is normally supported by alocal bank guarantee.

The exporter's performance obligations should becompleted at the time the exporter presents an invoice

for prepayment. Performance under turnkey contracts

involving execution or commissioning of equipment is

usually not factorable.

Require LC/Bills of exchange/Promissory note.

Credit periods can range from 90 days to 10 years

LCs not required.

Suitable for high value exports in:

Capital Goods

Consumer Durables

Vehicles

Consultancy & Construction contracts

Project exportsBulk commodities

Suitable for manufacturing/trading companies. Not

suitable under the following:

Credit more than 180days

Consignment sale

Sale to associate consignments/small retail outlets

Finance to be either on a fixed (market norm) or

floating rate basis

Factoring facilities are typically provided for "open

account" transactions and can also be structured for

transactions involving negotiable instruments such as

bills of exchange or promissory notes, on a case to case

basis.


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International Factoring

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Forfaiting

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asssss


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International Trade Latest Developments

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The growth in global trade over the past decade has put increasing demands onthe financial industry to find efficient methods of making international payments in

exchange for the delivery of goods and services.

Many companies have already tried to limit their number of trading partners so asto concentrate their orders among a small few trading partners. They can then quicklyestablish trust with these partners through service level agreements and so on. The

advantage of this is that when it comes to settling accounts, there is less need forexpensive and slow financing arrangements such as letters of credit.

Forming international trade organizations exTradeCard (US), Bolero.net(US)

All documentation in electronic format

Secondary market for LC. The holder of trade finance debt passes on the risk ofnon-payment to a third party but retains title to the instrument. This is achieved usinga participation contract.


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Thank You

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