Payment is almost always made with a commercial letter of credit, except for various small orders. Letters of credit allow a bank to act as an uninterested party between the buyer and seller. They have been used for centuries and are becoming a vital, ever-increasing instrument of international trade. They aid both parties by enabling the buyer to prove they can make payment and by reassuring the seller that payment will be received. Before placing an order, it is important to understand how letters of credit operate.
There are four major parties involved when issuing a commercial letter of credit in international trade:
- Applicant: Purchaser of the goods
- Beneficiary: Producer of the goods
- Issuing bank: Bank where the purchaser (applicant) draws the letter of credit
- Advising bank: Bank where the manufacturer (beneficiary) maintains an account
A typical transaction involving a letter of credit works as follows:
- An applicant (purchaser) in the US agrees to purchase a product from a beneficiary (e.g. a factory in China). Both parties agree a balance of $75,000 will be paid upon shipment.
- The applicant goes to the bank where they normally do business and draws up a $75,000 letter of credit for the beneficiary.
- The issuing bank goes through an underwriting process to ensure the applicant has the credit or collateral for the letter of credit.
- Once the process is complete, the issuing bank sends a copy of the letter of credit to the advising bank in China. The advising bank notifies the beneficiary the payment is ready.
- When the issuing bank is satisfied all the conditions in the letter of credit have been met, the money will be released to the advising bank, and the beneficiary will be paid. For example, if the payment is to be made upon shipment, the beneficiary will be paid when they receive the proper documentation (such as an official bill of lading) proving the goods have been shipped.
When using letters of credit, be aware of the following:
- A letter of credit is about documents and not goods. It is not an insurance policy for the quality of goods.
- It is important to understand all required documents before signing and it is also important to be sure all stipulated conditions can be met.
- The inability to meet time schedules is the number one reason letters of credit fail, so ensure time frames can be met.
- The failure to produce the required documentation on time can nullify the letter of credit.
- Even minor errors in documentation can render a letter of credit invalid, so it is critical to be careful with the documentation.
A letter of credit is not an absolute guarantee the beneficiary will receive payment. The issuing bank is obligated to pay under the letter of credit only when the stipulated documents are presented, and the bank is satisfied all the terms and conditions of the letter of credit have been met.
Common types of letters of credit include the following:
- Revocable letter of credit: A letter of credit that can be revoked by the bank without agreement from the beneficiary.
- Irrevocable letter of credit: A letter of credit that cannot be revoked unless all parties agree. Most letters of credit are this type.
- Revolving letter of credit: This is used when there are many repeat shipments between the two parties. It eliminates the need for a new letter of credit for each shipment.
- Standby letter of credit: The bank pays the beneficiary only when the applicant is unable to pay. While neither side intends to use it, this type of letter of credit serves as a secondary payment mechanism to ensure the beneficiary will receive payment in the event the applicant is unable to make payment.