Trade finance instruments
The next time you venture into any trade deal with someone on the other end of the planet do keep in mind that a LC could change the way you do business. As we live in a globalized world and uncertain times protecting yourself against political and commercial risks as business’ unwillingness to pay or bankruptcy, is not only necessary as it will prove to be profitable.
Despite this challenges, global trade must still carry on mitigating the trade risks involved, wherein the buyer wants to make payments as late as possible, the seller wants to secure his payment right away and herein lies the conflict of interest for everyone. This is where trade finance instruments like a Letter of Credit (LC) comes to the rescue by not only improving liquidity & cash flow of businesses but also considerably reducing risk.
What is a Letter of Credit (LC) one might ask?
Letters of Credit are a bank’s instrument ensuring payment of the amount indicated in the letter of credit to the Seller as per the Buyer’s instructions against the shipment of goods, performance of other conditions stipulated in the LC and submittal of relevant documents. Thus, upon transfer of ownership over the goods sent by the Seller to the Buyer and submittal of the document confirming the fulfilment of other conditions of the LC, the Bank (issuer) will ensure the transfer of payment to the Seller’s bank account.
How does a Letter of Credit Perform?
- A buyer and seller address the bank for LC requirement.
- A special account is opened with the bank for payments.
- Buyer transfers the amount indicated in the contract to this account in the bank.
- Buyer submits a document confirming the transfer of ownership over delivered goods and then the bank transfers the funds from the special account to the seller’s account.
- If the required documents are not submitted within the time indicated in the agreed contract, the bank returns the funds from the special account to the buyer’s account.
Advantages of LC for the Buyer:
- Elimination of risk of losing money for the buyer.
- Payments are made after fulfilment of the Seller’s contractual obligations.
- Transfer of ownership over shipped goods to the Buyer within the period indicated in the LC and according to other terms.
Advantages of LC for the Seller:
- Guarantee of payment independent of the Buyer (subject to the fulfilment of contractual obligations)
- Possibility of payment before handing the goods over to the buyer.
- Possibility of execution of complex commercial contracts
Different kinds of Letters of Credit (LCs)
1. Irrevocable LC. This LC cannot be cancelled or modified without consent of the beneficiary (Seller). This LC reflects absolute liability of the Bank (issuer) to the other party.
2. Revocable LC. This LC type can be cancelled or modified by the Bank (issuer) at the customer’s instructions without prior agreement of the beneficiary (Seller). The Bank will not have any liabilities to the beneficiary after revocation of the LC.
3. Stand-by LC. This LC is closer to the bank guarantee and gives more flexible collaboration opportunity to Seller and Buyer. The Bank will honour the LC when the Buyer fails to fulfil payment liabilities to Seller.
4. Confirmed LC. In addition to the Bank guarantee of the LC issuer, this LC type is confirmed by the Seller’s bank or any other bank. Irrespective to the payment by the Bank issuing the LC (issuer), the Bank confirming the LC is liable for performance of obligations.
5. Unconfirmed LC. Only the Bank issuing the LC will be liable for payment of this LC.
6. Transferable LC. This LC enables the Seller to assign part of the letter of credit to other party/parties. This LC is especially beneficial in those cases when the Seller is not a sole manufacturer of the goods and purchases some parts from other parties, as it eliminates the necessity of opening several LC’s for other parties.
7. Back-to-Back LC. This LC type considers issuing the second LC based on the first letter of credit. LC is opened in favor of intermediary as per the Buyer’s instructions and based on this LC and instructions of the intermediary a new LC is opened in favor of Seller of the goods.
8. Payment at Sight LC. According to this LC, payment is made to the seller immediately (maximum within 7 days) after the required documents have been submitted.
9. Deferred Payment LC. According to this LC the payment to the seller is not made when the documents are submitted, but instead at a later period defined in the letter of credit. In most cases the payment in favor of Seller under this LC is made upon receipt of goods by the Buyer.
10. Red Clause LC. The seller can request an advance for an agreed amount of the LC before shipment of goods and submittal of required documents. This red clause is so termed because it is usually printed in red on the document to draw attention to “advance payment” term of the credit.
Keep this at the back of your mind the next time you venture into any trade deal. It will improve your way to do business.