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Letter of credit
The letter of credit is an efficient tool for risk reduction in foreign trade transactions. The issuing bank is obliged to make the payment to the beneficiary provided the latter submits all requested documents within the time schedule indicated under the conditions of the letter of credit.
Letters of credit are normally used when the buyer and seller of the goods are located at a distance from each other, or know little about each other, and need a reliable intermediary to facilitate the transaction.
The bank issues a letter of credit pursuant to the application submitted by the buyer of goods. The application must show contact information of the parties, the transaction amount, expiration of the letter of credit, conditions and deadlines for supplying the goods, as well as a list of required documents. The application should also indicate which party bears the potential expenses. If no party is named, the buyer of the goods will bear all bank charges (incl. foreign bank expenses).
The issuing bank informs the seller’s bank, referred to as the advising bank, that a letter of credit has been issued for carrying out a particular foreign trade transaction. The information is passed either directly or through an internationally recognised bank, which may also be the bank confirming the letter of credit, i.e. the confirming bank. All obligations of the issuing bank are extended to the confirming bank.
The seller’s bank informs the seller that a letter of credit has been issued for its benefit. The seller will thereupon dispatch the goods specified in the sales agreement to the buyer, submitting consignment documents together with other documents specified in the letter of credit to its bank. A precondition for making the payment is the strict conformity of the documents with the conditions set forth in the letter of credit.
A specific type of documentary credit is the “standby letter of credit”. In this case the seller does not have to submit the consignment documents to the issuing bank provided the seller effects payment for the purchased goods within the agreed time period. Payment under the standby letter of credit is made by the issuing bank only in case the buyer does not make the payment in favour of the seller in due time. The standby letter of credit is basically a guarantee obligation.
The advantage of the standby letter of credit is that it may be used "repeatedly", i.e. within a more extensive period of time for the delivery of a number of shipments.The fact that the banks are not directly involved in monitoring the flow of goods allows the contracting parties to save both time and money.
The role of banks is mainly of an intermediary nature. They only check the conformity of documents with the conditions specified in the letter of credit. They are not held responsible for the storage, transport, origin etc. of the goods, nor for accuracy, lawfulness or genuineness of the documents submitted to them. However, the bank that has issued the letter of credit cannot refuse to make the payment if the submitted documents comply with the conditions defined in the letter of credit. The banks are, thus, responsible only for the financial aspects of the transaction. They do not have any relation to the physical goods traded.
Advantages to the buyer:
- elimination of risks arising from advance payment
- possibility of accurately determining the shipping term and price for the good
- more flexible cash flow planning
- possibility of purchasing goods on credit
Advantages to the seller:
- elimination of risks related to the solvency and payment discipline of the buyer
- elimination of delivery risks
- possibility of eliminating political risks of the buyer's country
- more flexible cash flow planning
Documentary credits are carried out in accordance with the Uniform Customs and Practice for Documentary Credits, ICCP No. 600, Paris, effective from 1 July 2007.