The letter of credit is the most used and most effective payment method in international trade. In our introductory article about the letter of credit, also known as documentary credit, we provided a definition of letter of credit and explained two important principles underpinning this financial arrangement.
Since the letter of credit involves banks (at least two) in two different countries, and is executed through a series of strict procedures, it is not straightforward. In this article, you will find the 8 steps that the parties must follow to execute a letter of credit smoothly.
The parties in an international sale contract agree that payment will be provided through a letter of credit. It may sound trivial, but a letter of credit is not automatically part of an international sale contract, it must be specifically included.
An extreme example would be if a letter of credit is stated as a condition to execute the sale contract; in this case, if a letter of credit is not provided, there will be no contract at all. However, generally the letter of credit is included in the contract and does not act as a condition to execute the contract.
If the parties want to use the UCP 600, i.e. the international standard rules that regulate the issuance and execution of letters of credit, they need to specifically state so in the contract (the same way as per the Incoterms).
The buyer (applicant) applies to his bank (issuing bank) to open a letter of credit in favor of the seller (beneficiary). It is important to understand that the letter of credit is a payment settlement against documents. In this step, the buyer will provide the issuing bank with all the details about the documents in the sale transaction that will be presented by the seller to his bank (advising bank).
If the documents do not comply, the advising bank may refuse to pay. Such documents include:
- Transport documents
- Insurance policies
- Certificate of quality
- Certificate of orign
The buyer must also instruct for the time and place for presenting the documents.
The issuing bank will instruct a correspondent bank in the seller’s country to advise him of the opening of the letter of credit.
Generally, although not necessarily, the correspondent bank, also called the advising bank, will be the seller’s bank. Yet, since banks play a central role in a letter of credit, sometimes the exporter may ask the importer to choose an international bank as the issuing and advising bank, or a branch of the exporter’s bank in the importer’s country. If the importer is located in a developing country, the exporter may insist that the importer do not choose a nationalized bank. The aim of the exporter is to deal with a bank that will honor its obligation to pay; in the latter case, the exporter may be concerned that a nationalized bank will part with the importer in case of dispute, or that political interference may hamper the smooth execution of the transaction.
The advising bank will inform the seller of the opening of the letter of credit.
This step is particularly important in the case of a confirmed letter of credit, whereby the opening of a letter of credit by the buyer is not enough to assure payment to the seller, but the credit must be confirmed by the seller’s bank.
The seller will ship the goods, provided that the letter of credit conforms with what was agreed in the sale contract.
This step illustrates the great advantage for the seller in a letter of credit, i.e. that he is required to ship the goods only after receiving notice that a letter of credit has been opened. This means that the seller ships the goods with the assurance, provided by the advising bank, that he will be paid by a bank in his country; essentially, the seller ships the goods knowing that he will be paid for sure.
On shipment, the seller will obtain the transport documents and other documentation as required under the credit and present them to the advising bank.
Such documents may include:
- Bill of lading
- Consignment note
- Certificate of quality
- Certificate of origin
The bank will accept clean transport documents. UCP 600 define a clean transport document in article 27:
A clean transport document is one bearing no clause or notation expressly declaring a defective condition of the goods or their packaging.
As we just wrote, the letter of credit is a payment settlement against documents, therefore, for the seller’s perspective, this is the most importat step; the seller should take extreme care in presenting the same documents that have been agreed upon opening of the letter of credit. If the documents do not comply, the advising bank may refuse to pay.
If the documents provided by the seller to the advising bank in step 6 comply with what has been agreed in the credit, the advising bank will effect payment to the seller.
Depending on what has been agreed, payment can occur in different forms:
- Payment at sight: the advising bank effects payment to the seller in cash the moment he presents the documents
- Deferred payment: the advising bank will effect payment after a certain time from the moment the seller presents the documents (for example, 30 days after sight)
- Acceptance credit: the advising bank will accept bills of exchange drawn on it by the seller. The bill can provide for immediate or deferred payment (sight bill vs time bill), which is more common. Even in the case of a time bill of exchange, the seller can raise cash immediately by selling the bill at a discount (since the acceptor is the bank, the discount is likely to be limited)
- Negotiation credit: in this case the advising bank negotiates the bill of exchange that the seller has drawn on the issuing bank or the buyer. The advising bank may retain the right to have recourse to the seller in case of the issuing bank does not pay due to discrepancies in the documents (negotiating bank) or may negotiate with the seller without recourse (confirming bank).
After the seller has been paid and is out of the process, the advising bank will move toward the issuing bank, and this latter on to the buyer. This step can be broken down into 4 micro-steps:
- The advising bank forwards the documents to the issuing bank
- The issuing bank reimburses the advising bank upon reception of the documents
- The issuing bank passes the documents on to the buyer
- The issuing bank collects payment from the buyer
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