Most commonly found in international trade, a letter of credit basically ensures the seller of a purchase that they will receive the full outstanding amount that the buyer owes, on time as agreed upon. The reason this letter of credit is so important is that at any point a buyer defaults on payment for whatever reason, the bank becomes liable for that payment.
The Letter will comprise a detailed list with specific conditions under which the funds can be released.
How is the letter funded?
If you require a letter of credit, you’ll approach the bank and they will go through the process with you on what’s required. Typically, this is an offer of collateral in the form of either cash or security. Letters of credit at the bank will also call for a fee that equates to a percentage of the size of the credit letter.
There are different types:
- Commercial Letters – Issuing bank of credit pays the beneficiary directly
- Standby Letters – Secondary method of payment to the beneficiary when the holder can’t make the payment
- Revolving Letters – Allows customers to draw money within limits for a specific time period, and multiple times
- Travellers’ Letters - Guarantees honouring any drafts made at foreign banks
- Confirmed Letters – involves a third-party bank guaranteeing the credit. The other bank is typically the seller’s bank and ensures payment is made if the holder or the issuing bank aren’t able to pay.
What is a straight credit?
This is actually also a type of letter of credit, however, it’s only paid at bank tellers of the paying bank or a bank that has been authorized to make the payment. These payments can’t go to any other bank, only to the beneficiary listed on the letter of credit. Speaking of the beneficiary, he would be required to have proof of documentation before the expiry date of the letter of credit.
Understanding Red clause letter of credit
This type is more specific and is used when a buyer wishes to extend an unsecured loan to a seller. They are used mostly by beneficiaries from other countries that stand in as purchasing agents for the credit. The funds, commonly known as “advances” are deducted from the true amount of credit when it’s time for payment. They’re also popular for international trade.
Sight letter of credit
Sight letters of credit are different in that payments are required upon presentation of documentation. Institutions that offer this type of letter of credit commit to paying the agreed amount when required, provided every condition and provision is met. Sight letters are more on demand due to their straight up fund's availability.
What are Bank confirmation letters?
A bank confirmation letter (BCL), also referred to as a “comfort letter”, is a letter from a financial institution that validates a loan or line of credit that has been extended to a borrower. So, in a nutshell, the BCL vouches for the borrower and his purpose for the loan as well as the amount he’d like to borrow.
Comfort Letters provide comfort to the sellers that the borrowers are able to complete purchases and payments for goods. Basically, ensuring access to funds not being a problem at all.
Synthetic letters of credit
This is a pre-funded model offered by financial institutions on the closing date, and not when funds are required to be drawn. One would have access to the funds via this Letter of credit and remain in a linked credit account until such time that the funds are required. They are seen as liquid funds due to their immediate availability and are therefore deemed safer than other types of Letters of credit.
Documents that may be requested for presentation
As discussed, Letters of Credit are commonly used between buyers and sellers who do not know each other personally, therefore international trade is big when it comes to this line of credit. But in order to receive payment, there are certain documents that are required to be presented.
A bill of lading is usually the Title document, but let’s have a look at the various document types that might be requested.
- Financial documents – for example – a bill of exchange
- Commercial documents – the invoice for items shipped, as well as a packing list
- Shipping documents – the bill of landing – i.e. the way-bill or courier receipt
- Official documents – Any insurance taken out on the shipped goods
Note that in each case the document requirements vary, and can be requested at any point, so just ensure that you look up what your country calls for when it comes time to release the funds.
Risks concerned with Letters of credit
Due to international trade being the predominant trade for Letters of Credit, it comes with a lot of risk in the lines of credit and on the legal side due to distance and differentiating laws of the countries.
Let’s briefly have a look at those risks, as they are vital to consider when applying for a Letter of Credit:
1. Fraud risk – documentation could be fraudulent in the form of forgery and could result is the credit is
2. Legal risk – the documentary credit could potentially be disturbed by legal action relating to the parties’ rights and obligations.
3. Applicant risk – goods not being delivered, late shipments, damage in transit
4. Issuing bank risk – the applicant could become or be insolvent
5. Beneficiary risk – potential delays in payment from the issuing bank