What are Letters of Credit and Why Do You Need Them in International Trade?

November 4, 2022
What are Letters of Credit and Why Do You Need Them in International Trade?

The movement of finances in international trade transactions can be a complicated process. Sellers want to receive payment, and buyers want to receive goods; but when those goods have to take the extra step of crossing borders, the transaction requires financial institutions to step in and facilitate. This is where a letter of credit come in.

Letters of credit are a common method of maintaining cash flow in cross-border transactions. They help insulate both importers and exporters from risk – but what exactly are letters of credit?

Here at clearBorder, we provide expert advice and consultancy on international trade. Whether you’re looking for online customs training courses to upskill your supply chain teams, or specialist import, export consultancy to help your organisation stay nimble, our independent and skilled team are on-hand to deliver assistance you need.

In today’s blog post, we’ll take a closer look at letters of credit, examining how they work, why they’re important, and how they represent a cornerstone of all trade finance.

What is a Letter of Credit from a Financial Institution?

A letter of credit, along with any specified documents, is a way for buyers of goods to guarantee the purchase, and that the payment will be received on time and in full. This guarantee is possible because a bank or financial institute vouches for the buyer’s ability to pay the outstanding amount; in effect, through issuing a letter of credit the bank assumes responsibility for the debt until such time as it is paid.

This is often viewed as an attractive option for sellers involved in international trade, who may not be able to verify the creditworthiness or financial means of a customer company, but are willing to trust the word of respected fiscal institutions. In the event that the customer cannot make payment, for any reason, it becomes the bank’s responsibility to cover the full or outstanding balance.

For this reason and owing to the assumption of risk, banks will typically charge a fee to provide a letter of credit. Generally, this will be a percentage of the total credit they are guaranteeing. The fee might lie in the region of 0.75%, although it does vary depending on the institution, the credit terms, and the nature of the transaction. A bank may also request asset collateral to protect themselves.

Different Types of Letters of Credit Offered by the Issuing Bank

There are several different letters of credit variations an advising bank can issue. For the purposes of cross-border trading, the most relevant are: a commercial letter of credit, a revolving letter of credit, and a confirmed letter of credit. We’ll look at these three types in more detail first, before touching on an alternative type, more commonly used by individual travellers.

A commercial letter of credit

Perhaps the most simple form, a commercial letter of credit is a direct payment method between bank and beneficiary. The issuing bank makes payments directly to the seller, either in periodic instalments or as a lump sum, to cover the cost of the purchase. Conversely, it is also possible to obtain a standby letter of credit. This is a secondary payment method. In this scenario, the bank steps in to pay the cost of the transaction only in the case that the purchaser lacks sufficient means.

A revolving letter of credit

This type of finance gives the borrower, or the purchaser of goods, more flexibility in the way they choose to manage cash flow. A revolving letter of credit allows the customer to make any number of withdrawals within the stated period, provided it satisfies the conditions set out in the original letter.

A confirmed letter of credit

In this scenario, a financial institution other than the issuing bank guarantees the letter of credit, and subsequent invoice payment. The second bank in this situation is known as the confirming bank, and is often the seller’s bank. A confirming bank is there to satisfy the letter of credit and fulfil the payment terms in the event that both the buyer and the issuing bank are unable to do so. In the case of international trade, it’s relatively common for the issuing bank to stipulate this arrangement.

For individuals travelling overseas, some banks offer a traveller’s letter of credit. This means that, for the person going abroad, the issuing bank will guarantee any withdrawals or drafts made at foreign banks, as long as it is recognised as a valid institution by the individual’s ‘home bank’.

How Do Letters of Credit Work in Trade Finance?

Because cross-border, international transactions often involve considerable sums and significant movement of resources, sellers often seek reassurance that the payment can be fulfilled before they invest the time and capital in arranging logistics. This reassurance comes in the form of a letter of credit, along with any relevant and correct documents.

Before the letter of credit process can begin, though, the buyer must prove that they are in possession of enough finance/assets to see the transaction through. It is only once the financial institution has verified this fact that they will grant documentary credit. In most cases the bank will also request security, such as cash or asset collateral.

A letter of credit is a negotiable instrument – meaning, an official document where one party promises to honour a debt owed to another. Therefore, the issuing bank may pay the seller of goods, or any nominated bank. Sometimes, a letter of credit is given as a transferable letter. This means that the beneficiary may name another organisation or third party as having the right to draw.

The usage and regulation of letters of credit in international trade are overseen by the International Chamber of Commerce Uniform Customs and Practice for Documentary Credits.

Liaising with the Seller’s Bank and Ensuring Smooth a Transaction: An Example

Let’s imagine a Latin America-based company relies on parts exported from the UK in order to carry out its operations. However, the economic situation in the country is unstable, meaning that the company is unable to obtain international credit without some assistance.

This is when a credit letter can make the difference. The buyer’s bank, or another financial institution, offers a letter of credit (along with any other documents required); this helps the UK exporter minimise the risk of not being paid, and helps the Latin American company facilitate the transaction. In effect, the letter stands as a ‘bank-guarantee’ that the invoice will be paid and, in the case that the customer company cannot make payment, it’ll be necessary to ‘bank-pay’ the debt. Of course, no bank works pro bono, and it’ll be up to the company to then make good those financial obligations.

The letter of credit is approved and supplied typically in two business days. Reassured by this letter, which carries the trust implied by the name of the bank, the UK company goes ahead and carries out the export, confident in the fact that even if the Latin American company proves at a later date to have insufficient funds, the bank pays. In this way, all business accounts are protected from risk, and the trade is enabled to proceed.

Strengthen Your Operations with Guaranteed Expertise

As we’ve seen, credit letters are often invaluable in international trade transactions, allowing operations to continue and minimising risks for both importers and exporters. In an ideal world, all buyers would pay for purchased goods in full and promptly, and it wouldn’t be necessary to involve financial institutions; however, there are many external factors that can affect a business’ finances, and in order to guarantee the ability to make payment, a letter of credit stands as an essential document.

There are many more trading procedures and peculiarities that it’s vital for companies to understand to protect themselves from risk. Lack of knowledge is often the direct cause of lost revenue or costly penalties. The best way to avoid these risks is to use experts to guide you. At clearBorder, we provide expert border advice and consultancy to companies in need – boosting trade efficiency and ensuring compliance. Whether through international trade training courses, or import/export consultancy services, our team’s unparalleled level of expertise in trade, government and data gives your company operations the best chance of success.

Get in touch with us today to find out how we can protect your cross-border operations from risk.