29 July Using Letter of Credits to Reduce Trade Risk
What is a Letter of Credit?
A Letter of Credit is a type of bank letter. It is also called a Credit Letter. By issuing a Letter of Credit, a bank executes a confirmation regarding a financial transaction. Let’s say, a buyer has made payment to a seller through a bank. The Letter of Credit is the bank’s way of saying that the seller will receive the correct amount within a certain time.
In import and export, one can expect to notice the use of Letter of Credit, a lot. One may ask why? Well, this is because international transactions are subject to any legal restrictions. Different countries have their own legislation. Hence, to keep the involving parties assured, the bank’s issuance of Letter of Credit becomes essential.
What are the types of Letter of Credit?
Now that’s the idea behind the Letter of Credit, let’s get into the details. There are two types of Letter of Credits that you may find. They are Documentary Letter of Credit and Standby Letter of Credit.
Documentary Letter of Credit
A Documentary Letter of Credit is when a bank promises the seller of a transaction to pay the full amount on behalf of the buyer. However, there’s a twist. This promise of a bank is valid as long as the seller complies with all pre-defined terms and conditions.
Standby Letter of Credit
The idea of the Standby Letter of Credit might seem close to the Documentary Letter of Credit. But there lies a small difference. It is also a guarantee from the bank. However, here bank promises its client that on the occasion of a client failing to make the payment, the bank makes the payment itself.
Ideally, this option must never be used.
Now that we’re discussing the Letter of Credit and international trade finance, let’s discuss MT799. Why? Because MT799 is an integral part of international trade. It is basically a free format message that is sent between one banks to another. The purpose would be creating proof of fund deposits on a trade transaction. It is a SWIFT system that lets banks interact with each other independently. Here to be discussed, every bank has its own SWIFT code consisting of letters and numbers. In the MT799 code, MT stands for Message Type. Any individual dealing with Letter of Credit very often, must have heard about MT799.
How does a Letter of Credit work?
By now, it is probably understood that a Letter of Credit is nothing but a Negotiable Instrument. Let’s have a look at how it works.
Startups are the most regular users of the Letter of Credit. Now, business transactions can happen in a variety of formats. It’s up to the buyers and sellers if they prefer cash, checks, or electronic transfers. However, it’s not that simple for international transactions.
Even though the large organizations tackle somehow, the startups often get confused. They don’t really know how to opt for an international transaction. In such a case, the Letter of Credit becomes a significant financial instrument for them.
It is like a verbal agreement of assurance that they would receive the money that is due to their international buyers. Typically, the time to realize the payment may vary from 60 days to 90 days. The bank’s guarantee may actually be a relief for the startups.
Is there something called Letter of Credit fee?
Yes! There’s a Letter of Credit fee. The bank will typically require a fee to issue such a letter. The fee can vary depending on the due amount. Banks typically collect a percentage of the payment as Letter of Credit fee.
In the majority of the cases, the bank in question is based in Buyer’s country. So, the seller (suppose the startup) is dealing with an international bank here.
Who are the involved parties?
By now it has been established that Letter of Credit is a pretty complex financial transaction. So, isn’t it evident that multiple parties will be involved there? So, let’s have an understanding of who all is the involved parties.
Applicant – the buyer here is the applicant as he/she applies for Letter of Credit.
Beneficiary – it is typically the seller.
Issuing bank – It is the bank that is based in the buyer’s country. This bank is responsible for reviewing all documents of the buyer. Afterward, this bank also holds onto the amount due in the Letter of Credit.
Negotiating bank – a negotiating bank’s role is to confirm that the seller is paid with the dues.
Intermediary – An intermediary’s role here is to assist the seller and the buyer. They try to complete the Letter of Credit deal as smoothly as possible.
Freight forwarder – a freight forwarder comes into question in certain situations. Say, there is a large volume of goods are involved. It is then that the distributor companies or the freight provider ensures the smooth shipping of those goods.
Shipper – the shipper is the one that delivers the goods to the buyer.
Legal counsel – as Letter of Credit transactions are complex, the lawyer or legal counsels often get involved. Their job is to provide legal assistance to either of the parties.
An example of Letter of Credit
Let’s take the example of Citi Bank. This popularly known bank offers a Letter of Credit to international buyers. Most commonly, it offers Letter of Credit to those based in Asia, Middle East, Africa etc.
This bank’s objective is to help sellers of those countries in receiving the amounts they’re supposed to receive from their American clients. Hence, the exporters can efficiently reduce the risks of the importers.
Letter of Credit generally offers a Letter of Credit within two business days of the application. Hence, a seller who is living in a vulnerable economic environment is benefitted due to this.
Letter of Credit is an excellent financial instrument that can reduce risk for both buyers and sellers. It simultaneously offers protection and assurance to buyers and sellers. For international trade finance, Letter of Credit is a vital tool.