Methods of Payment/Letters of Credit
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Unit 4.1-Methods of Payment |
Introduction | Cash in Advance | Documentary Collections | Letters of Credit | Open Account | Combining Methods | Summary | Resources | Activities | Assessment |
Letters of Credit
A letter of credit is a bank instrument that can be used to even the risk between a buyer and a seller since a seller is guaranteed to receive payment if when he/she has complied with the exact requirements of this buyer. A letter of credit offers a seller numerous advantages but only if that seller complies exactly with its terms and conditions of the transaction. In addition to providing reduced risk for both a seller and a buyer, there are many variables that can be used with a letter of credit to reduce the political and commercial risks that may accompany the transaction as well as provide extended terms to a buyer through the letter of credit instrument.
The terminology that is used when working with letters of credit is very specific and should be understood.
Involved Parties:
- Applicant = Buyer/ Importer
- Beneficiary = Seller/Exporter
- Opening Bank = Importer’s Bank >> Issues L/C
- Advising Bank= Exporter’s Bank >> Advises L/C
- Confirming Bank = Advising Bank or 3rd Party Bank >> Confirms L/C
- Paying Bank = Any Bank as Specified in L/C >> Pays the Draft
Activities and Terms:
- Advice – review and approval of L/C
- Amendment – change to L/C
- Confirmed – the commercial, political and economic risk of the transaction absorbed by the confirming bank
- Discrepancy – mistake in the documentation
- Documentation – documents required within L/C
- Draft – negotiable order to pay
- Sight Draft – payment assured upon shipment and presentation of documents in compliance with its terms
- Time Draft – bank assurance of payment at the maturity of the banker’s acceptance with option of obtaining immediate funds by discounting the BA (30, 60, 90 days at sight or acceptance)
- Irrevocable – cannot be changed without approval from beneficiary or advising bank
- Issuance – opening of L/C
- Negotiation – review of documents
- Revocable – can be changed without approval of beneficiary or advising bank
Types of L/Cs:
- Back-to-Back – credit and terms of a transaction rollover to a new transaction upon completion, which eliminates the need to apply or issue a new L/C for identical shipments
- Confirmed – credit risk taken by bank and agreement to pay (fee charged)
- Straight – payable only at paying bank
- Negotiation – payable at negotiating bank
- Sight – payable at acceptance of documents
- Standby – used by the beneficiary for payment should the applicant not pay the exporter directly
- Transferable – part or all of the proceeds from the L/C may be transferred to another party, used by sales brokers or agents to disguise buyers and sellers
- Usance – time draft based on invoice, bill of lading, or documents, up to 180 days
| Time of Payment | •As agreed between the buyer and seller and stipulated in the L/C, at sight of documents or acceptance of time draft. |
|---|---|
| Goods Available to Buyer | •Upon release of documentation and payment or acceptance of time draft. |
| Risks to Seller | •Delays in availability of foreign exchange and transferring of funds from buyer’s country if the L/C is not confirmed. •Payment blocked due to political events in buyer’s country if the L/C is not confirmed. |
| Risks to Buyer | •Seller creates documents to comply with L/C but does not ship actual product. •Seller does not ship. •Buyer ties up commercial lines of credit to secure L/C. |
| When Appropriate to Quote or Use | A seller should consider a number of factors: •corporate credit policy and ability to absorb risk •credit standing of the buyer •political environment in the importing country •type of merchandise to be shipped and value of the shipment •availability of foreign exchange •buyer and seller are establishing a new relationship •when buyer and/or seller’s governments require use of banks to control flow of currencies and products •products and/or services comply with quality steps during production and documentation is presented for payment •used less frequently in international transactions because of the high bank fees and time-consuming process |
| Financing | •Often a bank will favorably consider a request for an increase in a credit line to finance production of the goods. This is done with the knowledge that letters of credit have been opened and advised to an exporter for an export order. The bank may further require that the beneficiary assign its interest in the letter of credit to them. |