Letters of Credit: The Basics

Definition

A documentary credit is a (conditional) bank undertaking of payment. It is a written undertaking by a bank (issuing bank) given to the seller (beneficiary) at the request, and on the instructions of the buyer (applicant) to pay at sight or at a determinable future date up to a stated sum of money, within a prescribed time limit and against stipulated documents or other conditions. The issuing bank is putting out its credit and good name for the sake of the buyer.

Buyer

Because the documentary credit is a conditional undertaking, payment is made on behalf of the buyer against documents, which may represent the goods and give the buyer rights to them.

Seller

Because the documentary credit is a bank undertaking, the seller can look to the bank for payment, instead of relying upon the ability or willingness of the buyer to pay.

Summary
Documentary credits therefore:
  • Are an arrangement by banks for settling international commercial transactions.
  • Provide a form of security for the parties involved.
  • Ensure payment, provided that the terms and conditions of the letter of credit have been fulfilled.
  • Mean that payment by such means is based on documents only, and not on merchandise or services involved.

Types of Letters of Credit

Documentary; Merchandise, Commercial, Trade

The majority of LCs issued are in payment for goods in shipment or current services performed. Payment is normally made against documents for goods shipped. (Article 2 UCP 600)
Standby

Normally, this type of LC functions like a guarantee. This type of credit can be drawn against only upon performance of service or financial obligation default. It is a definite undertaking of the issuing bank. The standby letters of credit from Trade and Merchant Trust state that they are governed by UCP 600. If that is the case, should we mention ISP98.

Revocable

Under UCP 600 a letter of credit is revocable even if there is no indication to that effect (article 3).

Unconfirmed:

Bears only the obligation of the issuing bank. The beneficiary should look to the credit worthiness of only the issuing bank, and not to any intermediary (Article 7 UCP 600)

Confirmed:

Is a credit in which a second obligation is added to the letter of credit by another bank (Article 8 UCP 600)

Sight:

Payment is at sight, which means that the drafts and documents are honored, if in order, by making payment without delay.

Time, Usance:

The draft honored by accepting it for payment at a future date. Payment is delayed until the maturity of the draft.

Transferable credit:

Can be transferred by the original beneficiary to one or more other parties. It is normally used when the first beneficiary does not supply the merchandise himself, but is a middleman and wants to transfer all or part of his rights to the actual supplier (Article 38 UCP 600)

Comparison of various methods of payment

Method Goods Available ~Time of Payment Risk to Exporter Risk to Importer
Cash in Advance After Payment Before Shipment Very Low Maximum - Relies on exporter to ship goods as ordered
Letter of credit

*Confirmed

*Unconfirmed

(Advised)
After Payment When documents are available at shipment Very Low Assured of quantity and quality of shipment if inspection report is required
Documentary Collection Sight Draft Documents against Payment After Payment On presentation or draft to importer If draft unpaid, goods must be returned or disposed of, usually at loss Assured of quantity, also quality, if goods are inspected before shipment
Documentary Collection Time Draft Documents against Acceptance Before Payment On maturity of draft Relies on importer to pay draft Minimal - Can check shipment for quantity and quality before payment
Cosignment Before payment, exporter retains title until goods are sold or used After use; inventory and warehousing cost to exporter Substantial risk unless through foreign branch of subsidiary Very Low
Open Account Before payment As agreed Relies on importer to pay account as agreed -- complete risk Very Low