Importers and exporters normally require intermediaries such as banks or alternative financiers to guarantee payment and also the delivery of goods. Cash advances or trade credits on open accounts usually develop after the buyer and seller develop a trusted relationship; therefore trade finance requires financing mechanisms to help support these transactions.
What is a Letter of Credit?
Letters of credit (LCs), also known as documentary credits are financial legally bound instruments, issued by banks or specialist trade finance institutions, which pay the exporter on behalf of the buyer, if the terms specified in the LC are fulfilled.
A LC requires an importer and an exporter, with an issuing bank and a confirming (or advising) bank respectively. The financiers and their creditworthiness are crucial for this type of trade finance: it is called credit enhancement – the issuing and confirming bank replace the guarantee of payment from the importer and exporter. In this section, and in most cases, we consider the importer as the buyer and the exporter as the seller.
A LC transaction generally happens as follows
- An importer agrees to buy goods off an exporter – a purchase order (PO) is issued
- The importer will approach an issuing bank (trade financier) who will issue an LC if it fulfils their criteria (e.g. they are creditworthy)
- The exporter will work with a confirming bank who will request the LC documents to be shipped from the issuing bank of the importer
- The confirming bank will then check the LC and if the terms are correct, the exporter can then ship the goods
- The exporter then sends the relevant shipping documents to the confirming bank, who will then process the payment
- Once the confirming bank has examined the shipping documents in strict compliance against the LC terms from the issuing bank, they will forward these documents on to the issuing bank
- The importer pays the issuing bank
- The issuing bank then releases the shipping documents so that the importer can claim the goods that were shipped
- The issuing bank then transfers money to the confirming bank who will then transfer this money to the exporter
LCs are flexible and versatile instruments (we will talk about the different types of LC below). The LC is universally governed by a set of guidelines known as the Uniform Customs and Practice (UCP 600), which was first produced in the 1930s by the International Chamber of Commerce (ICC).
Written by Trade Finance Global