Letter of credit
From Wikipedia, the free encyclopedia
A letter of credit is a document issued mostly by a financial institution which provides an irrevocable payment undertaking to a beneficiary against complying documents as stated in the credit. Letter of Credit is abbreviated as an LC or L/C, and often is referred to as a documentary credit, abbreviated as DC or D/C, documentary letter of credit, or simply as credit (as in the UCP 500 and UCP 600). Once the beneficiary or a presenting bank acting on its behalf, makes a presentation to the issuing bank or confirming bank, if any, within the expiry date of the LC, comprising documents complying with the terms and conditions of the LC, the applicable UCP and international standard banking practice, the issuing bank or confirming bank, if any, is obliged to honour irrespective of any instructions from the applicant to the contrary. In other words, the obligation to honour (usually payment) is shifted from the applicant to the issuing bank or confirming bank, if any. Non-banks can also issue letters of credit however parties must balance potential risks.
The LC can also be the source of payment for a transaction, meaning that an exporter will get paid by redeeming the letter of credit. Letters of credit are used nowadays primarily in international trade transactions of significant value, for deals between a supplier in one country and a wholesale customer in another. They are also used in the land development process to ensure that approved public facilities (streets, sidewalks, stormwater ponds, etc.) will be built. The parties to a letter of credit are usually a beneficiary who is to receive the money, the issuing bank of whom the applicant is a client, and the advising bank of whom the beneficiary is a client. Since nowadays almost all letters of credit are irrevocable, (i.e. cannot be amended or cancelled without prior agreement of the beneficiary, the issuing bank and the confirming bank, if any). However, the applicant is not a party to the letter of credit. In executing a transaction, letters of credit incorporate functions common to giros and Traveler's cheques.
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[edit] How it works
Imagine that a business called Acme Electronics from time to time imports computers from a business called Beijing Computers, which banks with the Shanghai Business Bank. Acme holds an account at Commonwealth Financial. Acme wants to buy $500,000 worth of merchandise from Beijing Computers, who agree to sell the goods and give Acme 60 days to pay for them, on the condition that they are provided with a 90-day LC for the full amount. The steps to get the letter of credit would be as follows:
- Acme goes to Commonwealth Financial and requests a $500,000 letter of credit, with Beijing Computers as the beneficiary.
- Commonwealth Financial can issue an LC either on approval of a standard loan underwriting process or by Acme funding it directly with a deposit of $500,000 plus fees between 1% and 8%.
- Commonwealth Financial sends a copy of the LC to Shanghai Business Bank, which notifies Beijing Computers that payment is ready and they can ship the merchandise Acme ordered with full assurance of payment.
- On presentation of the stipulated documents in the letter of credit and compliance with the terms and conditions of the letter of credit, Commonwealth Financial transfers the $500,000 to Shanghai Business Bank, which then credits the account of Beijing Computers by that amount.
- Note that banks deal only with documents under the letter of credit and not the underlying transaction.
If the stipulated documents are presented and the terms and conditions of the letter of credit are met, then the issuing bank is obligated to pay under the letter of credit, even if the underlying transaction is not fulfilled.
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[edit] The price of LCs
The applicant pays the LC fee to the bank, and may in turn charge this on to the beneficiary. From the bank's point of view, the LC they have issued can be called upon at any time (subject to the relevant terms and conditions), and the bank then looks to reclaim this from the applicant.
[edit] Risks in International Trade
- A Credit risk is a risk from a change in the credit of an opposing business.
- An Exchange risk is a risk from a change in the foreign exchange rate.
- A Force majeure risk is 1. a risk in trade incapability caused by a change in a country's policy, and 2. a risk caused by a natural disaster.
- Other risks are mainly risks caused by a difference in law, language or culture. In these cases, the cargo might be found late because of a dispute in import and export dealings.
