A letter of credit is a payment method that offers the supplier and buyer of goods the greatest possible security in international business. Private consumers should be familiar with the basic elements of a letter of credit from the use of PayPal, which has roughly adopted the system. A letter of credit is an abstract but conditional promise to pay.
- The irrevocable letter of credit: In the event of changes to the commercial transaction, all parties involved must agree in writing.
- If the middleman does not have the financial means to carry out the purchase for the importer, a transferable letter of credit is an option.
- Although letters of credit are used in international trade, there is no international standard with regard to the formal conditions.
The importer and exporter conclude a sales contract that includes a letter of credit as the payment method. As part of his credit line, the importer opens a letter of credit with his house bank in favor of the exporter. The bank in turn uses the exporter’s bank or a correspondent bank as the paying agent. For the importer, a letter of credit means that he only has to pay for the delivery of the goods if certain conditions are met. The exporter has the guarantee that payment will be made if he has again complied with all contractual agreements.
The payment requirements
In the letter of credit, the document itself, all the framework conditions for trading are firmly defined.
- Type of goods
- Quantity and quality
- date of delivery
- Place of delivery
- Payment date
In addition to the letter of credit itself, however, other documents are required that trigger the payment. These are also named in the letter of credit. These are usually
- Certificate of origin of the goods
- Customs documents
- Freight invoice
- Loading papers
- Proof of loading (bill of lading)
- Unloading confirmation
- Confirmation of acceptance
- Documents from the shipping company or a goods inspection company about the goods
If the exporter’s bank has the letter of credit and all criteria are met, it notifies the exporter of this. The exporter then compares the sales contract with the letter of credit. If the data match, the importer can now receive the goods on presentation of the papers.
The irrevocable letter of credit
Revocable letters of credit only offer the exporter limited protection. Against this background, they are hardly used. The irrevocable letter of credit is much more secure. If there are changes in the course of the trade, all four parties involved, the importer, the importer’s bank, the exporter’s bank and the exporter, must agree to this change in writing. Letters of credit also regulate the point in time when the goods are transferred to the importer. The passage “released on board” means that the transfer of ownership takes place when the ship is in port and the goods are still on board. Alternatively, the goods remain the property of the exporter until they have been unloaded and are on the quay (alongside board).
The confirmed letter of credit
Short for LOC by abbreviationfinder, a letter of credit offers the exporter the security that his customer will pay for the delivery. However, there are still residual risks. This includes, for example, a possible bankruptcy of the importer’s bank. Furthermore, restricted currency regulations or conversion risks as well as political restrictions can mean that the payment cannot be made in the end. In these cases, the exporter’s bank can also make a promise to pay to the exporter as part of a confirmation of the letter of credit. The prerequisite, however, is that the importer’s bank approves this confirmation as part of the letter of credit.
The transferable letter of credit
Often enough, foreign transactions are carried out through intermediaries. If the middleman does not have the necessary financial means to carry out the purchase for the importer, a transferable letter of credit is an option. The importer opens a letter of credit which explicitly provides that a transfer is possible. The transfer itself can be unrestricted or subject to conditions.
The international standard
Although letters of credit are used in international trade, there is no international standard with regard to the formal conditions. In order to establish a uniform procedure, however, the uniform guidelines and customs for documentary letters of credit ERA 600 of the International Chamber of Commerce (ICC) in Paris are applied. In particular, these regulate the obligation of the banks involved to examine when issuing and paying out the letter of credit.