In letter of credit (documentary credit) transactions the buyer’s bank undertakes to pay the seller when the terms and conditions of the letter of credit have been met.
Before a letter of credit is opened, the seller and buyer should first agree on the details of the contract, defining letter of credit as the term of payment. A letter of credit is initiated by the buyer who contacts his bank, asking the bank to issue the letter of credit in favour of the seller according to the terms and conditions stated in the contract of purchase. The bank’s decision to issue the letter of credit depends largely on the relationship between the bank and the buyer and the buyer’s credit rating.
If the buyer does not wish to deposit the amount of the documentary credit in the bank at the moment of issuing the credit, the bank will observe the opening of the letter of credit as a decision to grant a loan (in other words, the credit committee’s approval is needed to issue the letter of credit, because with opening a letter of credit the issuing bank undertakes to pay the seller upon the receipt of documents meeting the conditions stated in the letter of credit, regardless of whether the buyer has the required funds available on the date of payment or not and/or wants to make the payment).
If the issuing bank has decided to issue the letter of credit, it will issue it according to the terms set by the buyer and will send an issuance message to the seller’s bank (advising bank). The seller’s bank then informs the seller of the letter of credit, asking him to check whether the terms and conditions stated in the letter of credit comply with the respective provision of the contract of purchase.
If the seller finds that some of the provisions are not or can’t be met, the seller should contact the buyer and ask that the letter of credit to be amended. If everything is in order with the letter of credit, the seller will dispatch the goods and supply the bank with the documents required in the letter of credit. The issuing bank or the bank authorised to make the payment are only required to pay the seller, if the seller supplies the required documents that are in full compliance with the terms and conditions stated in the letter of credit. If any mistakes are detected in the documents supplied by the seller, the buyer can decide whether or not to accept the documents and make the payment.
A letter of credit means a documentary payment; in other words, banks are required to check the documents and only make the payment according to the documents that are compliant with the letter of credit. The banks are not responsible for the movement or quality, etc., of goods (or services) related to the documents.
When is a letter of credit used?
Letters of credit are widely used in the event of large-scale transactions, if:
* the buyer and seller have only recently established their relations and there is no sufficient information concerning the partner’s business habits and solvency;
* the parties do not trust each other;
* one or both partners are residing in regions characterised by higher economical or political risk factors;
* goods are manufactured on order;
* legislation and trading practice of a given country requires the use of letters of credit;
* short-time funding from a bank is required for the completion of transaction.
Letters of credit are subject to international rules – “Uniform Customs and Practice for Documentary Credits” (UCP 600), published by the International Chamber of Commerce.
* can be sure that he is only required to pay the seller on condition that all the terms and provisions, stated by the importer in the letter of credit, have been met by the seller;
* can apply for more favourable terms of payment as the letter of credit, opened by the buyer’s bank, demonstrates the reliability and solvency of the buyer;
* the buyer can postpone the payment (for example, until the funds are received as the goods are re-sold) and at the same time guarantee the payment to the seller (letter of credit with deferred payment).
* is guaranteed the payment by the issuing bank, provided that he presents all the required documents that comply with the terms of the letter of credit. In other words – receipt of payment is not dependent on the buyer’s solvency or willingness to pay;
* can get the money for the goods immediately after the goods have been dispatched (confirmed letter of credit);
* a letter of credit can only be withdrawn or cancelled upon the receiving party’s (exporter) consent.