letter of credit

The letter of credit is a bank transaction in which the seller (usually an exporter) ensures the collection of the goods by a bank guarantee and the buyer (usually an importer) receipt of the paid goods is ensured.

Therefore, we are faced with a double guarantee operation: the buyer guarantees to receive the merchandise and the seller is guaranteed to charge it. It is a type of credit that is used mainly in international trade, where the security of payments and collections is lower.

Procedure and parties involved in a documentary credit

The most common procedure of documentary credit is the following:

  1. The documentary credit starts when the importer gives the payment order to his bank (importer’s bank). The importer has to inform the exporter that he is going to guarantee the operation with this credit so that the exporter communicates it to his bank (exporter’s bank).
  2. The importer’s bank will make the payment at the time the exporter’s bank certifies that the goods have been shipped correctly. The bank of the exporter will have to justify it presenting all the documentation of the operation.
  3. The importer’s bank will make the payment to the exporter’s bank regardless of whether or not the importer has a balance in the account. That is, the importer’s bank guarantees the transaction.

    letter of credit
    L/c

Therefore, we have four parts involved in the operation:

  • Buyer or importer. It is the one who acquires the merchandise and the obligor to make the payment.
  • Seller or exporter. It is the one in charge of sending the merchandise according to the agreement and who is going to receive the payment of the same
  • Bank of the importer. It is the one that guarantees the credit and the payment to the exporter. In any case, if the importer did not have funds and had to pay for it on his own, then he will claim to his client the payment made.
  • Bank of the exporter. It is responsible for sending the importer’s bank documentation justifying that the goods have been shipped correctly.

It is very important that the documentation sent by the bank of the exporter is exactly the one agreed in the documentary credit agreement. That is, it has to be very precise. Otherwise, the importer’s bank may refuse payment until it has the documentation agreed in the credit agreement

Advantages and disadvantages of documentary credits

The main advantage of documentary credits is the one we have discussed previously: to assure the seller the collection of the merchandise and the buyer the receipt of the same. However, there are numerous additional advantages:

  • Allows a deferment of payment to the buyer, securing the payment to the seller.
  • The seller can even anticipate the collection of the merchandise with respect to the term negotiated with the buyer.
  • It increases the possibility of business for the seller since it eliminates the country risk that exists in international trade.
  • Maximum legal protection.

The main drawback is the financial cost of this operation. That is, the fees charged by both the bank of the importer and the exporter. It is necessary to evaluate if the risk that is avoided is greater with this documentary credit or the amount of these commissions. If there is a high risk, the documentary credit will be profitable; If there is a low risk, it will not be.

 

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