Letters of credit: why and how to use them effectively

Lack of confidence about getting paid in a timely way can be a barrier to international trade, especially for smaller businesses. Letters of credit (LoC) remove much of that risk because they offer certainty over payment, as long as certain pre-agreed conditions are met.

And here lies the rub; using a letter of credit is a precise exercise. It relies on the importer completing it accurately and the exporter examining it thoroughly, understanding their responsibilities for providing accurate documentation, and adhering to the terms set.

All too often, inexperienced buyers and sellers underestimate the attention to detail required and can become unstuck. (Unstuck in this instance means incorrect presentation of paperwork can lead to additional charges and the possibility that the letter of credit is no longer valid.) However, if done properly, letters of credit remain one of the best ways to de-risk getting paid in international trade. In effect a letter of credit is two banks promising to pay against the terms agreed and set out. The buyer’s bank creates the letter of credit and the seller's bank receives it and passes it to the seller. In some circumstances the seller may look for ‘confirmation’ of the letter of credit which will add another bank into the process who acts as a guarantor if the buyer's bank is not of a triple A rating on S&P. 

Why use a letter of credit?

You may think that letters of credit sound like a lot of work and therefore may not be worth doing but, for most, this is not the case. For an exporter, it offers them a guarantee of payment from a bank, should the buyer not be able to pay. For the buyer, it enables them to dictate the terms under which their supplier will get paid. It’s therefore very beneficial to both parties.

How to use a letter of credit

At the heart of any letter of credit is a commercial contract detailing all the terms and conditions of the international transaction and identifying the letter of credit as the chosen method of payment. This needs to be agreed before completing an application for the letter of credit.

The application for the LoC must be made by the importer (buyer) and requires certain key information:

• The exporter’s name
• A description of the goods
• The value of the goods
• An expiry date (usually determined by when the goods are sent)
• The latest shipment date
• Where the goods are being despatched from
• The destination of the goods
• The agreed Incoterms® 2020
• A list of the documents required to confirm that the terms have been met. This will usually include:
  • Invoices
  • Proof of shipment (eg Bill of lading or Air Way Bill)
  • Packing list
  • Certificate of origin

An application to the bank can usually be completed online.

It is important that the importer does not include any terms that the exporter is unaware of. It is therefore also important that the exporter scrutinises the LoC carefully to ensure that it is able to comply with all the terms within it. Failure to do so could see the exporter not get paid as they have to comply with everything in the LoC to the letter before the bank will cover payment.

It is always recommended that the exporter obtains a draft of the proposed LoC before the application is submitted to the bank, so that they can double check the details. Amendments can be made after the LoC has been issued but this can incur charges and delays.

Items to note

Naturally, using a letter of credit involves fees from the banks involved in the transaction and both parties share the costs. As you may expect from something that provides such certainty, these charges can be expensive and the cost could potentially be prohibitive, especially for smaller transactions so it’s always worth considering other payment options as well such as advance payment, invoice factoring, and trade credit insurance.