LETTERS OF CREDIT

Letters of Credit (Letter of Credit) are a powerful tool of international trade. There are two types of Letters of Credits the Documentary Letter of Credit used in trade finance and the Standby Letter of Credit (SB Letter of Credit) which in essence is a bank guaranty. US banks issue SB Letters of Credit because they cannot issue bank guarantees due to regulatory reasons. For the issuer an SB Letter of Credit is a very dangerous instrument because the beneficiary can draw on the SB Letter of Credit just by making a demand for payment.


Here we will discuss the Documentary Letter of Credit.

Many attempts have been made to replace the Letter of Credit but with not much success. The reason Letters of Credits are still here is because via the Letter of Credit a third party bank irrevocably guarantees payment to the Seller if the Seller performs with the terms that the Buyer and Seller have agreed on. The irrevocable nature of this ‘guaranty’ issued by a bank, allows the Exporter’s bank to provide pre-export (pre-shipment) financing. The Letter of Credit is one of the main means of financing international and domestic trade.

Letter of Credits are unique financial instruments that connect the movement of physical goods that are being bought and sold with the funding of these goods as they move through the channels of trade. Over the years, certain terms and modality have been established which are reflected through specific Incoterms through which the Buyer, Seller and the transporting company know when the responsibility for the goods move from one party to another and when title to the underlying goods transfers from one party to another.

Generally a Letter of Credit will be irrevocable and at sight. This means that the Letter of Credit issuing bank is irrevocably committing to paying the Seller once the seller meets the terms of the Letter of Credit. ‘At Sight” means that when the Letter of Credit issuing bank receives the documents from the Seller and ‘sees’ them then the issuing bank is obligated to pay if all the Letter of Credit documents are in order.

It is important to note that Letters of Credits deal with documents not with goods. In other words the Letter of Credit requires that to be paid, the seller has to provide certain documents such as an Invoice, Packing List and Bill of Lading showing the goods have been taken over by the shipping company. If these documents are correct, then the issuing bank will pay. The issuing bank will not physically verify that the goods have actually been shipped but will do reasonable due diligence to make sure that the documents are authentic. For this reason, it is important to have the goods inspected by reliable third parties such as the shipping company and the freight forwarders who are reputable, established credit-worthy companies. If something goes wrong the buyer will have redress to financially strong companies.

Other than ‘at sight’ Letters of Credits, there are Letter of Credits where the payment is made after a certain period of time. The starting point should be from the date on the Bill of Lading, or the date the draft was accepted by the issuing bank, etc.

Letters of Credits use “Incoterms” which are abbreviations of International Commercial Terms that are key elements of international contracts of sale. In a trade transaction there are generally three parties involved: the Seller, the Buyer and the Transporting Company moving the goods from the seller to the buyer. The Incoterms explain the distribution of function, costs, risks and title to the goods relating to the transfer of goods from seller to buyer

Some common Incoterms:

  • FOB (Free on Board)
    a) Transportation or carriage is to be arranged by the Buyer.
    b) Risks transfer from the Seller to the Buyer when the goods pass the ship’s rails.
    c) Costs transfer from the Seller to the Buyer when the goods pass the ship’s rails. Here Buyer’s costs are the cost of the goods, freight and insurance.
  • CIF (Cost, Insurance and Freight)
    a) Freight and insurance to be arranged by the Seller.
    b) Risks transfer from the Seller to the Buyer when the goods pass the ship’s rails.
    c) Costs transfer at port of destination, Buyer pays the costs of the goods but not the freight and insurance. In essence the Buyer pays for all the costs when the goods arrive at port of destination and takes delivery.
  • CFR (Cost and Freight)
    Same as CIF except the insurance is the responsibility of the Buyer.
  • FAS (Free Alongside Ship)
    a) Transportation to be arranged by the Buyer.
    b) Risks transfer from the Seller to the Buyer when the goods have been placed alongside the ship.
    c) Costs transfers from the Seller to the Buyer when the goods have been placed alongside the ship.
  • EXW (Ex Works)
    a) Transportation to be arranged by the Buyer who is responsible to pick up the goods from the Seller’s warehouse.
    b) Risks transfer from the Seller to the Buyer when the goods are delivered at the warehouse and are at the disposal of the Buyer.
    c) Costs transfers from the Seller to the Buyer when the goods are at the disposal of the Buyer at the warehouse.
  • DDP (Delivered Duty Paid)
    a) Transportation to be arranged by the Seller.
    b) Risks transfer form the Seller to the Buyer when the goods have been put at the disposal of or delivered to the Seller.
    c) Costs transfer from the Seller to the Buyer when the goods have been put at the disposal of or delivered to the Seller. The Seller pays for the transportation of the goods, any duties, and insurance.

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If you have valid Purchase Orders (PO) and you are unable to obtain funding to purchase the goods, call Ashford Finance for 100% funding.