The letter of credit is in the best interests of the exporter, ensuring that he receives timely export revenue. The use of letters of credit allows satisfying the needs of customers in payments that provide payment. Banks, participating in a letter of credit operation, receive significant profit from commission fees, since the share of participation, as well as the responsibility and risk of the bank in a letter of credit transaction is higher than when calculating by bank transfers or collection.
A letter of credit is a conditional monetary obligation of a bank issued by it on behalf of an importing client, make a payment in favor of the exporter (accept its spending) or provide payment (attract) by another bank within a certain amount and within the prescribed time period against the documents specified in the letter of credit.
In settlements on foreign trade operations, documentary letters of credit are used, payments for which are made subject to the submission of commercial documents to the bank (accounts, transport, insurance and other documents, certificates, etc.).
The use of letters of credit in international settlements is regulated by the “Unified Rules and Customs for Documentary Letters of Credit” developed by the International Chamber of Commerce. The rules are binding on banks that have joined them and their customers who are paying letters of credit. Each documentary letter of credit includes a clause stating that the Rules are an integral part of such a letter of credit.
Unified rules determine the basic concepts and types of letters of credit, the methods and procedure for their execution and transfer, the duties and responsibilities of banks, the requirements for documents submitted by letters of credit and the procedure for their presentation, provide an interpretation of various terms, and also consider other issues arising in the practice of settlements with letters of credit.
Participants in the accreditation operation are:
1. buyer – buyer (importer) who calls his bank to open a letter of credit;
2. beneficiary (exporter) – the party to which the letter of credit is addressed and in whose favor the payment will be made subject to the submission of documents specified in the letter of credit;
3. issuing bank – a bank that opens a letter of credit on behalf of a client or asks another bank to open a letter of credit at his expense and on his behalf;
4. advising bank – a bank that notifies the beneficiary of the opening of a letter of credit. The receiving bank may be an issuing bank, an executing bank or any third bank;
5. confirming bank – a bank that assumes obligations in addition to the obligations of the issuing bank to make a payment (tratt acceptance) to the beneficiary subject to the terms of the letter of credit. A third bank may be confirming, but it must be a large, well-known bank;
6. payer bank (performing bank) – a bank indicated in the letter of credit as making a payment to the beneficiary against documents provided for by the letter of credit; it may be an issuing bank confirming, advising bank, any other bank, authorized by the issuing bank.
In addition to banks, other non-financial institutions participate in the accreditation operation:
1. transport companies – carry out the transportation of goods and write out transport documents – bills of lading. The holder of the bill of lading has the right to dispose of the goods;
2. customs broker – acts as an agent of the importer. He exercises control over the received documents, checks the goods, transfers documents and goods to the importer;
3. insurance company – provides cargo insurance and the issuance of an insurance policy or insurance certificate, as well as reimbursing losses in the event of an insured event.
The exporter and importer conclude a contract (1), which indicates that settlements for the delivered goods will be made in the form of a documentary letter of credit. The contract must determine the payment procedure, i.e. clearly and fully formulated the terms of the future letter of credit. The contract also indicates the bank in which the letter of credit will be opened, the type of letter of credit, the name of the advising and executing bank, the conditions for the execution of the payment, the list of documents against which the payment will be made, the validity period of the letter of credit, the procedure for paying the bank commission, etc. The terms of payment contained in the contract must be contained in the order of the importer to the bank to open a letter of credit.
After the conclusion of the contract, the exporter prepares the goods for shipment, as notified by the importer (2). Upon receipt of a notice from the exporter, the buyer sends an application to his bank to open a letter of credit, which indicates the terms of payment contained in the contract (3).
After the letter of credit is issued, the issuing bank sends the letter of credit to a foreign bank, as a rule, to the bank serving the exporter (4) – the advising bank. The advising bank, having verified the authenticity of the received letter of credit, notifies the exporter of the opening and conditions of the letter of credit (5).
The exporter checks the compliance of the terms of the letter of credit with the payment terms of the contract. In case of non-compliance, the exporter shall notify the advising bank of the non-acceptance of the terms of the letter of credit and the requirement to amend them. If the exporter accepts the terms of the letter of credit open in his favor, he will ship the goods within the time period established by the contract (6).
Having received transport documents from the transport organization (7), the exporter submits them, together with other documents stipulated by the terms of the letter of credit, to his bank (8).
The Bank checks whether the submitted documents comply with the terms of the letter of credit, the completeness of the documents, the correctness of their preparation and execution, and the consistency of the details contained in them. After checking the documents, the exporter’s bank sends them to the issuing bank (9) for payment or acceptance. The cover letter indicates the procedure for crediting revenue to the exporter.
Having received the documents, the issuing bank carefully checks them, and then transfers the amount of payment to the bank serving the exporter (10). The importer’s account (11) is debited for the amount of payment. The exporter’s bank credits revenue to the exporter’s account (12).
The importer, having received commercial documents from the issuing bank (13), takes over the goods.
The “Unified Rules” and Customs contain a description of various types of documentary letters of credit.
A revocation letter of credit that can be canceled or the terms of which can be changed by the issuing bank at the direction of the client at any time without prior notice to the beneficiary. However, the issuing bank must provide the bank authorized to make the payment with compensation if this bank made a payment against the documents submitted by the beneficiary (or accepted these documents for payment by letter of credit with installment payment), until a notice of change of conditions or cancellation of a revocation letter of credit is received from the issuing bank. Feedback letters of credit are used in settlements between firms that have long-term trade relations and trust each other, since this form of settlement has a high risk of rejection of goods.
An irrevocable letter of credit cannot be canceled or amended without the consent of the parties concerned. The application for a letter of credit must indicate whether it is withdrawn or irrevocable.
To increase the degree of guarantee of payment under a letter of credit, confirmed letters of credit are used in the calculations. Confirmation of a letter of credit means a guarantee of payment by another bank that is not an issuing bank. The bank that has confirmed the letter of credit assumes the obligation to pay documents that comply with the terms of the letter of credit if the issuing bank refuses to make the payment. In international practice, as a rule, there is a bank serving the exporter.
Unconfirmed letter of credit – here only the issuing bank is responsible for the execution of the payment, and the bank serving the exporter plays a mediating role and is not responsible for payments under the letter of credit.
A cross-cutting letter of credit (translation) allows payments from it in favor of not only the beneficiary, but also third parties – the second beneficiaries. The translation of the letter of credit is made in favor of third parties at the request of the beneficiary in whole or in part. A transferable letter of credit is usually used only if the beneficiary is not a supplier of goods or delivery is carried out through an intermediary.
The second beneficiary, by shipping the goods to the importer, submits to the bank commercial documents that comply with the terms of the letter of credit for payment. The beneficiary, in whose favor the transfer letter of credit was opened, was given the right to replace the accounts (and expenses) submitted by the second beneficiary with his accounts (and drafts) and to obtain a possible difference between the amounts of these accounts (Fig.thirteen).
Stages:
1. buyer’s application for opening a letter of credit;
2. notice of the seller bank on the opening of the letter of credit;
3. seller’s advice on opening a letter of credit;
4. the order of the beneficiary to transfer the letter of credit in favor of the supplier;
5. advising the second beneficiary on the opening of a letter of credit;
6. shipment of goods to the buyer;
7. submission to the bank of documents stipulated by the terms of the letter of credit;
8. payment from a letter of credit in favor of the supplier;
9. sending documents on behalf of the beneficiary to the issuing bank.
If the conditions of the letter of credit do not provide for the possibility of its translation, and the beneficiary of the letter of credit is not a supplier of goods, compensation letters of credit can be used in the calculations. It is opened by the beneficiary on the main, basic letter of credit as a counter letter of credit in favor of the manufacturer of the goods or the subcontractor. Basic and compensatory letters of credit are independent and legally not related.
After the opening of the main letter of credit (1), the issuing bank notifies the seller’s bank (2). This bank, acting as an advising and, as a rule, confirming the bank, notifies the seller of the opening of the letter of credit (3). The seller applies to the bank for the opening of a counter letter of credit on the basis of the basic letter of credit in favor of the manufacturer of the goods or subcontractor (4). The second issuing bank opens a letter of credit and notifies the bank serving the product manufacturer (5) about this, and the bank notifies the supplier (6). The supplier ships the goods to the buyer (7) and submits to the bank the documents stipulated by the terms of the letter of credit.
When opening a compensation letter of credit, it is necessary to comply with the terms of the compensation letter of credit with the conditions provided for by the basic letter of credit. This applies primarily to the conditions for the delivery of goods and the requirements for the submitted documents. If the conditions of the base and compensation letters of credit coincide and in order to receive payment under the letter of credit it is necessary to submit the same documents, then after replacing the spending documents submitted by the supplier on the compensation letter of credit, can be used to receive payment under a basic letter of credit. If the conditions of the base and compensation letters of credit do not coincide, the seller must supplement the set of documents received from the supplier when implementing the compensation letter of credit.
To ensure payment of a compensation letter of credit, its validity period must go beyond the validity of the base letter of credit.
For constant deliveries of goods in equal batches, revolver (renewable) letters of credit may be used in the calculations. It provides for the replenishment of the letter of credit not a certain amount (quota) or up to the initial value as used. When opening a revolver letter of credit, the total amount, the amount of one quota and the number of quotas, as well as the term for using the quota, are indicated.
To ensure payment under the letter of credit, a letter of credit with currency coverage may be opened. When opening covered letters of credit, the issuing bank makes available to the foreign bank executing the letter of credit the amount of the letter of credit opened for its duration, subject to the use of these funds for payments under the letter of credit. Currency funds may be transferred:
by lending to the account of the executing bank in the issuing bank or third bank; by providing the executing bank with the right to debit the account of the issuing bank opened in that bank by the amount of the letter of credit; by opening a deposit with the issuing bank in the performing bank.
The provision of currency coverage at the opening of the letter of credit leads to the freezing of the funds of the issuing bank for its validity. Therefore, in international practice, uncovered letters of credit are mainly used that do not require the diversion of funds from the issuing bank at the time of opening the letter of credit.
The letter of credit “with a red reservation” – provides for the issuance of advances to the exporter by the performing bank to a certain amount. Advance is usually used by the beneficiary to purchase goods intended for export. In fact, part of the amount of the letter of credit goes to pay for unloaded goods. Banks issue advances against the presentation by the exporter of “obligations to make shipment” or other similar document.
Opening the letter of credit “with a red reservation”, the issuing bank undertakes to reimburse the amount of advances paid to the performing bank even if the goods were not shipped under this letter of credit.
As a way to fulfill contractual obligations, a standby (guarantee) letter of credit is used in international practice.
It opens both in favor of the exporter and in favor of the importer under the contract. A standby letter of credit can be used similarly to documentary, as well as to additionally provide payments in favor of the exporter in settlements in the form of collection or bank transfer. At the same time, a standby letter of credit may be a guarantee of a return of an advance previously paid by the importer or payment of fines and penalties in favor of the importer in the improper performance of the terms of the contract by the exporter.
Payments under a standby letter of credit are made by banks on the basis of the beneficiary’s statements that the ordering agent for the standby letter of credit has not fulfilled his obligations. At the same time, banks do not verify the accuracy of such a statement, i.e. make a payment of course. T.O., a standby letter of credit can be considered as a guarantee of payment security in the event that the ordering agent under the standby letter of credit does not fulfill his obligations under the contract.
The use of a letter of credit transaction in the calculations is most beneficial for the exporter, who receives an unconditional payment guarantee before the goods are shipped. Moreover, receipt of payment under the letter of credit (subject to the fulfillment by the exporter of the terms of the letter of credit and submission to the bank of the documents specified therein) is not connected with the buyer’s consent to pay.
However, for the exporter, the letter of credit is the most difficult form of settlements: receiving a payment from the letter of credit is associated with the exact observance of its conditions, the correct execution and timely submission to the bank of the documents specified in the letter of credit. By monitoring compliance with the terms of the letter of credit and the documents provided, banks protect the interests of the buyer, acting on the basis of his instructions.
The disadvantage of the letter of credit form of settlements is the complex document management and delays in the movement of documents related to the control of documents in banks and their transfer between banks.
Given the complexity of the calculations with letters of credit, the share of participation and responsibility in carrying out these operations, banks charge a commission for conducting operations under the letter of credit. Its size depends on the amount of the letter of credit. The letter of credit must indicate at whose expense (buyer or beneficiary) the bank commission will be paid and the bank will be reimbursed by postal and telegraph expenses.