Introduction to Letters of Credit

Since the inception of international trade, the need for risk minimization of the transaction for both buyer and seller has been paramount. Letters of credit have been used for a long time to accomplish that purpose by facilitating payments in the form of guarantee. As LCs derisk transactions by essentially shifting the credit risk from an unknown party to a major financial institution, LCs are an excellent lubricant for business and world trade.

LCs are a major line of business for banks, usually falling under commercial banking, corporate banking and trade finance divisions. The more global a bank, the more important their LC business is, with notable trade finance dominant financial institutions including HSBC, Citi and Scotiabank.

The Letter of Credit (LC) is a financial contract that involves at least three parties: a buyer’s bank, the buyer, and a seller. The bank guarantees the buyer’s payment to a seller, also called a beneficiary, assuming certain conditions are met. A letter of credit provides a promise from the bank that if the buyer, also called the applicant, fails to provide the payment the bank will compensate the beneficiary if certain documentation is provided by the latter.

For the buyer, LCs eliminate the need to provide the seller with cash collateral or other forms of security to support the performance under obligation. When the need to prepay for products and services is eliminated, the buyer can use funds for alternative purposes before the payment becomes due.

When the buyer is an importer, using LCs can ensure that the company only pays for goods after the seller provides evidence that they have been shipped.

On the other hand, the letter of credit is insurance for an exporter in case the buyer fails to pay for the goods that were shipped. It also guards the seller against a variety of legal risks since the payment is ensured as long as the conditions on seller’s side of obligations are satisfied.

The use of this instrument continues to increase as the global economy evolves, though LCs are being widely used for domestic transactions as well. Letters of credit can be posted for tax liabilities, environmental liabilities (posted to the government to cleanup chemical sites once the useful life is over), and a variety of other purposes.

The seller must satisfy documentation, requirements, conditions, and deadlines pursuant to the letter of credit to receive the compensation from the issuing bank, which can vary drastically from the sales agreement between buyer and seller. The sales agreement takes place between the buyer and seller only. The Letter of Credit is a separate document issued by the buyer’s bank, and it might contain the information from the sales agreement. However, two are not identical.

The Role of Banks in LC Issuance

The bank serves as a trusted intermediary that reduces the risk of the transaction and provides key benefits for both parties. Typically, a bank is financially more stable than most buyers and hence provides more confidence for the seller, especially in the event of the international trade.

For LCs, the bank’s credit rating is extremely important. As an example, if buyer is rated BB- or has no credit and TD Bank issues an LC, the seller now has counterparty risk with TD. TD is rated AA, so the probability of default is far slimmer. The higher the credit rating of the bank, the better positioned they are to win LC business. Also, the wider the delta between the bank’s credit rating and the LC issuer’s rating, the more the bank can charge for the credit.

It is always a requirement for a bank that acts on behalf of the applicant (buyer) to ensure that all the conditions of the letter of credit are met and to release the funds to the beneficiary. However, there might be more banks involved, which can act on behalf of the seller or provide the additional layer of guarantee by backing up the issuing bank.

Advising Bank for LC Issuance

The bank that is selected by the seller for representation and advising is called an advising bank. Particularly in international transactions, the beneficiary would want to use the local bank to ensure that the letter of credit is valid by evaluating the country and bank where the letter is originated from. Serving solely as an adviser, the advising bank does not have obligations under the letter of credit and does not carry any responsibility if the issuing bank does not pay. The advising bank is most commonly used when the beneficiary is concerned regarding the financial stability of the issuing bank. When nominated by the beneficiary, the advising bank can become the receiver of the payment from the issuing bank.

Confirming Bank for LC Issuance

The advising bank can also serve as a confirming bank, which obligates itself to ensure the payment under the letter of credit. The confirmation is usually done at the request of the issuing bank (buyer’s bank).

Types of Letters of Credit – Commercial and Standby

Broadly speaking, there are two types of letter of credit: commercial and standby.

The commercial standby letter represents a primary payment mechanism in the transaction – it guarantees the payment if the conditions of the letter are met and appropriate documentation presented.

The standby letter has a different function: the issuing bank assures the buyer’s ability to perform under the conditions of the sale by providing the payment only if the buyer fails to pay. Instead of facilitating the transaction, the standby letter provides the contingency payment when something goes wrong and is not expected to ever be drawn upon under normal conditions.

Letters of Credit Example

The hypothetical example covers the international trade transaction between the buyer John (importer) and the seller Jane (exporter), so the commercial letter of credit is assumed.

Once agreed on conditions of the sales agreement (price, quantity, and type of the product) John and Jane decide to use LC. Jane never dealt with John before and has reservations regarding the political unrest in John’s country that might severely affect his ability to pay her. In order to provide more confidence for Jane in his commitment to the deal, John contacts his Bank X that operates in his country.

John provides his bank with the information pertaining to the deal with Jane (from the sales agreement) that is needed for the bank to issue the LC. Despite being based largely on the information from the sales agreement, the LC is based on the provision of documentation rather than the actions.

When committing to the LC, the bank needs to know if John can provide the funds for the purchase. If John does not have the deposit in the bank that is sufficient to cover the purchase, the bank might offer John a separate deal in the form of a loan.

After the bank takes care of its risk exposure with John, it sends the LC to Jane’s bank ( aka Advising Bank), which operates in her country. After a review, Jane’s bank sends the LC to her for another review.

Jane reviews the LC carefully in ensure that it accurately represents the conditions she agreed to satisfy. Once everything seems to be in order, Jane goes forward to execute her part of the deal with John.

Once Jane sends goods to John over the sea, the ship that carried the goods never made it to John’s country in a terrible accident. Janes has the documentation supporting the fact that the goods were sent out.

John refuses to pay because according to the sales agreement the transfer of ownership is recognized upon the delivery of goods. However, the issued LC recognizes the transfer once the goods leave Jane’s warehouse, and she meets all the requirements under LC. Now that John decides not to pay, the bank is left on its own to provide the payment to Jane.

Once the advising bank verifies all the documentation, it is sent to the issuing bank for the similar review. Everything matches perfectly, Jane receives her payment from the bank. The banking analyst is reprimanded for not looking into the transfer of asset ownership when drafting the LC.