International Buyers and Suppliers might use Letters of Credit (LCs) - also known as Credit Letters - to minimise the risks of their trade transactions.
What is a Letter of Credit?
A Letter of Credit is a secure international trade payment guarantee, written on behalf of a Buyer (Importer) to pay the Supplier (Exporter) within the specified time of a payment agreement. The bank or finance provider that issues the LC assumes responsibility for payment if the Buyer cannot meet repayment terms.
In international trade, it is often difficult for Suppliers to determine the reliability and trustworthiness of Buyers and trading partners. A Supplier may request a Letter of Credit if it is concerned about a potential trade. Working with a validated finance provider that guarantees payment through a Letter of Credit removes the risk of non-payment by the Buyer and provides peace of mind for the Supplier.
How Does a Letter of Credit Work?
The Supplier would request a Letter of Credit from the Buyer once a trade deal is agreed upon.
The Buyer then consults its bank or financial institution to secure that Letter of Credit. Similar to applying for a bank loan, there is an application and due diligence process which takes time to complete. The process may well involve the Buyer having to lodge assets as security before the LC can be issued.
The Buyer's bank has no interest in the goods or services themselves or whether they were shipped. The Buyer's bank requires only stipulated documents from the Supplier's bank before issuing payment. The Buyer and its bank will have agreed on what company assets to use as collateral should the Buyer default on payment.
There are a few points to note about obtaining a Letter of Credit:
- If requesting a Credit Letter from a bank, applicants (Buyers) must consult specific departments such as the Commercial or International Trade Division.
- Applicants will be charged a fee to obtain a Letter of Credit, usually a percentage of the deal amount.
- If the applicant defaults on payment, the bank will request physical collateral (e.g. property) or financial collateral.
What Happens After a Letter of Credit is Issued?
With the LC in place, the Supplier then exports the goods in accordance with the agreement.
Once the goods are received, the Importer makes full and timely payment to the Exporter. The financial institution that issued the Letter of Credit then takes a small service fee, ending the agreement with no long-term repayment plans enforced.
If the Importer doesn't pay, responsibility for payment lies with the financial institution that issued the LC. It may then seize the assets pledged as collateral as part of the agreement.
Letter of Credit Example
The following is an example of a traditional Letter of Credit agreement:
ABC Importer Ltd. requires materials from an overseas company, XYZ Exporter Co. However, XYZ Exporter is hesitant to engage in international trade with ABC Importer due to the legal and political complexities associated with international trade.
So, ABC Importer works with an international trade finance provider to secure a Letter of Credit, guaranteeing that ABC Importer will provide full and timely payment for goods. If ABC Importer cannot meet the repayment terms, the provider will become responsible for payment. To secure this service, ABC Importer agrees to pay the finance provider a fee of 1% of the value of the trade deal.
With the LC in place, XYZ Exporter sends the materials and raises an invoice, which ABC Importer pays on time and in full. ABC Importer then pays the fee owed to the finance provider.
Benefits of Using Letters of Credit
- Letters of Credit provide security for Suppliers in international trade deals.
- They help Exporters and Importers build trust and form long-term trade deals with each other.
- In the highly complicated international trade landscape, these letters help the easy movement of funds from one party to another.
- Banks and finance providers can provide highly customisable Credit Letters written to satisfy the terms of individual trade deals.
- Neither Buyer nor Supplier is subjected to long-term repayment agreements.
International trade is often complicated by factors including regional laws and regulations, global payments, currency conversions and challenges in checking the reliability of trading partners. A Letter of Credit alleviates many worries that Suppliers face by placing an internationally recognised and regulated finance provider as guarantor at the centre of the agreement.
Can International Suppliers Use Letters of Credit?
Exporters typically request a Letter of Credit in the following cases:
- Where the trading volume and associated costs exceed a specific limit.
- The operating country of the Importer is politically or economically unstable.
- The Importer has an unsatisfactory credit history.
- Where there are risks associated with National Exchange Controls or currency conversion.
Considerations When Using International Credit Letters
- There are service fees involved for Buyers when requesting a Letter of Credit.
- Depending on the trade agreement and credit history of the Buyer, banks and financiers occasionally won't provide Letters of Credit as an option.
- Credit Letters don't account for external issues in the supply chain, international trade laws, regulations, foreign exchange rates or geopolitical issues.
- A Letter of Credit is a financier's guarantee to pay against the presentation of documents that comply with the terms and conditions of the trade deal. It is separate from the trade deal on which it is based. The Supplier has the bank's undertaking to pay, provided it presents specified documents, irrespective of any dispute in the underlying contract.
- Letters of Credit typically take a long time to issue.
- They are bound by Uniform Customs & Practice for Documentary Credits (UCP 600) trading rules, which are worth examining to ensure no laws will be broken in the trade.
- Letters of Credit are easy to fabricate and can be used to create illegitimate, fraudulent or illegal trade deals. Letters of Credit should be sent only by a legitimate nominated bank and never directly by a Buyer. Fraudulent Buyers can also draft fake Letters of Credit to 'guarantee' payment for goods for which they don't pay.
- Some fraudulent Suppliers can convince Buyers to have their banks approve and issue Letters of Credit. That could ultimately mean that poor quality goods - or none whatsoever - are shipped to the Buyers before the scamming Supplier disappears without a trace. Banks are obligated to pay Letters of Credit even if a fraudulent transaction has been made.
Types of Credit Letter
Subtle variations of Letters of Credit may be helpful for specific Buyers depending on their financial situations and the Supplier's requirements.
- Standby Letter of Credit (SBLC) - Issued when the financier pays the Supplier if there is proof that the Supplier delivered the promised goods.
- Commercial Letter of Credit - Used when the Buyer's bank makes direct payment to the Supplier's bank.
- Revolving Letter of Credit - Used for a series of payments where multiple deals are expected between Exporter and Importer.
- Red Clause Letter of Credit - Issued when an Exporter requires advance payment, with the Importer remaining liable after delivery.
- Transferable Letter of Credit - Used when intermediaries are involved in the deal, with the Supplier as the middle man. For example, when a Supplier needs to purchase goods from a third party with funds from the Letter of Credit.
- Back-to-back Letter of Credit - Consisting of two Letters of Credit used together to finance a single purchase, involving an intermediary between Supplier and Buyer.
Should My Company Use a Letter of Credit?
Letters of Credit boost international trade by providing guaranteed payment. It's clear to see their value in deals where complicated international laws often cause confusion and delays.
However, business owners should perform due diligence on all Credit Letter agreements, including working closely with banks or finance providers to review and validate agreements.
Letters of Credit are not the only trade finance solution available to Importers and Exporters. Payment-in-advance, working capital loans or invoice finance may be more efficient alternatives for specific Suppliers. It's wise to consider the type of trade finance that works best for each business.
If you are interested in learning more about invoice factoring, Stenn has a dedicated FAQ section where you can find more information about our invoice financing services. We also provide videos which explain the company and the financing process in detail.
About the Authors
This article is authored by the Stenn research team and is part of our educational series.
Stenn is the largest and fastest-growing online platform for financing small and medium-sized businesses engaged in international trade. It is based in London, provides financing services in 74 countries and is backed by financial giants like HSBC, Barclays, Natixis and many others.
Stenn provides liquid cash to SMEs within the global financial system. On stenn.com you can apply online for financing and trade credit protection from $10 000 to $10 million (USD). Only two documents are required. No collateral is needed and funds are transferred within 48 hours of approval.
Check the financing limit available on your deal or go straight to Stenn's easy online application form.
© Stenn International Ltd. All rights reserved. Any redistribution or reproduction of part or all of the contents in any form is prohibited other than the following:
- You may copy the content to your website page but only if you acknowledge this website as the source of the material and provide a backlink to this article.
- You may not, except with our express written permission, distribute or commercially exploit the content in any other way.
Disclaimer: The above article has been prepared on the basis of Stenn's understanding of the subject. It is for information only and doesn't constitute advice or recommendation. Whilst every care has been taken in preparing this article, we cannot guarantee that inaccuracies will not occur. Stenn International Ltd. will not be held responsible for any loss, damage or inconvenience caused as a result of anything published above. All those applying for credit should seek professional advice when doing so.