INTERNATIONAL TRADE INTERNATIONAL TRADE PAYMENT INSTRUMENTSPAYMENT INSTRUMENTS

Summary description

Goods can rarely be paid for while still in the possession of the seller and not inspected by the buyer. There is generally a timing mismatch between the time that the buyer receives the goods and the time that the seller is paid. The buyer and/or seller therefore run payment risks - for example, if payment is made before the goods arrive, the goods may turn out to be defective, but if the goods are only paid once received by the buyer, the buyer may pay too little or too late. Various trade payment instruments have been developed to mitigate the various risks to the trade parties.

This chapter describes the main forms that international trade payments take and how and when these methods can be used.

Introduction

Open Account

Cash in Advance

Documentary Collections

Documentary Credits

Introduction

Open Account

Cash in Advance

Documentary Collections

Documentary Credits

Table of ContentsTable of ContentsClick herefor a brief

discussion on the impact of

electronic trade on payment systems

International Trade Payment InstrumentsInternational Trade Payment Instruments

IntroductionIntroduction

Seller BuyerGoods

Money

There is generally a timing mismatch between the flow of goods and money, which results from the time it takes to transport goods over larger distances.

Such a variance creates credit risks. If the seller ships the goods and the buyer pays on arrival, the buyer may default. If the buyer pays in advance, the goods may not be shipped, or the quality or other aspects of the goods may not conform to specifications. Various international trade payment instruments have been developed to overcome this problem.

International trade presents a number of challenges to bankers especially in getting the buyers, who have no physical contact with the sellers to pay for goods and services received in sufficient time. To achieve this objective, various payment instruments have been designed to take into account not only the payment risk of the buyers, but also the risks inherent in their countries of domicile. The overall aim is to ensure that the buyer receives the consignments of the right quantity and quality at the right price and time, and that it ensures the seller receives due payment.

The are four principal payment mechanisms for settling international trade transactions. These are: Open AccountOpen Account, Advance PaymentAdvance Payment, Documentary Documentary CollectionsCollections and Documentary CreditsDocumentary Credits.

The level of security that these mechanisms provide to the buyer and seller varies subsequently. The same goes for the level of banks' involvement and the cost that implies when dealing in any of these payment mechanisms.

Open account

Documentary collections

Documentary credits

Payment/cash in advance

Most secured for Exporter/Seller

Most secured for Importer/Buyer

Least secured for Importer/Buyer

Least secured for Exporter/Seller

Risk Perspective

The next page looks at this in greater detail.

risks

Least secured for Exporter/Seller

Most secured for Exporter/Seller

Extended payment terms: importer pays for goods over a period of time after receipt (up

to 10 years for capital goods). They would normally issue a set of promissory notes upon shipment.

Open account, clean draft: exporter expects payment from importer on shipment or arrival.

Time or date draft, or documents against acceptance: exporter makes shipment and presents draft and shipping documents to bank, with instructions that the documents be only released to the importer once they acknowledge the draft.

Consignment (with retention of title): exporter makes shipment, and is paid when importer sells goods. Sales contract gives exporter the right to repossess goods when left unsold. Only works when importer’s country has good legal system allowing retention of title and easy repossession of goods.

Sight draft, documents against payment, cash against documents: after shipment, exporter sends documents to bank with instructions that they only released once importer pays the draft.

Cash against goods, shipment into bonded warehouse: shipment to exporter’s or independent warehouse in importer’s country. Works well when there are many potential buyers.

Irrevocable L/C: payment will be made to exporter on presentation of proper documents. Can be costly, and the exporter has to prepare the documents carefully. He remains exposed to the importer’s country risk.

Confirmed irrevocable L/C: similar to simple irrevocable L/C, but greatly reduces country risk.

Cash in advance: importer pays before goods are shipped.

Risks for exporter/seller of different payment terms

Payment mechanismsPayment mechanisms

Documentary Credit

Documentary Collections

Payment in Advance

Open Account

Document against Payment

Documentagainst

Acceptance

Revocable D/C

IrrevocableD/C

Open account means the exporter selling on credit terms to the buyerOpen account means the exporter selling on credit terms to the buyer

This is the most secure method of payment for the importer. It allows the importer to make payments at some specific date in the future (or in the case of extended terms, in installments over time) and without the buyer issuing any negotiable instrument evidencing his legal commitment to pay at the appointed time. On the part of the seller, it is therefore the most risky payment

mechanism the buyer bears the cost of financing and the credit risk of the buyer. Open account does not involve the bank, except in moving the funds from buyer to seller in due course. This mechanism offers the seller no protection in case of non-payment. However, an exporter can structure his open account sale transaction to minimize the risk of non-payment; for example, reducing the repayment period and retaining title to the goods until payment is made. Even then it is difficult to enforce this, especially if the goods have either been resold by the buyer or consumed in some other processing activity.

A.A. Open AccountOpen Account

Open Account may just be a marketing ploy… Open Account may just be a marketing ploy…

Often, an exporter may offer open account terms with deferred payment to a potential client, but without taking on any credit risk himself since he has already established a framework through which he can immediately discount the accounts receivable on a non-recourse basis, e.g., with a forfeiting company. The discount that the exporter has to accept in order to forfeit the trade paper is then calculated into the price that he charges the buyer.

Forfeiting is not necessarily the most cost-effective way of financing for a buyer. If a buyer buys on open account, he should carefully consider whether the premium that he pays for this privilege (through the higher price for the product) is not more than what he would be charged for other forms of finance.

When can Open Account be used?When can Open Account be used?

1. This payment mechanism is used when the exporter has a well-established commercial relationship with a credit-worthy importer and when the importing country enjoys reasonable political and economic stability.

2. When the exporter is shipping goods to a parent or subsidiary company, it is expected that payment timing and modalities, including provisions for unsold portions, would be outlined.

3. When the exporter is faced with excessive inventory, it seeks markets desperately and would take the risk of delivering to a seller without excellent credit records. This is more relevant for items with short expiration dates that could spoil.

4. Sellers faced with strong competition may also decide to ship goods on open account as a way to squarely face the challenges posed by competition. It is a way of making their products visible in the international market.

5. Extended terms can be used for an otherwise creditworthy importer in a country with scarce foreign exchange, but where the importer produces goods that are sold in hard currency – the importer can then pay out of these earnings.

Open Accounts - summaryOpen Accounts - summary Informal arrangement whereby goods are shipped and the importer is billed later

(Invoice sent with or after shipment). Provides great flexibility and fits well with small shipments which have good profit

margins. Useful with well known customers who are good credit risks, and common with

longstanding good customer-supplier relationships. Government loan guarantees (by Export Credit Agencies) may be available.

Typical disadvantages:

– If ECA guarantees are not available, credit insurance and factoring can be expensive.

– If payments are made under extended terms, the notes can be sold on the secondary market, but only with the aval of the importer’s bank, and even then, deep discounts may be necessary.

Typical risks include:

– Customer refuses to take possession

– Customer unable or unwilling to pay

– Customer is slow in paying

– Customer restricted from paying by its central bank

B.B. Payment/Cash in Advance Payment/Cash in Advance

In contrast to open account, payment against documents is the most secure payment method for the exporter, but more risky for the buyer since goods are not shipped until payments are received in part or full.

In this arrangement, the seller retains total control over the transaction and there is no guarantee that goods paid for will even be delivered in good time. There is very limited bank involvement in this method of payment since the seller sends the documents directly to the buyer. The bank’s only role involves wire transfers of money.

Cash in advance can be expensive to the exporter since buyers who are forced to pay in advance may ask for a discount on the value of the exports.

When is Payment in Advance used?When is Payment in Advance used?

1. This method of payment is usually used only for small purchases, one-off sales and custom-made goods.

2. The exporter may need the advance payment to prepare the shipment.

3. Essentially, sellers request payment in advance when foreign buyer's credit status is doubtful and unsatisfactory and/or the country political and economic risks are very high. In these circumstances, the seller does not want his funds to be trapped in a foreign land on grounds of buyer failure or difficulties in remittance due to exchange restrictions by the government.

Although political risk coverage has tended to reduce risk factor, there are still concerns by exporters that these covers are not

entirely all embracing. For instance, numerous disturbances in parts of Africa that do not necessarily result in full blown war, but nevertheless interrupt business, are hardly regarded disruptive enough by insurers to warrant claims-calling.

It could lead to under-pricing since buyers usually request for huge discounts to compensate for their funds tied down. In this regard, both exporter and importer tend to take local market rates as a benchmark, but where the local rates in the importer’s country are higher, as is the case, for example, for African importers, they tend to demand higher discounts than the exporter could afford. Striking a balance between these two positions is always a problem.

Payment in advance may be outlawed in some countries, making it difficult for importers to effect remittance of funds meant for goods payment. Where goods have already been produced for the specific benefit of an importer, this could create some problems for the exporter.

What are the Disadvantages to the Exporter?What are the Disadvantages to the Exporter?

Cash in Advance - summaryCash in Advance - summary

Occurs when exporter is in strong bargaining position relative to importer

Relationship between parties un-established

Typical risks include:

– Supplier may not ship.

– Supplier may ship late, low grade or less than agreed.

– Supplier may not be permitted to export by authorities.

C.C. Documentary CollectionsDocumentary Collections

This is a method of payment by which the sale transaction is settled through an exchange of documents, thus enabling simultaneous payment and transfer of title. The principal obligations of parties to a documentary collection arrangement are set out in the guidelines of the ``Uniform Rules for Collection’’ (URC) drafted by the Paris-based International Chamber of Commerce.

This method makes use of Bill of Exchange or Draft supported with other shipping documents.

Documentary collections offer a middle-of-the road approach to satisfying both the exporter and importer. In the arrangement, the importer is not obliged to pay for goods prior to shipment and the exporter retains title to the goods until the importer either pays for the value of the draft upon presentation (sight draft) or accept to pay at a later date and time (term draft).

For a further explanation and example of a draft, click here.

Role of Banks in Documentary CollectionsRole of Banks in Documentary Collections

Banks play essential roles in transactions adopting documentary collections. Two major banks come into the scene:

Remitting Bank: This is the exporter’s bank and acts as the exporter’s agent in collecting payment from the importer. It basically transmits the exporter’s instructions along with the terms of the draft to the importer’s bank. The bank does not assume any risks and does not undertake to pay the exporter, but maintains influence to settle a bill. Collecting Bank: This is the importer’s bank and takes up the role of ensuring that the buyer pays (or accepts to pay) for the goods before shipping documents are released to them.

Generally, banks in the transaction control the flow and transfer of documents and regulate the timing of the transaction. They must ensure the safety of the documents in their possession, but are not responsible for their validity and accuracy.

Collecting/Presenting

Bank

Collecting/Presenting

Bank

Exporter (Drawer)Exporter (Drawer)

Remitting Bank

Remitting Bank

Importer(Drawee)Importer(Drawee)

1. Contract of sale

2. Delivery of goods

3. S

hip

pin

g do

cum

ent s

an

d

i nst

ruct

i on

s f o

r pa

ymen

t

7. p

aym

ent

6. Payment

4. Documents and collection order

5. Presentation of documents and receipt of

payment

Documentary Collections Flow ChartDocumentary Collections Flow Chart

1. Exporter/drawer and Importer/drawee agree on a sales contract, including payment to be made under a Documentary Collection.

2. The Exporter ships the merchandise to the foreign buyer and receives in exchange the shipping documents.

3. Immediately thereafter, the Exporter presents the shipping documents with detailed instructions for obtaining payment to their bank (Remitting bank).

4. The Remitting bank sends the documents along with the Exporter’s instructions to a designated bank in the importing country (Collecting Bank).

5. Depending on the terms of the sales contract, the Collecting Bank would release the documents to the importer only upon receipt of payment or acceptance of draft from the buyer. (The importer will then present the shipping documents to the carrier in exchange for the goods).

6. Having received payment, the collecting bank forwards proceeds to the Remitting bank.

7. Once payment is received, the Remitting bank credits the Exporter’s account less its charges.

Variations of Documentary CollectionsVariations of Documentary Collections

Cash against documents/Sight Drafts:

In a transaction on documents against payment, the exporter releases the shipping documents to the importer only on payment for the goods. In this arrangement, the exporter retains title to goods on board and may decide to refuse their discharge if payments are not received. This demands the buyer’s immediate payment of the exporter relies on the a sight draft drawn on the buyer.

Cash against documents can only be used for importers with good credit rating and low-risk countries. It cannot be used for custom-made goods.

The exporter runs the risk of the shipment being refused, as insurance would typically not pay out.

Cash against goods, shipment into bonded warehouse

Goods are released to an exporter’s agent in the importing country. The importer can take “just-in-time” delivery by paying cash.

Variations of Documentary CollectionsVariations of Documentary Collections

Document against Acceptance/Term Drafts:

An exporter may decide to release shipping documents to a buyer on acceptance of the exporter’s drafts. In this case, the importer is under an obligation to pay at a future date. This method satisfies both parties since the importer is able to receive the goods before payment and the exporter has a firm assurance that payment will come at a future date.

It only works for importers with a good credit risk and low country risk. It may be a good alternative for sales to countries where the legal framework does not allow the exporter to retain effective title to goods, or to obtain an effective security interest in accounts receivable. In such countries, drafts may make it possible to instigate legal collection proceedings.

Insurance is available and term drafts can also (particularly with the aval of the importer’s bank) be sold on the secondary market.

Risks in Documentary Collections Risks in Documentary Collections

• To the ExporterTo the ExporterIf it is a sight draft, the exporter will reduce the risk of non-payment but will not eliminate it totally since the importer may not be in a position to pay for the goods or may not be able to procure sufficient foreign exchange to make the payment. In this case the exporter may be forced to either call back the goods or negotiate sale to some other interested party, may be at a reduced rate. In the case of term draft, the risk to the exporter is higher since the foreign buyer will take possession of the goods and may not pay at due date, forcing the exporter to try and collect payment from the foreign buyer in the foreign buyer's home country.

• To the ImporterTo the ImporterThe importer faces the risk of paying for goods of sub-standard quality or even with shortages. In such a circumstance, it would take some time to get refunds from the exporter. It could also happen that the exporter refuses to make refunds, leading the importer to lengthy legal proceedings.

When can Documentary Collections be used?When can Documentary Collections be used?

Since Documentary Credit transactions entail some measure of differed payment it advisable to use only when the following conditions apply:

when the exporter and importer have a well established relationship

when there is little or no threat of a total loss resulting from the buyer’s inability or refusal to pay

when the foreign political and economic situation is stable and when a letter of credit is too expensive or not allowed.

Some governments do not allow their exporters to sell under documentary collection terms.

D.D. Documentary CreditsDocumentary Credits

A documentary credit is a written undertaking from a bank to pay a certain sum (or to accept payment to negotiate it or to authorize another bank to do so) on instructions from the importer (the Applicant) to the exporter (the Beneficiary) within a prescribed time limit, provided that the exporter submits the required documents, and the terms and conditions of the letter of credit are strictly complied with. Documentary credits are also known as Letters of Credit (L/Cs).

Trade transactions on the basis of L/Cs are governed by Uniform Customs Practice (UCP) for documentary credits established by the International Chamber of Commerce (ICC). Letters of credit are typically issued and advised via tested telex, with shipment taking place within 90 days of the issue date. Certain circumstances may also demand that an L/C’s life be extended. This is also effected via tested telex without altering other terms of the transaction.

Documentary credit is for an exporter the next best thing after Payment in Advance. Compared to other payment forms, a bank’s role is substantial.

DCs are one of the most widely used methods of settlement for international trade transactions because the security they offer is well balanced between the two commercial parties.

How does a L/C work?

A commercial agreement proceeds the initiation of the L/C process. The seller agrees to deliver certain goods on certain conditions to a buyer. The buyer agrees to pay for these goods under a L/C, and negotiates with the seller what documents the seller should deliver in order to obtain payment under the L/C (although much international commodity trade is under standard contract which spell out many of the documents required under the contract, many buyers prefer to make certain amendments). The list of documents they agree on become the documentary conditions in the L/C.

The first step in the L/C process is taken by the buyer who applies to his bank (the Issuing Bank) to open a letter of credit in favour of a beneficiary (the seller), that is, to issue a letter of credit to the seller undertaking either payment of the contract price or payment, or acceptance or negotiation of a bill of exchange drawn for the contract price. The buyer at this stage is required to complete the bank’s standard form of application to open a credit.

The Issuing Bank then contacts a bank in the exporter’s country, to open the L/C. This bank (the Advising Bank) then informs the exporter that the L/C has actually been opened.

The exporter exports and sends the documents (together with a draft demanding payment) which, presumably conform to the list as spelled out in the L/C, to a bank which was appointed the Negotiating Bank (it can be the advising bank). The Negotiating Bank checks the documents, and if they conform (and assuming it has not confirmed the L/C), sends them to the issuing bank for payment. Payment is then made by the Issuing Bank.

The next page shows a flow chart.

Issuing Bank

Negotiating Bank

Exporter(Beneficiary)

Importer(Applicant)

Advising Bank

1.

7.

5.

3.

4.

2.

6.

Sales contract agreement (specifyingquantity, payment terms and documents)

Request to open L/C by completing application form specifying terms and conditions of the transaction

Opens L/C and forwards details for delivery to exporter

Advises L/C (validates authenticity of L/C, checks its workability and completeness from a bank perspective, and forwards details to exporter)

After examining documents and clearing up any discrepancies, Negotiating bank presents documents to Issuing bank for payment

Checks documents and pays Negotiating Bank and forwards documents for importer to claim the goods

Adv

isin

g B

ank

can

also

act a

s N

egot

iatin

g B

ank

Letter of Credit Flow Chart

Presents L/C and require documents for settlement once shipment of goods is arranged

Role of Banks in Documentary CreditsRole of Banks in Documentary Credits• The banks provide additional security for both parties in a trade transaction by playing the role of intermediaries. The issuing bank working for the importer and the advising bank working for the exporter.

• The banks assure the seller that he would be paid if he provides the necessary documents to the issuing bank through the advising bank.

• On the other hand, the banks also assure the buyer that his money would not be released unless the shipping documents evidencing proper and accurate shipment of goods are presented.

• On the basis of these roles, it can be said that banks are the beacon which guide parties in an international trade transaction, without which, pitfalls would abound.

• But: banks pay on the basis of documents. If the L/C is irrevocable, then this is an irrevocable obligation. If proper documents are presented, the bank must pay. Suspicion of fraud does not absolve the bank from its payment obligation. Such refusal is only accepted if it is proved to the satisfaction of the bank that the documents tendered are fraudulent and the seller is a party to the fraud or knew of it. This would normally expose the buyer rather than the bank. But if the buyer

and seller are colluding, the bank would be the victim. Click here for more.

Seller Buyer1. Contract

2. Request to open L/C

Bank

6. Presents documents

4. Advises on valid character

L/C8. Documents

Bank7. Documents

3. Forwarding of L/C to exporter’s bank

5. Goods

L/Cs depend on bank country credit lines

Banks are selective in confirming L/Cs. There is significant counterparty risk between the buyer’s bank and the seller’s bank. The buyer requests the bank to open an L/C in favor of the seller. To do so, this bank must find another bank in the seller’s country to work with. The seller’s bank has to advise the seller whether or not the L/C is acceptable. The seller may insist the bank confirm the L/C. If the seller’s bank confirms the L/C, then on presentation of the documents by the seller, it will make the agreed payment. And then the bank has to wait for the buyer’s bank to pay against the documents with all the risk that this brings.

SellerBuyer1. Contract

2. R

eque

st to

op

en L

/C

Seller’s bank

8a. Goods

6. Silent confirmation

on L/C

10a.

Doc

umen

ts

Buyer’s bank

L/Cs depend on bank country credit lines - which may be unstable

For a bank to confirm the L/C of another bank, it must have an open line of credit with the other bank. This in turn has two elements: its willingness to take exposure towards the country in which the other bank is based (it needs to position itself against such exposure so it comes at a cost), and its willingness to take (more) exposure towards the bank itself. If it has no credit line or its credit line is full, it needs to pass through a third bank or more (as a result, actual payments often appear as outlined below). This results in higher costs for the buyer and seller, and makes the L/C based payment system vulnerable to shocks. Country credit lines can be cut from one day to the other making it difficult for importers to open new letters of credit, even if they wish to import raw materials for later export.

Reimbursing bank

Advising bank 2

Negotiating bank

Freight forwarder

7. L/C & goods

8b. L

/C &

do

cum

ents

12. Payment

9b. Reimbursement claim

11. Reimbursement

13. Payment

5. L/C

10b. Reimbursement Authorization

3. L/C

9a. Documents

Advising bank 14. L/C

Documentary credits are based on documents, not on the goodsDocumentary credits are based on documents, not on the goods

Banks which issue L/Cs operate under the doctrine of strict compliance. Under this doctrine, the seller, to obtain payment, must tender documents which strictly comply with specifications by the buys, otherwise the correspondent bank will refuse to honour the credit. The banks which operate the L/C should not pay against documents that are different from those specified. If they do pay on non-compliant documents, they can be held liable for any resultant losses. For example, if a L/C specifies that payment can be made only if, inter alia, the documents contain a certification of experts that the goods are conform contract, and this certificate is only by one individual expert, the bank should not pay.

Thus, L/Cs hinge on the appropriateness of documents. Banks involved in the transaction do not need to know about the physical state of the goods in question but concern themselves only with documents. If proper documents are presented, banks will make payment whether or not the actual goods shipped comply with the sales contract. If documents are not conform, even in a minor way, banks should not pay.

Click here for adescription of thevarious types ofletters of credit

Thus, exporters need to take special care in preparing the documents since a slight omission or discrepancy between required and actual documents may cause additional costs, delays, seizures or even total abortion of the entire deal (because within the period of the L/C, there may not be enough time to correct the error).

Problems may result from improper documents

L/Cs are expensive and in the majority of cases, documents presented under L/Cs do not conform to the requirements spelled out in the L/C.

Nevertheless, even though most documents under L/Cs do not conform, very few sets of documents, not even a fraction of a percent, are actually refused – problems are normally solved by the bank in discussion with the seller.

What happens when discrepancies are found between documents and L/C requirements?

1. The negotiating bank contacts the exporter (the beneficiary) to explain the discrepancies and gives the exporter a chance to correct the documents, insofar as possible.

2. If discrepancies cannot be corrected, the negotiating banks informs the issuing bank with a list of the discrepancies and a request for permission to pay.

3. The issuing bank will contact the buyer and ask his permission to pay despite discrepancies.

4. Once the buyer has given a waiver, the issuing bank informs the negotiating bank, thus giving it permission to pay.

This process may take up to two weeks.

This method of dealing with improper documents is expensive…..

Given the prevalence of non-conforming documents, it is expensive and time-consuming for banks to communicate among themselves and with their clients on every little detail. Nevertheless, under the doctrine of strict compliance for L/Cs, banks would be liable for any payments made if there is even a relatively small discrepancy.

A solution to this conundrum can be for a buyer’s bank (the Issuing Bank) to sign a Master Agreement with its client under which the importer agrees to reimburse the bank for all payments made against the documents as long as certain (listed) discrepancies did not appear. These discrepancies are negotiated between the bank and the importer – they would include an overdrawn L/C, an expired L/C and other discrepancies as listed by the importer.

This makes it much easier for the issuing bank to give permission to pay to the negotiating bank. It releases the issuing bank from checking the documents in detail and contacting the importer to ask for waivers for each discrepancy. It reduces cost of the L/Cs considerably and diminishes the burden on the importer to give individual waivers under most of its L/Cs.

The Negotiating Bank could sign a similar agreement with its client (the exporter), under which the exporter guarantees the bank that it will reimburse it for any payments made if the issuing bank refuses the documents (this is called a “shipper’s indemnity and is covered under UCP 14(f) – the issuing bank is given 7 banking days to check and, eventually, refuse the documents; faster than would normally be the case when discrepancies are found). Click here for suggested wording on such a shipper’s indemnity.

But still, be careful with improper documents

Documents presented under L/Cs may not conform to the requirements spelled out in the L/C for various reasons:

• The complexity of much documentation and international trade.

• In some countries, legal and regulatory requirements are such that sellers are virtually unable to provide all the documents that their buyers require by law (e.g. certification that the ship transporting the goods does not stop in ports of

“blacklisted” countries).

• It could be deliberate, because banks and buyers can benefit from ambiguities in documentary requirements.

For banks, ambiguities lead to L/Cs being open longer, funds being blocked at the bank, etc., which add to its income (during the time that discrepancies are being resolved, the money can be used by the bank).

For buyers, ambiguity improves their bargaining power: if the seller does not provide the proper documents, only the buyer can approve payment by the bank - and may do so only if the seller agrees to a discount on the originally negotiated price. Documents under L/Cs are typically rejected more often in times of falling prices than in times of stable or rising prices.

One example of how one can build in a deliberate ambiguity: say the L/C requires an “original document in triplicate”. This can be interpreted to mean three original documents, one with two copies or one with three copies.

Revolving L/Cs can reduce potential documentary problems

If buyers and sellers want to have an easy L/C process without bank-caused problems, it is advisable to open an L/C and then not draw on it in its entirety (e.g., leaving 1,000 US$ unutilized). The bank will screen the documents and once the seller really knows what is needed, the buyer can extend the L/C and increase its amount to cover a next transaction. In which the L/C is also not drawn completely, so that it can be revolved again.

The costs of L/Cs

Most L/Cs call for splitting the related fees. The importer and exporter both pay for all fees in their own country. Exporters simply build these costs into their pricing.

Stand-by L/Cs as payment instrument

Stand-by L/Cs are meant to function as guarantees – e.g., they accompany a bid on a tender and if the bidder wins the tender but later fails to perform, the tender agency can call on the stand-by L/C as compensation.

However, stand-by L/Cs are increasingly being used as a payment instrument, primarily for repeated transactions between a buyer and seller. The volume of stand-by L/Cs has in effect, already overtaken that of documentary L/Cs.

Stand-by L/Cs are cheaper than documentary L/Cs and are much easier and faster to initiate. They are particularly attractive for sales to large, well-known firms (the risk that they will fraudulently call on the L/C is very small). They act as an umbrella for direct relations between a buyer and a seller: documents are sent directly to the buyer; the exporter ships on receiving a seller’s order; and the seller directly bills the buyer. If there is non-payment, the L/C comes into play.

The stand-by L/C can be revolving (even evergreen – that is, automatically revolving), and transferable.

Some countries, particularly in the Middle East, do no permit the use of standby LCs.

Stand-by L/Cs remain risky for a buyer, as the seller can easily call on them. Abuses have occurred, as they are part of the arsenal of tools used by international trade fraudsters.

Letter of credit summaryLetter of credit summary

Provides exporter the greatest degree of safety when extending credit Useful when importer is not well known Useful when exchange restrictions exist or are possible But, care is required in their use.

Online resources

The Food and Agriculture Organization (FAO) of the United Nations has published a guide entitled Global Agricultural Marketing Management. (Marketing and Agribusiness texts - 3) (1997) which is available on-line, and which includes an extensive chapter on “Global Marketing, Logistics - Access And Documentation”. This chapter describes the documents used in international trade in detail and introduces primary payment and financing mechanisms.