Letters of credit are documents that guarantee payment from a bank. Letters of credit are often used in trading businesses, and they provide security for the buyer and seller. Because international transactions have entrepreneurs face risks internationally, the letter should point out ways in which banks reduce risks.
What international trade is all about
Due to globalization, even local companies are required to enter into relationships with multinational firms. In the direct or indirect links may be: competition with foreign entities, manufacturing of products according to international standards, and utilization of technological and management solutions developed and utilized by foreign entities. There are two ways to look at foreign trade: narrow and broad. When considered narrowly, foreign trade is concerned with material goods. The broad sense of the term includes, for instance, assets and credit turnovers, purchases of tangible and intangible goods.
What are the risks?
Different risks accompany the conclusion of foreign trade agreements. These include:
- Risk of loss of goods
- Currency risk
- Payment risk
- Risk of product destruction
- Contractual risk
- Commercial risk
As international trade grows in importance, a need for secure financing methods has emerged. Business loans can be secured by documentary letters of credit, which are clearing instruments. In 2007, the International Chamber of Commerce in Paris issued UCP 600, a standard that regulates it.
Types of letter of credit
Starting with the four most common letters of credits, here are the types:
Once it’s been issued, you can’t amend or change an irrevocable letter of credit without each party’s consent.
· Red claused
When a seller needs to raise money from the letter, for example, to purchase raw materials for a building contract, this clause can be very beneficial. It is called red claused due to the available amount being printed on the document in red ink.
Letters of credit of this type allow the seller to purchase goods from third parties that are needed to fulfill the contract. A building contract might require steel, concrete, and brinks, for example. The seller can use this method to raise funds by guaranteeing the payment to the third-party supplier when they may not have the funds to purchase the goods necessary to complete the contract.
Due to political or financial unrest in the buyer’s country, the seller may be afraid the buyers’ bank will not honor the letter. Therefore it gets confirmed by a second bank which is the seller’s bank. When confirming the payment, the confirming bank becomes the primary payer and asks the buyer’s bank for reimbursement. It is a little complicated at first, but when we dive into the details, it will become clear.
How to get it
Get in touch with your bank if you would like a letter of credit. A trade department or a commercial division will most likely be of assistance to you. Letters of credit are not available from every bank or credit union, but you can often find someone who can help you.
Advantages and disadvantages
Considering both the benefits and disadvantages of a letter of credit settlement, we can determine if it is viable to settle transactions through a letter of credit. Here we have mentioned all the effects on each participant:
The agreement stipulates that only the documents specified in the agreement will be paid. Also, the bank verifies the exporter’s documents. In addition, Delivery at the specified time with confidence is guaranteed.
A set amount of cash will be held for a specific time period. Also the costs of this letter is high and all a burdonsome for the importer. Uncertainty exists as to whether the exporter will fulfil its contractual obligations.
Guarantee of payment upon compliance with contract terms is one of the advantages that exporters have here. Getting paid early (discounting termination fee) is another advantage in addition to being able to pay his contractors with a letter of credit.
It can be challenging for the exporter to make payments. Time constraints make it difficult and frustrating to complete documents on time.