Why use a Letter of Credit in International Trade Transactions

WHY USE A LETTER OF CREDIT IN INTERNATIONAL TRADE TRANSACTIONS

international trade

Premise: A Seller (Exporter) is contemplating selling to an unknown Buyer (Importer) in another country.

A) SELLER'S CONCERN

The following are some key concerns of a Seller regarding selling goods to a Buyer in a foreign country:

Contract risk: Having a well-crafted sales agreement with proper terms of sale and payment.
Production risk: What if the buyer cancels the order?
Legal risk: What are the foreign laws and jurisdiction in case of disputes and/or defaults?
Currency Risk: Doing business in hard currency. i.e. currency widely accepted around the world as a form of payment for goods and services.
Export regulations.
Risk of misunderstanding: Using terms of sale and payment terms that has common interpretation in the buyer’s and seller’s countries.
Title Retention: Risk of losing title to goods in a foreign country.
Insolvency risk: What if the buyer goes bankrupt? Knowing the credit worthiness of the buyer.
Control on logistics of shipping the goods.
Control on transfer of risk from seller to buyer during transit of goods.
Risk of non-acceptance: Goods may not be accepted by the buyer upon arrival in buyer’s country.
Payment Risk: Payment may not be made on time or as per terms of the sale.
Country Risk: The risk factors associated with the country of import: Geographical, Economic and Political.
Financing: Opportunity of getting financed for the job.

B) BUYER'S CONCERN

The following are some key concerns of a Buyer regarding buying goods from a Seller in another country:

Contract risk: Having a well-crafted sales agreement with proper terms of sale and payment. Accurate description of goods; pricing; invoicing; origin etc.
Import Regulations.
If pre-paid, what if the seller takes the money and does not ship?
What if the seller sends substandard goods or goods not as per description in the contract?
Legal risk: Knowing the local laws and jurisdiction in case of disputes and/or defaults.
Risk of misunderstanding: Using terms of sale and payment terms that has common interpretation in the buyer’s and seller’s countries.
Control on the timing for shipment of goods.
Control on logistics of shipping the goods.
Control on transfer of risk from buyer to seller during transit of goods.
Negotiating credit terms from the seller for payment: Net 30, Net 60 etc.

A Letter of credit (LC, LoC, L/C) makes it possible to do business globally since it largely meets the aspirations and the above-listed concerns of buyers and sellers that engage in cross-border trade.

Upon the instructions of a buyer, a bank issues a letters of credit in a way to ensure a seller that payment will be made as long as the seller complies with conditions agreed upon, solely by submitting the required documents within a strict time frame stated in the LC. The Buyer is the Applicant or the Account Party of the Letter of Credit and the Seller is the Beneficiary or the recipient of funds. In between the Applicant and the Beneficiary stands the Bank that replaces the risk of the buyer who in turn undertakes to pay the beneficiary (seller) when conditions stipulated in its issued letter of credit are met by the seller. Once issued, this undertaking is binding even if the buyer goes bankrupt.

At the very outset it should be noted that LCs deal in documents. In order to make payment, the bank that issues the letter of credit scrutinizes the 'documents', that are submitted by the beneficiary (the seller), for compliance and not the physical 'goods' that the seller is selling . The technical term for Letter of credit is therefore 'Documentary Credit' (since the pact is mainly about submission and scrutiny of documents).

The LC process favours both the buyer and the seller. The instrument is designed to reduce the risk taken by each party. The Seller gets assured that if documents are presented on time and in the way that they have been requested in the LC, payment will be made by the bank. On the other hand the Buyer is assured that the bank will thoroughly examine the presented documents and make sure that they meet the terms and conditions stipulated in the LC that the buyer had applied for before releasing payment to the seller. The LC process is regulated by standard international rules that the banks follow.