Methods of Payment in International Trade: Letters of Credit

How are you going to get paid for your exports? Relying on cash up front might eliminate the risk of non-payment, but it limits your universe of potential customers. There are five primary methods of payment in international trade. This video explains letters of credit. Watch our other videos to learn about the other payment options.

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The most secure method of payment for the exporter is the least secure method for the importer, and vice versa. The key is striking the right balance for both sides. Let’s take a look at letters of credit.

What Is a Letter of Credit?

Letters of credit, or LCs, are one of the most secure instruments available to international traders. An LC is a commitment by a bank, on behalf of the importer, that the exporter will be paid if the terms and conditions stated in the LC are met. Specific documents are used as evidence.

An LC, also referred to as a documentary credit, is useful when a foreign buyer’s credit is hard to prove or unacceptable, but the exporter is satisfied with the creditworthiness of the importer's bank. The importer is also protected since the documents required to trigger payment provide evidence that goods were shipped as agreed.

LCs should be prepared by trained professionals because discrepant documents, literally not having an "i dotted and t crossed," may negate the bank's payment obligation.

It’s important to note that the banks do not deal with the quality of the goods, or if each party fulfills the sales contract. LCs can be arranged for one-time transactions or used for a series of transactions.

Unless otherwise stated, the LC may not be changed or canceled unless the importer, banks and exporter agree.

Confirmed Letters of Credit

The exporter gets even more protection when an LC is confirmed by a U.S. bank. Confirmation means that the U.S. bank adds its engagement to pay the exporter to that of the foreign bank. If unconfirmed, the exporter is subject to the payment risk of the foreign bank and the political risk of the importing country.

Consider a confirmed LCs when operating in high-risk markets where political upheaval, economic collapse, devaluation or exchange controls could put payment at risk, or when importers ask for extended payment terms.

How to Use Letters of Credit

These are the seven steps to getting paid with a letter of credit:
—The importer arranges for the issuing bank to open an LC in favor of the exporter.
—The issuing bank transmits the LC to the nominated bank, which forwards it to the exporter.
—The exporter forwards the goods and documents to a freight forwarder.
—The freight forwarder dispatches the goods and either the dispatcher or the exporter submits documents to the nominated bank.
—The nominated bank checks documents for compliance with the LC and collects payments from the issuing bank for the exporter.
—The importer's account at the issuing bank is debited.
—The issuing bank releases documents to the importer to claim the goods from the carrier and to clear them at customs.

Special Letters of Credit

There are a few different forms of letters of credit to be aware of:

Transferrable
When an LC is made transferable, the payment obligation under the original LC can be transferred to one or more second beneficiaries.

Revolving
With a revolving LC, the issuing bank restores the credit to its original amount each time it is drawn down.

Standby
A standby LC is not intended to serve as payment, but it can be drawn if an importer fails to pay invoices when due or a contract goes into default. They’re often posted by exporters in favor of an importer because they can serve as bid bonds, performance bonds, and advance payment guarantees. Standby LCs are also used as counter guarantees against the provision of down payments and progress payments on the part of foreign buyers.

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Chapters
00:00 Introduction
01:00 What Is a Letter of Credit?
02:05 Confirmed Letters of Credit
02:42 How to Use Letters of Credit
03:36 Special Letters of Credit
03:37 Transferrable LC
03:46 Revolving LC
03:54 Standby LC

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