When the buyer and seller are in different countries, trust alone is not always enough. A letter of credit allows a bank to act as an intermediary in the transaction and makes payment contingent upon the exact presentation of the agreed-upon documents.
Selling or buying goods in another country involves risks that do not always arise in
a domestic transaction. Distance, legal differences, transportation, and the difficulty
of collecting a debt abroad can turn a profitable transaction into a collection problem.
A documentary credit (also known as a letter of credit) is one of the most widely
used instruments for enhancing security in international trade.
It operates on a simple principle: the bank agrees to make payment when the
exporter submits, within the specified timeframe and under the established
conditions, the documentation required by the credit itself. It does not, on its own,
guarantee that the goods are flawless. What it does guarantee is that payment will
be made if the documents submitted strictly comply with the terms agreed upon.
What is a letter of credit?
A letter of credit is a payment order issued by the importer’s bank in favor of the
exporter. The importer asks his or her financial institution to open the letter of credit
and specify the conditions that the foreign supplier must meet. The bank will notify
the exporter of the transaction, usually through an institution located in the
exporter’s country. Once the goods have been shipped, the exporter submits the
required documents. If they are complete and contain no discrepancies, the bank
will proceed with payment according to the agreed terms.
The bank thus plays a central role. The exporter is not solely dependent on the
importer’s willingness to pay, and the importer knows that payment will only be
made if the correct shipment is documented.
How does the transaction work?
The first step is for the buyer and seller to agree on the terms of the international
sale. They must establish the price, the goods, the payment terms, transportation,
the place of delivery, insurance, and the documents required to prove compliance.
Next, the importer asks its bank to open a letter of credit in favor of the exporter. The
bank assesses the risk of the transaction and, if it approves it, issues the letter of
credit. A bank in the exporter’s country notifies the beneficiary of the letter of credit’s
issuance and its terms.
The exporter reviews the terms and, if they match what was negotiated, proceeds to
ship the goods. The exporter then submits the required documentation to their bank.
If the documents are in order, payment is processed and the documents are
forwarded to the importer’s bank so that the importer can take possession of the
goods.
The documentation determines the collection
In this type of transaction, documentation is not merely an administrative formality. It
is the key to receiving payment. Among the most common documents are the
commercial invoice, the bill of lading, the packing list, the certificate of origin, the
insurance policy, health certificates, and inspection documents.
The credit must specify precisely which documents are required, who must issue
them, what information they must contain, and by what deadline they must be
submitted.
An incorrect date, a description that does not match the text exactly, or a missing
signature can result in a documentary discrepancy and delay or prevent payment.
Physical Inspection Protects the Importer
The bank verifies the documents but does not open containers or check the actual
quality of the goods. For this reason, the importer may include among the
requirements a physical inspection certificate issued prior to shipment. The
inspection may be conducted by the buyer, a trusted individual, or an independent
specialized company.
This certificate verifies aspects such as the quantity, condition, quality, packaging,
and technical characteristics of the product.
For high-value transactions or those involving sensitive goods, including a pre-
shipment inspection can prevent problems that are difficult to resolve once the
shipment has already arrived in the destination country.
Revocable and Irrevocable Letters of Credit
A revocable letter of credit can be modified or canceled prior to payment without the
beneficiary’s consent. This type of letter of credit offers very little security to the
exporter and, in practice, is used only to a limited extent.
In contrast, an irrevocable letter of credit cannot be canceled or modified unilaterally
once issued. Any changes require the consent of the affected parties.
For this reason, the irrevocable letter of credit is the standard option when the goal
is to provide the foreign supplier with a real guarantee of payment.
Confirmed and Unconfirmed Letters of Credit
In an unconfirmed letter of credit, the primary payment obligation rests with the
issuing bank, which is typically the importer’s bank. The advising bank notifies the
exporter of the opening and may handle the processing of the documents but does
not necessarily provide its own payment guarantee.
In a confirmed letter of credit, another bank adds its commitment to that of the
issuing bank.
This confirmation can be particularly advantageous when there are doubts about the
issuing bank’s solvency, the stability of the buyer’s country, or the ability to transfer
funds abroad.
Payment at Sight or Deferred Payment
In a sight letter of credit, the exporter receives payment once they present compliant
documents and the bank completes its review. In a deferred payment letter of credit,
payment is made later. The due date can be calculated from the date of shipment,
the presentation of documents, or any other agreed-upon time.
This second type allows the importer to obtain a period of trade financing, while the
exporter can explore the possibility of receiving payment in advance through their
financial institution.
Divisible Credits and Open Lines of Credit
A divisible credit allows for partial drawings as different shipments are made. This
option is useful when goods are delivered in batches or on a staggered basis.
Revolving credits or open lines of credit can also be established, which are renewed
within a specified limit and for a set period.
These structures facilitate ongoing commercial relationships, although they require
rigorous monitoring of the amounts drawn, due dates, and documentation
corresponding to each shipment.
Transferable credits and transactions with intermediaries
A transferable credit allows the initial beneficiary to request that all or part of the
credit amount be made available to another beneficiary. It is typically used when the
exporter acts as an intermediary and needs to pay one or more suppliers. For this
option to be available, the credit must expressly provide for it. It is not sufficient for
the parties to have discussed it informally.
Another structure used by intermediaries is the back-to-back credit. In this
arrangement, the beneficiary of an initial credit uses that backing to open a second
credit in favor of their supplier.
Advance-Payment Credits and Revolving Credits
Some credits allow the exporter to receive a portion of the funds before submitting
all the documentation. In credits with a “red clause,” the advance payment may be
made against a receipt or a specific guarantee. When there is a “green clause,” the
beneficiary must also provide proof of the availability or storage of the goods.
Revolving credits allow the amount to be reused over a period, in accordance with
the established terms. They are common in recurring business relationships
involving multiple similar shipments.
For more information, please contact our tax advisory service.
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