You want a Letter of Credit, Really? Part 2

The last post talked about why corporations still use Commercial Letters of Credit.  Relating to the themes of risk mitigation, finance, and payment & settlement, the L/C process is as follows:

Risk Mitigation

Because the L/C is a Credit instrument, the process to open an L/C is intensive.  The Buyer advances money to the buyer's bank in the form of a reduction in credit line, or collateral, or cash, in order to initiate the transaction, prior to the acceptance of the order by the seller.  In essence, the Corporate is substituting the Banks Credit in place of its own – this is RISK MITIGATION!

Finance

At any time, the seller can use this Letter of Credit to get financing in the form of Pre Shipment finance. There is also Post Shipment finance once the Seller ships (which can occur for the Buyer (his bank pays, but extends him terms) or the Seller (his Bank provides him financing and then collects from the Bank).

Payment and Settlement

  1.  The buyer controls the logistics process that documents shipment, and therefore controls timing of payment for a pre-agreed amount.
  2. The buyer's bank controls document administration through a domestically domiciled bank according to agreed rules in the L/C-usually UCP 600 or eUCP.
  3. Both the buyer and seller control change procedures through amendments to the original L/C, although buyer can waive reconciliation procedures upon Shipment if there are mistakes in documentation (eg. Wrong goods description, different weight measures, etc.)   Remember, banks deal in the documents, not the goods.  They don’t know whats in the crates or containers, all they know is what the paperwork says is in them.
  4. When sellers ship, they draw on the original L/C, up to and including the full amount.
  5. Letter of credit payment takes place before the transaction for the buyer, and after the transaction for the seller (typically 20-30 days-anecdotal evidence.)

 

Its time and document intensive, even in this Internet age.  And because of increased regulations, there can be even more delays ensuring goods shipped are in compliance with export controls or counterparties are not on some money laundering or terrorist list.

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