How a Letter of Credit Works

May 12, 2012 by  Filed under: Credit 

Letters of credit are mainly used for large transactions between customers in one country and suppliers in another. Because of the nature of international trade, the specifics of different transactions, and factors such as national legislation, distance, and difficulty knowing all trade partners personally, letters of credit have become an important tool for carrying out commercial transactions. The main characteristics of this type of financial instrument are revocability, negotiability, sight and time drafts, and transfer and assignments. Letters of credit are also used for public facilities such as water ponds, sidewalks, and streets, ensuring that they will be built. Letters of credit are usually irrevocable meaning that they cannot be cancelled or amended without the consent of the confirming bank, the issuing bank, or the beneficiary.

To receive the payment, the shipper or exporter must present certain documents. These include financial documents such as co-accepted draft and bill of exchange, which is a negotiable instrument guaranteeing payment at a set time or on demand. Commercial documents to be presented include an invoice and a packing list, also known as delivery docket, packaging slip, and unpacking note. The packing list serves to inform customers, government authorities, transport agencies, and other parties about the contents of a package. Shipping documents that can be presented include legal, commercial, or official documents, insurance certificates, and transport documents. An air consignment note, AWB, or air waybill is a receipt issued by international airline carriers in evidence of a contract and for goods shipped. The air consignment note may be used as an invoice or bill along with supporting documentation, which indicates charges due to the airline carrier or agent and expenses to be covered by the consignee. Air waybills show the carrier’s logo, name, head office address, and the bill’s eleven digit number.

Referred to as a B/L and BOL, a bill of landing is a transport document to be presented by the shipper or exporter. It can be issued by a carrier and involves the use of different modes of transport – sea, air, road, and rail. Transport documents are also the forwarder cargo receipt, other than mate receipt, and railway receipt.

Official documents also include origin certificates, embassy legalization, licences, and inspection certificates. Finally, insurance documents that can be presented include certificates and insurance policies.

There are different international payment methods, including direct payment, documentary collection, documentary credit, and advance payment. Direct payment is a payment method that is secure for the buyer while documentary collection is secure for the buyer and seller. Documentary credit and advance payment are more secure for the seller.

It should be noted that letter of credit transactions involve certain risks, including legal risks, regulatory and sovereign risks, and fraud risks. Risks to the applicant include late or early shipment, inferior quality, non-delivery of goods, and more. Goods may be damaged in transit or short-shipped. It is important that sellers review the requirements and present all documents on time.

J.P. Stevenson writes for Canada banks – an informational financial site. For more information click here.

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