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Trade Finance : Letter of credit

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Letter of Credit
Risk and operations

Published in: Economy & Finance
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Trade Finance : Letter of credit

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  2. 2. Table of contents  Origin of LC  Definition of LC  Elements in LCs  Importance of LCs  Terms commonly used in LCs  Legal principles  Types of LCs  Risks in import LCs  Documents in LCs  Common defects in documents 2
  3. 3. Letter of Credit - Origin  The name "letter of credit" came from the French word "accréditation", a power to do something  Origin is from Latin "accreditivus", meaning trust.
  4. 4. Letter of Credit - Definition  A letter from a bank guaranteeing that a buyer's payment to a seller will be received on time and for the correct amount.  The bank will make full or part of the purchase price (shortfall) in case the buyer defaults to make payment.  In today’s competitive world banks face increasing competition.
  5. 5. Letter of Credit - Definition  ICC in the Uniform Custom and Practice for Documentary Credit (UCPDC) defines L/C as:  "An arrangement, however named or described, whereby a bank (the Issuing bank) acting at the request and on the instructions of a customer (the Applicant) or on its own behalf :  Is to make a payment to or to the order third party ( the beneficiary ) or is to accept bills of exchange (drafts) drawn by the beneficiary.
  6. 6. Letter of Credit - Definition  Authorized another bank to effect such payments or to accept and pay such bills of exchange (draft).  Authorized another bank to negotiate against stipulated documents provided that the terms are complied with.
  7. 7. Letter of Credit - Elements  A payment undertaking given by a bank  On behalf of a buyer  To pay a seller for a given amount of money  On presentation of specified documents representing the supply of goods / services  Within specified time limits  Documents must conform to terms and conditions set out in the letter of credit  Documents to be presented at a specified place
  8. 8. Why Letters of Credit are important  Nature of international dealings.  Distance between seller and buyer.  Differing laws of various countries.  Difficulty to know each party personally.  To break the deadlock between the buyer and seller.
  9. 9. Terms commonly used in LCs  Sight LC - requires payment to be made immediately to the beneficiary upon presentation of the correct documents.  Time or date LC - specifies when payment is to be made at a future date.  Negotiation - giving of value for draft(s) or document(s) by the bank authorized to negotiate, with the nominated bank.
  10. 10. Terms commonly used in LCs  Presentation – Submission of documents against LC or the document itself  Complying presentation – When the presentation is as per the  terms and conditions of credit  applicable provisions of UCP  international standard banking practice  Confirmation— a definite undertaking from the confirming bank to honor or negotiate a complying presentation in addition to that of the issuing bank.
  11. 11. Terms commonly used in LCs  Letter of Credit— an irrevocable commitment of the issuing bank to honor a complying presentation  Honor - to act according to commitment of the LC. Based on type of facility presentations are honored in various ways  making payment at sight for sight LC  paying at maturity for deferred payment LC.  accepting a Draft drawn by the beneficiary and paying at maturity for deferred acceptance LC
  12. 12. Legal principles - LCs  Payment obligation is independent from the underlying contract of sale or any other contract in the transaction {article 4(a) of UCP}.  Banks deal with documents only - not concerned with the goods (article 5 of the UCP).
  13. 13. Legal principles - LCs  The “principle of strict compliance” to be applied. Hence, if the documents tendered under the credit deviate from the language of the credit the bank is entitled to withhold payment.  General legal maxim de minimis non curat lex is not applicable in this field. De minimis is a Latin expression meaning about minimal things.
  14. 14. Types of LCs  There are broadly two types:  Commercial Letter of Credit  primary payment mechanism  Standby Letter of Credit  secondary payment mechanism
  15. 15. Types of LCs  Standby Letter of Credit assures the beneficiary of the performance of the customer's obligation.  The beneficiary is able to draw under the credit by presenting evidence that the customer has not performed its obligation.  The bank is obligated to make payment if the documents presented comply with the terms of the letter of credit.  Standby letters of credit are issued by banks to stand behind monetary obligations.
  16. 16. Types of LCs  Import/Export LC – Same LC is import LC for importer and export LC for exporter.  Revocable—The buyer and the bank are able to manipulate the LC or make corrections without informing from the seller. According to UCP 600, all LCs are Irrevocable.  Irrevocable—Any amendments or cancellation of the LC is done by the applicant through the issuing Bank. It must be authenticated and approved by the beneficiary.
  17. 17. Types of LCs  Confirmed—An LC is said to be confirmed when a second bank adds its confirmation to honor a complying presentation at the authorization of the issuing bank.  Unconfirmed—Does not require the other bank's confirmation.
  18. 18. Types of LCs  Transferrable—The exporter has the right to make the credit available to one or more subsequent beneficiaries.  Untransferable—A credit that seller cannot assign all or part of to another party.
  19. 19. Types of LCs  Deferred / Usance— A credit that is not paid/assigned immediately after presentation, but after an indicated period that is accepted by both buyer and seller.  At Sight—A credit that the issuing bank immediately pays after inspecting the carriage documents from the seller.  Red clause - L/C that carries a provision which allows a seller to draw up to a fixed sum from the paying bank in advance of the shipment or before presenting the prescribed documents.
  20. 20. Types of LCs  Back to Back—A pair of LCs in which one is to the benefit of a seller who is an agent. In that event, a second credit is opened for another seller to provide the desired goods. Generally this is used by trading houses.  A revolving LC is issued when the seller sends regular shipments to a particular buyer as part of long-term supply contract. Once the buyer reimburses the amount paid to seller by the issuing bank, the LC amount is reinstated.
  21. 21. Risks in import LC  The financial standing of the importer  Goods  Exporter risk  Country risk  Foreign exchange risk
  22. 22. Documents in LCs  Bill of Exchange  Invoice, packing list  Shipping documents  License  Embassy legalization  Origin certificate  Inspection certificate  Insurance policy

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