Business Users Guide to Commercial Letters of Credit

By: Christopher Connolly

The George Washington University

The issue of exporting is ranked number 26 in the list of Small businesses Problem areas. A very effect way to finance exports is commercial letters of credit. This site is intended as a business user guide to Commercial Export Letters of Credit.

International commercial trade begins with a buyer and a seller. The two parties agree on the product to be shipped, the price of the product and the method of payment. In many cases the buyer is not familiar with the seller and visa-versa. This lack of knowledge creates a risk for both the buyer and the seller. Both parties desire to do business but cannot fully trust that the other party will uphold their end of the deal. The buyer would prefer to receive the product and then send payment, while the seller would prefer to receive payment and then ship the product. Small businesses are particularly vulnerable since cash flow is of the highest importance. One resolution to this impasse is a commercial letter of credit.

A commercial letter of credit (L/C) is defined as " A written instrument issued by a bank on behalf of its customer (the buyer, applicant or importer) making available a maximum amount of money to a beneficiary (the seller or exporter) against the presentation of documents which comply with the terms of the letter of credit." In laymen’s terms, a letter of credit substitutes the creditworthiness of the issuing bank for that of the buyer.

It is important to understand that a L/C is not a contract between the buyer and the seller. A L/C is a contract between the issuing bank and the seller. The L/C does not guarantee the product being delivered but rather guarantees payment on the product, given all the terms and conditions of the L/C are satisfied.

Short of receiving cash, a L/C offers the seller the highest degree of payment protection. The L/C process on the surface appears complicated and complex, however once the process is understood, L/C are a very effective trade financing tool.

A standby letter of credit is another type of letter of credit. A standby L/C is an assurance that the buyer will pay the seller for the shipped product. Standby L/C not the principal payment source as with a regular L/C but rather a back-up payment source. As with a regular L/C, a standby L/C substitutes the creditworthiness of the bank for that of the buyer.

Payment under a standby L/C is done by the presentation of a draft and a letter by the seller that the buyer did not perform or defaulted from the terms of the L/C.

Standby L/C presents considerable risk to the buyer since the seller can request payment with only a draft and a letter. The buyer should be very confident of the seller’s morals.

Letters of credit are beneficial tools for both exporters and importers, however their use must be weighted against the fees assessed by the intermediary banks. Following is a sample of the fee charges for L/C services. Actual charges differ from bank to bank.

L/C Opening 0.2% of principal ($150 min)

Advising of L/C opening $75.00

L/C processing 0.2% of principal ($150 min)

L/C Amendment $80.00

L/C cancellation $70.00

Message service $30.00

Although L/C’s are expensive, the cost can be justified by the guarantee of payment L/C’s provide. Small businesses must weight the costs against the possibility of a delayed or defaulted payment.

Commercial letters of credit are a safe and efficient way to perform international business transactions. As an importer, you are assured the delivery of the ordered product and as an exporter, you are assured payment on the shipped goods. Letters of credit offer buyer and sellers a means to minimize their business risk.