Appreciating The Function Of Trade Finance Instruments Part 2- Letter Types By Mark Darko

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As previously discussed, trade finance instruments, especially letters of credit are indispensable for international transactions since they ensure that payment will be received. Using documentary letters of credit or standby letters of credit allows the seller (beneficiary) to significantly reduce the risk of non-payment for delivered goods, by replacing the risk of the buyer with that of the banks.

With a letter of credit-standby or documentary, an exporter is assured of full payment as per the terms of the LC. This helps seller to plan and focus on future businesses rather than worry about how to recover debt in the event of default. Another advantage is that the exporter receives money on time. As we all know, ‘finance at the right time’ is a prime factor for any business transaction in view of the general principle of time value of money. This article is focused on types of letters of credit and how useful each of them may be in cross-border trade deals.

 

Revocable and Irrevocable Letters of Credit

 

A revocable letter of credit can be withdrawn by the issuer (importer) or issuing bank (importer’s bank) at any time. Withdrawal can be effected without notice to the exporter. Revocable letter of credit, therefore, does not sufficiently protect the interest of the exporter in getting or receiving payment. Be careful when you are issued with a revocable letter of credit especially by a counterparty you have no previous relationship with or an issuer you would be doing business with for the first time.

An irrevocable letter of credit on the other hand cannot be withdrawn, amended or cancelled without the prior permission or consent and intimation of the issuing bank, the confirming bank, if any, and the beneficiary. The payment is guaranteed by the bank if the credit terms and conditions are fully met by the beneficiary. This letter of credit type is more reliable and provides a good guarantee to the exporter.

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Clean Letter of Credit

 

clean letter of credit does not lay down any condition as regards making the payment. Further, it does not contain any condition for acceptance of bills of exchange drawn by exporter upon the importer. It is clean in the sense that there is no condition for payment to be made.

 

Assignable and Non assignable Letter of Credit

 

An assignable letter of credit is transferable while a non-assignable letter of credit is not transferable. Assignable letter of credit means an LC can be easily transferred by the exporter with all rights in favor of any person. Therefore, exporter can unconditionally assign this letter of credit to another person, entity or any other third party.

A non-assignable letter of credit cannot be transferred or assigned in favor of any person. Only the beneficiary who is named in the letter can utilize it or receive payment with it.

 

Revolving Letter of Credit

 

A revolving letter of credit is a single letter of credit but covers multiple transactions over a long period of time. It is very specific in a way that it is used for regular shipments of the same commodity between the same buyer (importer) and the seller (exporter). This letter of credit is issued only once for a certain period of time or a certain number of transactions.  It avoids the need for repetitive arrangements to open a new letter of credit for every transaction. Revolving letter of credit is used when the export transaction between the same parties is regular and continuous. Credit can be availed against one and the same letter of credit for all subsequent export transactions. There is no need to open a separate letter of credit for every export transaction again and again.

 

Confirmed and unconfirmed Letter of Credit

 

The opening bank appoints a banker in the exporter’s country which is known to the exporter. Through such bank, the confirmation of credit is made by the opening bank. Exporter can draw the bill of exchange on such confirming bank. So, any letter of credit which confirms credit is known as confirmed letter of credit. Simply put, confirmed LCs require the backing of more than one bank by a buyer in a domestic or international transaction. A confirmed letter may be required if the seller is not satisfied with the creditworthiness of the first letter of credit. In many cases, the second bank is the seller’s bank. When the buyer gets the second letter, it confirms the first one and qualifies it as a confirmed letter of credit. The second bank promises to pay the seller the amount stated if the first bank fails to do so when it issues the confirmed letter of credit.

The process of securing the second letter of credit is the same as the first one. The buyer must find a second bank to back its purchase in case of default. The structuring of the funds for the second letter of credit generally takes the terms of the first letter of credit into consideration as well. In some cases, the seller may only require the second letter of credit represent a percentage of the total due because the sale already comes attached with a credit letter by the first bank.

 

Just like the first letter of credit, banks may also charge the buyer a fee when they issue a confirmed letter of credit. The amount of the fee may depend on the size of the transaction and payment amount, as well as the relationship between the buyer and the bank. In many cases, they may ask the buyer to put up securities or cash collateral in exchange for the letter.

 

 

 

 

Back to Back Letter of Credit

 

Merchant exporter purchases goods from the manufacturer for the purpose of export. Such exporter requests opening bank to open the letter of credit in favor of such manufacturer or supplier. The manufacturer or supplier gets the money directly from the importer. This letter of credit helps the exporter to get goods for export on credit basis. A back-to-back letter of credit can also involve two letters of credit to secure financing for a single transaction. These are usually used in a transactions involving an intermediary between the buyer and seller.

 

With or Without Recourse Letter of Credit

 

In with recourse letter of credit, the paying bank can hold the exporter responsible for recovery of payment if the importer fails to reimburse it to the paying bank. Exporter, then will have to refund all the money he has received along with interest to paying bank in such an eventuality.

In case of without recourse letter of credit, the exporter cannot be held responsible if the importer does not reimburse the paying bank. In such an eventuality, the paying bank has the recourse to the importer only.

 

Red Clause and Green Clause Letter of Credit

 

Under the red clause letter of credit, the exporter can get advance money from the negotiating bank. This gives an authority to the negotiating bank to extend credit and lend advance money to exporter. A red clause letter of credit is printed in red.

Green clause letter of credit provides an arrangement for the storage of goods at the port. Pre-shipment finance and storage facility are available to the exporter.

 

 

 

 

 

Restricted Letter of Credit

 

The importer may insist that shipping documents be negotiated (transferred) through a specified bank only. Any letter of credit with such a restriction is known as restricted letter of credit.

 

Travelling Letter of Credit

 

A traveling letter of credit enables the exporter to travel abroad and draw the money specified from the bank. All banks honor all the cheques or bill drawn upon. This refers to a letter of credit that is addressed to a correspondent bank, from which one can draw credit by identifying oneself as the person in whose favor the credit is drawn. The holder signs a check on the issuing bank, and the local bank forwards it to the issuing bank for its credit.

 

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MARK DARKO

 

MANAGING DIRECTOR (AFRICA)-EVRENSEL CAPITAL PARTNERS

 

PRESIDENT-ASIAN-AFRICAN CHAMBER OF COMMERCE AND INDUSTRY, GHANA CHAPTER

 

EXECUTIVE DIRECTOR-AFRICAN RATING AGENCY

 

SENATOR-WORLD BUSINESS ANGELS INVESTMENT FORUM (WBAF)

 

 

 

 

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