International Buyers and Suppliers might use Letters of Credit (LCs) - also known as Credit Letters - to minimise the risks of their trade transactions.
A Letter of Credit is a secure international trade payment guarantee, written on behalf of a Buyer (Importer) to pay the Supplier (Exporter) within the specified time of a payment agreement. The bank or finance provider that issues the LC assumes responsibility for payment if the Buyer cannot meet repayment terms.
In international trade, it is often difficult for Suppliers to determine the reliability and trustworthiness of Buyers and trading partners. A Supplier may request a Letter of Credit if it is concerned about a potential trade. Working with a validated finance provider that guarantees payment through a Letter of Credit removes the risk of non-payment by the Buyer and provides peace of mind for the Supplier.
The Supplier would request a Letter of Credit from the Buyer once a trade deal is agreed upon.
The Buyer then consults its bank or financial institution to secure that Letter of Credit. Similar to applying for a bank loan, there is an application and due diligence process which takes time to complete. The process may well involve the Buyer having to lodge assets as security before the LC can be issued.
The Buyer’s bank has no interest in the goods or services themselves or whether they were shipped. The Buyer’s bank requires only stipulated documents from the Supplier’s bank before issuing payment. The Buyer and its bank will have agreed on what company assets to use as collateral should the Buyer default on payment.
There are a few points to note about obtaining a Letter of Credit:
With the LC in place, the Supplier then exports the goods in accordance with the agreement.
Once the goods are received, the Importer makes full and timely payment to the Exporter. The financial institution that issued the Letter of Credit then takes a small service fee, ending the agreement with no long-term repayment plans enforced.
If the Importer doesn’t pay, responsibility for payment lies with the financial institution that issued the LC. It may then seize the assets pledged as collateral as part of the agreement.
The following is an example of a traditional Letter of Credit agreement:
ABC Importer Ltd. requires materials from an overseas company, XYZ Exporter Co. However, XYZ Exporter is hesitant to engage in international trade with ABC Importer due to the legal and political complexities associated with international trade.
So, ABC Importer works with an international trade finance provider to secure a Letter of Credit, guaranteeing that ABC Importer will provide full and timely payment for goods. If ABC Importer cannot meet the repayment terms, the provider will become responsible for payment. To secure this service, ABC Importer agrees to pay the finance provider a fee of 1% of the value of the trade deal.
With the LC in place, XYZ Exporter sends the materials and raises an invoice, which ABC Importer pays on time and in full. ABC Importer then pays the fee owed to the finance provider.
International trade is often complicated by factors including regional laws and regulations, global payments, currency conversions and challenges in checking the reliability of trading partners. A Letter of Credit alleviates many worries that Suppliers face by placing an internationally recognised and regulated finance provider as guarantor at the centre of the agreement.
Exporters typically request a Letter of Credit in the following cases:
Subtle variations of Letters of Credit may be helpful for specific Buyers depending on their financial situations and the Supplier's requirements.
Letters of Credit boost international trade by providing guaranteed payment. It’s clear to see their value in deals where complicated international laws often cause confusion and delays.
However, business owners should perform due diligence on all Credit Letter agreements, including working closely with banks or finance providers to review and validate agreements.
Letters of Credit are not the only trade finance solution available to Importers and Exporters. Payment-in-advance, working capital loans or invoice finance may be more efficient alternatives for specific Suppliers. It’s wise to consider the type of trade finance that works best for each business.
If you are interested in learning more about invoice factoring, Stenn has a dedicated FAQ section where you can find more information about our invoice financing services. We also provide videos which explain the company and the financing process in detail.
About the Authors
This article is authored by the Stenn research team and is part of our educational series.
Stenn is the largest and fastest-growing online platform for financing small and medium-sized businesses engaged in international trade. It is based in London, provides financing services in 74 countries and is backed by financial giants like HSBC, Barclays, Natixis and many others.
Stenn provides liquid cash to SMEs within the global financial system. On stenn.com you can apply online for financing and trade credit protection from $10 000 to $10 million (USD). Only two documents are required. No collateral is needed and funds are transferred within 48 hours of approval.
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Disclaimer: The above article has been prepared on the basis of Stenn’s understanding of the subject. It is for information only and doesn’t constitute advice or recommendation. Whilst every care has been taken in preparing this article, we cannot guarantee that inaccuracies will not occur. Stenn International Ltd. will not be held responsible for any loss, damage or inconvenience caused as a result of anything published above. All those applying for credit should seek professional advice when doing so.