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Unpacking Letter of Credit

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As a trade finance person by training and experience, I am often reminded that I do not say much — if anything at all — about trade financing issues in this column, despite the need to share information on this specialist area being one of the fundamental reasons the idea of the column was actually conceived.

I admit that I am guilty as charged and coming to think about it, I do not even have a good reason for the neglect, which becomes even more glaring when one considers that I often train bankers in areas of trade finance such as letter of credit, documentary collections, incoterms as well as structured trade commodity finance (STCF).

Having shared insights on structuring in trade finance with executives and some non-executive directors of one of the local banks earlier this week, it occurred to me that it’s about time I started sharing some trade finance insights in this column as well. So this week I duly look at the letter of credit, a very important payment instrument in international trade.

What is a letter of credit?

It is a conditional undertaking by a financial institution that it will pay a specified amount or amounts at a specified time or times, provided that all terms and conditions described in the letter of credit have been observed.

The import of the conditional undertaking is that the financial institution is obligated only if all terms and conditions of the letter of credit have been met

Origins of the letter of credit

Though the historic roots of the letter of credit, also known as a the documentary credit, date back some 3000 years, the first recognised modern letter of credit was issued in 1646 by the Monte dei Paschi Bank of Sienna, an Italian bank.

Key characteristics of letter of credit

Documentary or commercial credits require the presentation of documents that prove certain events have taken place. Letter of credit provides security advantages for both exporter/seller and importer/buyer.

The seller is assured of payment upon production of constructive evidence of shipment of the contract merchandise while the buyer is assured that the bank will not pay unless the seller has met documentary requirements complying with the buyer’s instructions.

Advantages for the seller

lSecurity: The seller has assurance of payment from an international bank on condition that the terms and conditions of the letter of credit are complied with:
lFinance: The seller has the opportunity to raise finance against the letter of credit issued in his favour.

Advantages for the buyer

lCash flow management: The buyer does not have to pay cash up front to a foreign country before receiving documents of title to the underlying goods. This is quite helpful when unfamiliar with the suppliers and other legalities.

lSecurity: Letter of credits protect the buyer’s interests subject to presentation of documents that comply with the terms and conditions of the credit.

lRisk management: The buyer can build safeguards into the letter of credit such as inspection of the goods for quality (think Bureau Veritas) control as well as set production and delivery times.

Types of letters of credit

There are several types/characteristics of letters of credit such as irrevocable, revocable, standby, confirmed, unconfirmed, revolving, transferable, back-to-back, sight/usance, red clause, green clause, evergreen and straight letter of credit. Each of these is designed to fulfil a different need in import/export transactions according to the specific circumstances of the counter-parties.

A letter of credit is a secure instrument, but what goes into it comes from the underlying negotiation process between the exporter and importer.

The letter of credit can, therefore, be only as good as the agreement or contract of sale between the seller and buyer that
led to it.

lFeedback: omen.muza@gmail.com. Omen N Muza writes in his personal capacity. You can view his LinkedIn profile at zw.linkedin.com/pub/omen-n-muza/30/641/3b8

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