REVOLUTION OF THE LETTER OF CREDIT
To secure transactions in international trade, banks offer letters of credit (L/C).
The process for a letter of credit is set out in the Uniform Customs and Practice for Documentary Credits (UCP) and is used by banks in more than 175 countries. The process has changed little for centuries and is for the most extend done manually. It is paper-based, slow, error-prone, time-consuming and expensive.
Letters of credit are predominantly desired and used by sellers to minimize their risk.
If the buyer does not meet the bank’s requirements for a letter of credit, the bank will refuse to finance the trade.
Statistically, 11% of all requested securities or financing for global trade transactions worldwide are rejected by banks. This often leads to the failure of the trade deal. The rejection rate for small and medium enterprises (SMEs) is much higher at 45%. The main reasons are KYC concerns (29%), lack of collateral (21%), lack of suitability for financing (20%), and the banks’ margin being too low (15%).
Up to 45% of applications for trade finance for SMEs are rejected.
Letter of Credit Process
A letter of credit is a contractual agreement between the buyer’s bank and the seller’s bank. The buyer’s bank opens the letter of credit upon request of its customer and guarantees a payment.
The individual steps of a letter of credit:
- Buyer and seller agree on a commercial transaction. The seller requests a letter of credit as security.
- The buyer applies to his bank (issuing bank) for a letter of credit in favor of the seller.
- The issuing bank checks the credit risk of the buyer for the commercial transaction, opens the letter of credit and forwards it to its correspondent bank (negotiating bank).
- The correspondent bank is usually located in the same country as the seller (beneficiary).
- The correspondent bank certifies the letter of credit and confirms the letter of credit to the seller and specifies all requirements and documents necessary for disbursement.
- The seller (beneficiary) prepares the required documents. The required documents may be very extensive, especially in the case of risky commercial transactions.
- The seller submits the required documents to his correspondent bank.
- The bank checks the documents for full compliance with the agreements in the letter of credit. If this is the case, the Correspondent Bank forwards the documents to the Issuing Bank and requests payment.
- The buyer’s bank checks the documents again. If those fully comply with the agreements in the letter of credit, the buyer’s account is debited.
- The issuing bank forwards the payment to the correspondent bank, which in turn pays the amount to the seller.
- The issuing bank subsequently forwards the received documents to the buyer so that the buyer can request the goods for delivery.
At this time, the goods are usually still in transit. The buyer has made the payment solely based on the documents provided. In the event of an incorrect or incomplete delivery of goods, there is no possibility of intervention.
The core elements of a letter of credit are the related documents. If the seller provides all the required documents, the payment is triggered.
Regarding a letter of credit, the banks exclusively “trade” documents and not commercial goods to which the documents relate.
Defective and Rejected Letters of Credit (L/C)
About half of all L/C documents presented are issued with errors.
Errors are any deviations from the terms and conditions in the letter of credit. All terms of the letter of credit may be amended only with the express consent of all parties. Any amendment incurs costs and delays disbursement. Every slightest change and clarification in the letter of credit will be charged by the banks to your customer.
If errors and discrepancies cannot be resolved, payment to the seller may be denied by the bank and the only recourse left to the trading partners is legal action.
Frequently identified inconsistencies between letter of credit terms and documents include:
- Outdated documents.
- Invoice details differing from the letter of credit.
- Different description of the commercial goods.
- Errors in the insurance document.
- Difference between invoice and letter of credit amount.
- Transport route, port of loading or destination do not correspond to the information in the letter of credit.
- A required document is not presented or is incomplete.
- The content of the documents presented does not correspond to the terms of the letter of credit.
- The names of the documents and the names of the trading partners in the documents do not exactly match the information in the letter of credit.
- The invoice or statement of account is not signed in accordance with the terms and conditions of the letter of credit.
Deviations can be corrected quickly in some cases under the supervision and subect to approval of the involved banks. However, if documents have to be resent, there is always the risk of a letter of credit rejection by the banks. Even if the goods are already on their way to the buyer.
The entire verification process is still to the most extend conducted manually and can take several weeks, depending on the type of letter of credit.
Cargodian eliminates the need for letters of credit and provides increased payment security for the seller and delivery security and quality control for the buyer.