Doing business always involves risk. This, in turn, increases when the counterparties are located in different countries and the transaction amounts are high. When exporting or importing goods, it is quite common to encounter the concept of a letter of credit, which will be expected by one of the parties to the transaction. What is an export letter of credit and how to use it? How much does it cost and where can it be ordered?
Before explaining what a letter of credit is, it is necessary to recall in a few words that the role of banks is not only to “store” funds accumulated in settlement accounts or to grant credit, but also to provide services that at first glance may have little to do with banking.
Most commercial banks in Poland and around the world provide, among other things, sureties, guarantees, or handle so-called letters of credit – special types of settlements between counterparties.
What is an export letter of credit?
An export letter of credit or bank letter of credit is a special type of payment, which is intended to secure the parties to transactions usually international. When opening a letter of credit at the parent bank (the one where the importer has an account), the importer declares, or in principle his bank does, to make the payment after the exporter meets the conditions included in the letter of credit.
In practice, the way it works is that the importer’s bank (the opening bank) blocks the amount of funds specified in the letter of credit, and when the exporter meets all the conditions imposed on him, so, for example, he delivers the goods, the bank transfers to the exporter’s account the funds blocked in the importer’s account.
Why is a letter of credit used?
As we mentioned earlier, the role of a letter of credit is to secure the interests of both parties to a trade agreement. We write both, because a letter of credit can include provisions that obligate both parties to meet certain conditions. An export letter of credit can include provisions on the quality of goods and services, the date and place of delivery, quantity and much more.
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Since an export letter of credit is handled by banks (the exporter’s bank and the importer’s bank), the importer gains certainty of receipt of goods, while the exporter gains certainty of payment for the delivered goods.
Parties to an export letter of credit
Although the letter of credit theoretically applies only to relations between counterparties, a total of four parties need to be involved in order to speak of a letter of credit. These will be:
- The importer / procurer of the goods or service and ordering the opening of the letter of credit,
- exporter / supplier of goods or service provider (beneficiary of payment),
- the opening bank (importer’s bank), which will provide the exporter’s bank with information about the opening of the letter of credit and will execute the transfer once its conditions are met,
- the beneficiary’s bank, i.e., for example, the exporter’s bank, whose purpose is to receive the payment, and before that to inform the exporter of the opening of the letter of credit by the importer.
Export letter of credit in practice
An export letter of credit at the opening bank is ordered by one of the parties to the transaction. Usually this is the payer, so for example, the importer / ordering party. Before opening the letter of credit, all the conditions of the transaction must be established in advance in detail, after the fulfillment of which by both parties and their confirmation by appropriate documentation, the opening bank will make funds available to the exporter’s account.
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When opening a letter of credit, the payer’s (importer’s) bank blocks the amount included in the letter of credit, and then notifies the exporter’s bank that the letter of credit has been opened.
The exporter fulfills its part of the contract, i.e. delivers the goods or performs the service that is the subject of the contract, and provides the bank with documentation to confirm that the terms of the letter of credit have been met. After proper verification of these documents, the opening bank makes a transfer to the exporter’s account.
Documentation of an export letter of credit
As we wrote above, in order for the opening bank to unblock the funds blocked for payment for the exporter’s compliance with the terms of the agreement, it is necessary for the exporter to provide the appropriate documentation. This usually includes commercial invoices, insurance documents, quality approvals, certificates of origin, waybills or other documents confirming the delivery of goods.
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However, it is important to remember that each trade agreement involves different products and services, and the type of documentation needed for an export letter of credit transfer may depend on them.
How much does an export letter of credit cost?
The security of the transaction unfortunately comes with certain, and usually quite high, costs, which are often charged to both parties to the transaction. Depending on the financial institution, the cost of a letter of credit may consist of such fees as:
- the fee for preparing the letter of credit;
- the commission for its conclusion, which is usually between 0.2 and 0.3 percent of the transaction value;
- the fee for verification of transaction documents by the financial institution;
- a fee for confirmation of the letter of credit by the financial institution.
It is quite common practice to split these costs between the two parties to the transaction, i.e. the importer and the exporter, but it all depends on the agreement between them.
Is it worth using an export letter of credit?
An export letter of credit allows you to secure both counterparties, who very often make only the first transaction between them. This type of payment increases the security of fulfillment of the trade agreement by both the exporter and the importer, and guarantees timely payment for goods or services performed.
The biggest downside of an export letter of credit is, of course, its cost, which can be really high when the value of the transaction is a large amount.
