International Finance

Letter of Credits (LC)

MPE -2009-11 DIV B

Group A

1) Asif Khan 2) Amit Kothari 3) Tushar Mistry 4) Sumit Mukherjee 5) Ramesh Nair 6) Jignesh Parmar

Roll No. Roll No. Roll No. Roll No. Roll No. Roll No.

: 64 : 67 : 84 : 87 : 93 : 107

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International Trade Finance

International trade finance involves commercial transactions between buyers and sellers in different countries. It presents a number of difficulties for the firms involved.

International Trade - Risks

Types of Payments in International Trade

Types of Methods of Payment Payment The buyer agrees on a price for the goods and makes the payment to the seller before the goods are shipped. This method is typically used where the buyer can negotiate a Payment in significant cash discount for taking on the trade risk. It could also be possible that the Advance buyer is unable or unwilling to open a letter of credit. This method of payment involves an agreement between the seller and the buyer whereby the goods are shipped to the buyer and the buyer makes the payment at a Open predetermined date in the future. In this case, it is the seller who is taking on all the Account trade risk. We will discuss open account trading in more detail at a later stage in this Trading tutorial. Clean Payments Clean Payments are the means of forwarding funds overseas. These can be made by: 1. Telegraphic Transfer - a message forwarded electronically to an overseas branch or a correspondent bank, instructing it to pay a named party (beneficiary) a specified sum of money by order of the remitter (applicant). 2. Draft - similar to a bank check but drawn on an overseas bank. Payment is made to the payee after adequate verification of identity.
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Open Account Trading

Despite all the technological developments that have occurred in the past decade, nothing seems to be able to stop the growing popularity of open account trading.

Open account trading works as follows. A company sells goods to another. It then sends the buyer an invoice, and in due course (usually within 30 days) it receives payment.
Open account trading allows settlement to be achieved at a lower cost because credit lines will not be used to underwrite transactions. The savings that companies make will depend on the number of transactions, the level of automation, and so on.

Open Account Trading

However, open account trading presents an administrative burden for traders, because it entails taking data from multiple sources, consolidating it and matching commercial invoices/bills of lading against purchase orders. This manual process is both time-consuming and subject to error. With an L/C, the issuing bank handles this administration in return for a fee. Many companies may choose to outsource this work to banks, because of their expertise in the administration of trade documentation, and the fact that they have invested in the technology and have the geographic coverage to facilitate global trade.

Open account trading leaves the seller fully exposed to non-payment or default on the part of buyers. Sellers may have to look at receivables financing or factoring to manage their working capital demands. The cost of capital can be disproportionately high for small suppliers, even offsetting the savings made through the elimination of L/C fees. Therefore, there will probably always be a need for L/Cs in many cases.

Letter of Credit (LC)

Letter of credit is a widely popular commercial instrument used as a means of financing international business transactions. A letter of credit is a contract under which a bank agrees to pay the seller in connection with the export of specific goods.The credit is issued at the request of the buyer (the applicant) in favour of the seller (the beneficiary) It facilitates trade by providing payment against presentation of documents relating to the transaction as specified in the credit The transaction of LC take place through SWIFT ( Society for Worldwide Inter-Bank Financial Telecommunication) network.

Role of ICC & International Banks in LC

International Chamber of Commerce (ICC) has the primary objective to facilitate and ease flow of international trade. It plays a major role in preparation and promotion of uniform practices all over the world.
In order for letters of credit to become widely acceptable, cooperation between banks in different countries was required. Internationally agreed standard procedures were therefore drawn up by the ICC which became know as the Uniform Customs & Practice for Documentary Credits (UCP), or UCP600. When an LC is opened, it is subject to UCP and this is disclosed in the documents. Letters of credit therefore provide a strong degree of security and confidence in international trade because of the consistency of the rules across the world The purpose of banks as intermediaries is to reduce the trade risks that both the buyer and the seller face in open market trading. Banks undertake this intermediary role in return for a fee, usually paid for by the buyer. A large part of this fee is to compensate the bank for accepting an obligation to pay the seller regardless of the financial standing of the buyer. Charges are usually set at a certain percentage of the value of the letter of credit and are usually less than 1%.

Regulatory Requirements
Trade Control Requirements i.e. Foreign Trade Policy Exchange Control Requirements i.e. RBI & FEMA Uniform Customs & Practices for Documentary Credits ( UCPDC) i.e ICC is engaged in formulation of business policy and mechanics of trade and

various other relevant international trade practices. The guidelines are accepted to facilitate trade & payment through LC.

Letters of Credit - Primary Function

The primary function of letters of credit is the provision of a method of payment in international trade. Therefore, letters of credit serve as: 1. A compromise between the opposing wishes of the seller's desire for payment in advance and the buyer's preference for making payment only on receipt of the goods

2. A form of insurance for both the seller and the buyer that greatly reduces the credit risk for each, while not sacrificing the length of time for payment to be made

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LC LIFE CYCLE
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Aspects of the LC & bill transaction works in the following manner

The importer (opener) has concluded a purchase order for buying of certain goods with his overseas supplier who wants payment by a LC. The importer asks his bank to open a LC in favour of his overseas suppliers After the request from the supplier and considering the proposal,his bank opens a LC in favor of supplier ( exporter) The advising bank ( an intermediary bank in the exporters country) receives credit from the opening bank and after satisfying itself about the authenticity of the credit it forwards the same to the beneficiary After receiving the credit from the advising bank , the exporter checks it to ensure that it confirms to the terms of sale contract and if necessary , ask the importer to effect amendments to the credit and then proceeds to effect the shipment of goods After the shipment is effected the exporter prepares the documents and draws his bill under the LC for obtaining payment from the negotiating bank After getting the documents and bill from exporter, the negotiating bank checks them with the LC and if in order, negotiates the bill and pays to the exporter The opening bank ( importers bank) receives the bill and documents from the negotiating bank ( exporters bank) checks them and if found in order, reimburses, if reimbursement is obtained already , confirms it to the negotiating bank. The opening bank presents the bill for acceptance / payment to the opener ( importer) The importer ( opener) receives the bill , checks the documents and then accepts / pays the bill. On acceptance / payment , he gets the shipping documents covering the goods purchased by him.

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Letter of Credit - Participants

Applicant (Opener) : Applicant is normally a buyer of the goods, who has to make payment to beneficiary.LC is initiated and issued at his request and on the basis of his instructions

Issuing Bank (Opening Bank) : Issuing bank is one which issues the Credit. i.e. it is the bank that creates a letter of credit and undertakes to make payment Advising Bank : Advising bank communicates with the beneficiary about the LC. It is normally situated in the country / place of Beneficiary. The Advising Bank may be correspondent bank of the issuing bank or could be specifically notified by the Beneficiary. The Advising Bank primarily performs the function of an informer. The only assurance implied is that the LC is genuine

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Letter of Credit Participants

(contd)

Beneficiary : Beneficiary is normally a seller of the goods, who has to receive payment from the applicant. If he transfers the credit to another party, then he is referred to as the First or Original Beneficiary Confirming Bank : Confirming Bank adds its guarantee to the LC opened by another bank, thereby undertaking the responsibility of payment/ negotiation/acceptance under the credit, in addition to that of the issuing bank. A Confirming Bank is required where the exporter feels more comfortable dealing with a local bank. Negotiating Bank : Negotiation is the process of giving value to the documents. The negotiating bank is one with whom the documents may be negotiated. The LC may either specify the Negotiating bank ( restricted negotiation) or the exporter may be free to negotiate through any Bank ( unrestricted negotiation)
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Letter of Credit Participants

(contd)

Reimbursing Bank : Reimbursing Bank is the bank authorized to honor the reimbursement claim in settlement of negotiation / acceptance / payment lodged with it by the negotiation bank. It is normally the bank with which issuing bank has an account, from which payment is to be made. This role may also be played by the issuing bank itself. Second Beneficiary : Second beneficiary is the person in whose name the first or original beneficiary to credit has transferred the credit designated as transferable. The rights of the transferee are subject to terms of transfer.

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Types of Letter of Credit

Irrevocable LC Irrevocable LC is a undertaking given by the Issuing bank and cannot be cancelled or amended without the consent of all the parties to LC, particularly the beneficiary. From on exporters point of view this is more favourable. This nature has enabled building up an elaborate commercial system on the basis of irrevocable bankers credit.
Confirmed LC In a Confirmed LC, another bank (usually a Bank known to the beneficiary), adds its confirmation/guarantee. It is a double guarantee & is more favorable to beneficiary. This is generally desired by the Beneficiary so that his risk becomes localized and he can deal easily with a local bank rather than deal with a bank abroad. This type of LC is costlier to the parties concerned.
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Types of Letter of Credit

(contd)

Transferable Letter of Credit It is a credit which can be transferred by the original Beneficiary in favor of a second beneficiary or several second beneficiaries, such that credit can be transferred only once i.e from the first beneficiary to a second beneficiary and not (thereafter) from the Second beneficiary to third beneficiary & subject only to the original terms and conditions Sight credits & Usance Credit (deferred payment credits ) Sight credit states that payment be made by the issuing bank at sight i.e. on demand/ presentation. Usance credit drafts calls for payment against drafts calling for payment at a future date. This allows the buyers to arrange for selling & arranging funds to reimburse the issuer

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Types of Letter of Credit

(contd)

Back to Back Letter of Credit Back to Back LC is an LC based on the security of another LC. It is also called as Countervailing Credit. This is useful when an LC is opened by the ultimate buyer in favor of a particular beneficiary, who may not be the actual supplier or manufacturer . He will open another credit with near identical terms in favor of the actual supplier / manufacturer offering the main credit opened in his favor as security and will be able to obtain reimbursement by presenting the documents received under back-to-back credit under the main LC.

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Role & Responsibility of an Issuing Bank

To determine that the transaction falls within the scope of the banks policies and procedures That the transaction falls within the clients usual mode of business and within its given credit facility Act accordingly to any Government regulations that may apply to that branch of the bank or the bank as a whole Complete regular due diligence on the client That the transaction is issued in a workable form To determine compliance of any presentation of documents and honour where such complying presentation is made, or to refuse according to article 16 and To educate and inform the client of best practices and changes in international procedures

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Role & Responsibility of an Applicant

Complete regular due diligence on their client Recognise that the UCP will not offer any protection and therefore the LC terms and conditions must fulfill that need To provide the bank with clear and unambiguous instructions on the LC application form To recognise that once issued the credit cannot be amended or cancelled without the agreement of the beneficiary and confirming bank, if any. To recognise that any instructions given post issuance of the credit i.e. to amend or to waive discrepancies , may be disregarded by the bank and To remain cognisant of best practices and changes in international procedures i.e. UCP & Incoterms.
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Risks Issuance JP to check

Applicable UCP 600 rules Sub-Article 14 (a)

A nominated bank acting on its nomination , a confirming bank , if any, and the issuing bank must examine a presentation to determine , on the basis of the documents alone, whether or not the documents appear on their face to constitute a complying presentation Applicant : the documents must speak for the goods

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Advantages/Disadvantages of an LC
Seller
Advantages: Safe method of payment Cannot be amended without the Sellers permission Provides double guarantee (issuing bank and confirming bank Advice & assistance can be received from any major banks since the terms& conditions are internationally set
Disadvantages Even a small discrepancy in the supporting documentation can cause delay in receipt of sale consideration Revocable LC can be cancelled/amended without sellers permission Lot of associated risks. Ex Country/political risk Seller has to finance the credit (so provided to buyer)

Buyer
Advantages: Buyer protects his position based on detailed and accurate documentation from the seller Based on the shipping dates (provided by seller,) the buyer can ensure that the payment is not released till the goods are shipped Buyer obtains short term credit from banks because of the time gap in payment for goods

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Disadvantages Buyer has to incur additional cost of raising LC Mismatch between payment made and receipt of goods Because of LC facility, Buyers bank may reduce credit facility, till the LC is paid. In an Irrecoverable LC, if the buyer cannot cancel/amend the LC without everyone consent.

Necessary information on an LC
WHO? 1. Name of the buyer 2. Name and address of the seller 3. Name and address of the advising bank (usually chosen by the issuing bank) 4. Name of the person(s) on whom any of the following payment mechanisms are to be drawn: a) bill of exchange b) draft c) check
WHAT? 1. Amount and currency (ISO currency code) of the credit 2. Amount of the letter of credit in words and figures 3. The buyer must specify the: a) exact total amount b) maximum amount c) approximate amount 4. Details of the documents required 5. Quantity and description of the goods 6. Place, destination, latest date, and terms of shipment 7. Additional instructions if any

Information on an LC

HOW? 1. Types of letters of credit: Revocable/Irrevocable 2. Whether the letter of credit is settled by - payment acceptance/negotiation 3. How the letter of credit is to be advised by (air) mail or otherwise 4. Whether partial shipment or transshipment is allowed 5. Whether the letter of credit is to be transferable

WHEN? 1. Expiry date (last date for receipt of documents) 2. Period of time after the issuance date of the transport document(s) within which the document(s) must be presented

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Incoterms 2010
Sr. 1 2 Group E F Code EXW FCA FAS FOB 3 C CIF Ex-works Free Carrier Free Alongside Ship Free on Board Cost , Insurance & Freight INCO TERMS 2010

CPT
CIP CFR 4 D DDP DAT

Carriage Paid To
Carriage & Insurance Paid To Cost & Freight Delivered Duty Paid Delivered At Terminal (NEW)

DAP

Delivered At Place (NEW)

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Documents requested in an LC
Commercial Invoice

Packing list
Transport documents such as Bill of lading ( SEA mode ) or

Airway Bill ( Air mode)

Insurance Certificate , if applicable i.e CIF Inspection / Test Certificate Certificate of Origin ( issued by Chamber of Commerce)

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General documentary credit conditions

If the credit stipulates a latest date of dispatch: were the goods shipped in time? Can the deadline for presenting the documents to the bank be met?(Under UCP 600 Art. 14 c this is 21 days after the date of shipment, unless the credit states otherwise and an original transport document is required) Are all documents presented in the prescribed number (originals and copies)? Does the invoice amount match the credit amount, i.e. is it not higher or lower or within the permitted tolerances? (UCP 600 Art. 30) Is the supplied quantity consistent with the credit? (UCP 600 Art. 30) Are the terms of delivery (e.g. INCOTERMS 2010) consistent with the credit? Does the credit prohibit partial shipments? Does the credit prohibit transshipment? Are the markings, weights, quantity, type and dimensions of the packages consistent throughout the documents? Are the descriptions of goods, services and performance consistent throughout the documents?. If documents are required to be presented in a particular language: Is this document obtainable in the required language?

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Amendment of a letter of Credit

The process for amending an LC is as follows Seller requests a modification or amendment of any questionable terms in the

LC
If the terms are agreed upon, Buyer issues order to his or her (buyers) bank to

make an amendment to the terms of the LC

Buyers bank notifies sellers bank of amendment thru the advising bank Sellers bank notifies seller of amendment.

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Advantages & Disadvantages

The LC provide a relatively risk-free environment to both importer & exporter.

IMPORT

EXPORT
Advantages An undertaking from the issuing bank that you will receive payment under the LC provided that you meet all terms & conditions of the LC. Shifts credit risk from the Importer to the issuing bank Not obliged to ship against LC that is not issued as agreed.

Advantages 1. 2. Importer is assured that , for the Exporter to be paid, all 1. terms & conditions of the LC must be met Ability to negotiate more favorable trade terms with the Exporter when payment by LC is offered 2. 3.

Disadvantages 1. 2. LC assures correct documents but not necessarily correct goods. Ties up line of credit. 1.

Disadvantages Documents must be prepared in strict compliance with the requirements stipulated in the LC. Non-compliance leaves Exporter exposed to risk of non-payment

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Articles, Application format & LC swift copy

UCP - 600 Appl LC format SWIFT Message format

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Precautions for Exporters & Importers :

The documentary letter of credit (credit) is an important and well-

established instrument for securing payments in international trade.

However, to ensure smooth processing it is vital for exporters /beneficiaries

to fulfill the terms and conditions of the credit exactly and to present complying documents to the bank.
Even minor discrepancies or errors can result in the honoring of the

documents being delayed or prevented altogether. It is always important to check the credit very carefully as soon as customers receive it to ensure that it conforms to the underlying contract and that the terms and conditions can be met.
If necessary it is possible to have the credit amended accordingly. Banks

have to educate their customers in this regard.

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International Trade Financial Risk Mitigation

Factoring - is a receivable management service encompassing finance, credit protection, collection and sales ledger management for exports on open account terms. They provide financing upto 90-95%.

Forfaiting - is the discounting of international trade receivable on a 100% "without recourse" basis. It is a form of suppliers credit involving the sale or purchase of receivables falling due at some future date. The exporter is, of course, responsible for the validity of his order and execution thereof, but once documentation has been delivered and accepted and discounting is done, there is absolutely no recourse to the Exporter, with the exception of an underlying fraudulent transaction. Forfaiting effectively transforms a credit sale into a cash sale.
Securing terms of payment (L/C) Acquiring insurance backed financial packages
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Forfaiting 100% financing without recourse to the seller.

Characteristics Forfaiting/Factoring
Factoring Upto 90% financing

Importer's obligation is normally supported by a The exporter's performance obligations should be local bank guarantee. completed at the time the exporter presents an invoice for prepayment. Performance under turnkey contracts involving execution or commissioning of equipment is usually not factorable. Require LC/Bills of exchange/Promissory note. LCs not required. Credit periods can range from 90 days to 10 years Suitable for high value exports in: Suitable for manufacturing/trading companies. Not suitable under the following: Capital Goods Consumer Durables Credit more than 180days Vehicles Consignment sale Consultancy & Construction contracts Sale to associate consignments/small retail outlets Project exports Bulk commodities Finance to be either on a fixed (market norm) or Factoring facilities are typically provided for "open floating rate basis account" transactions and can also be structured for transactions involving negotiable instruments such as bills of exchange or promissory notes, on a case to case basis.
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International Factoring

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Forfaiting
asssss

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The growth in global trade over the past decade has put increasing demands on
the financial industry to find efficient methods of making international payments in exchange for the delivery of goods and services.

International Trade Latest Developments

Many companies have already tried to limit their number of trading partners so as
to concentrate their orders among a small few trading partners. They can then quickly establish trust with these partners through service level agreements and so on. The advantage of this is that when it comes to settling accounts, there is less need for expensive and slow financing arrangements such as letters of credit.

Forming international trade organizations ex TradeCard (US), Bolero.net(US) All documentation in electronic format

Secondary market for LC. The holder of trade finance debt passes on the risk of

non-payment to a third party but retains title to the instrument. This is achieved using a participation contract.
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Thank You

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