Trade Finance - Part 1 Introduction - Simple Mechanism of Letter of credit
Trade finance offers variety of products
A) To ease the market, credit and operational risk to the buyer and seller.
B) Allow easy flow of goods/services across cross-boundaries
C) Ensure smooth running of supply chain
D) Leading to the better reach, healthy competition, good prices in the market
Below are the few trade finance products:
A. Letter of Credit
B. Invoice financing
C. Working capital loans
D. Overdrafts
. Bills of collection
F. Other types of business finance
All these financial products in some way or other helps to ensure running of whole supply chain process and operations of the business day-in and day-out.
Letter of Credit
Concept
- General Players in the market?
In general trade where-in buyer and seller know each other and are in close vicinity trade happens as is.
What if, buyer and seller are residing in different countries and didn’t know much about each other. How is the trade supposed to go? Refer below article to understand bit more on this scenario :
https://medium.com/@nilutjain/business-trade-finance-relevance-b901e29649c4
Traditional Trade in general — Trust (Verbal)
Modern Trade — Trust(replaced by 3rd party coming into picture providing assurance of the obligation — Facilitator)
Let us understand ICC & UCP before running into Letter of credit(L/C) as they have lot to do with it.
2. International chamber of commerce (ICC)?
💡ICC, which was established in 1919, had as its primary objective facilitating the flow of international trade.
UCP were first introduced by ICC - to alleviate the confusion caused by individual countries’ promoting their own national rules on letter of credit practice.
The objective, since attained, was to create a set of contractual rules that would establish uniformity in that practice, so that practitioners would not have to cope with a plethora of often conflicting national regulations.
The universal acceptance of the UCP by practitioners in countries with widely divergent economic and judicial systems is a testament to the rules’ success.
So ICC is basically an independent organisation set up to enable business. It is not government company. It is build by private players who lays ground rules to ensure smooth business for all. For Letter of credit also, the first rules UCP in 1933 followed by six revisions so far are also the effort of ICC.
3. What is UCP (Uniform Customs and Practice)?
💡UCP is Uniform Customs and Practice that govern the operation of letters of credit.
💡First circulated in 1933 and subsequently updating it throughout the years by ICC. The recent revision is the sixth revision of the rules known as UCP 600. Came into effect from 2007.
💡The 39 articles of UCP 600 are a comprehensive and practical working aid to bankers, lawyers, importers, and exporters, transport executives, educators, and everyone involved in letter of credit transactions worldwide.
4. What is letter of credit?
In a simple way, it is a document in which all terms are written like :
a)Name of seller
b)Name of buyer
c)Credit terms
d)When payment has to be made
e)Document to be submitted by buyer before payment is released by sellers bank (facilitator bank)
f) and so many other trivial matters to ensure smooth flow of the process
Mechanism of L/C
5. How Letter of credit (L/C) issued practically?
Xoxo - Austria - Buyer
Yoyo - Fiji - Seller
Xoxo and Yoyo want to do trade, how will they do?
1. Xoxo will go to bank
2. Ask for letter of credit to be issued department
3. Depending on Xoxo credit history/ credibility, other factors bank on case to case basis will evaluate on its issuance
4. If bank will accept to issue the letter of credit then it will be at small margin like 0.75%–2%% of the overall credit limit, collateral (if) and nominal processing fees separately to be charged to buyer
5. Bank will provide format of L/c
6. Take the format, discuss term with Yoyo (seller) for mutual agreement
7. Once agreed, ask bank to issue letter of credit to Yoyo’s bank
8. Yoyo bank will accept it based on Yoyo consent and inform to Yoyo about it
9. Yoyo will sell the goods
10. Yoyo will present the documents of sell like Bill of lading, original invoice, process manual, etc. to its bank for further sending to Xoxo bank
11. Xoxo bank will receive the documents and if they find that all the documents are in order they will release the payment to Yoyo bank
12. Yoyo bank will inform Yoyo about incoming receipts as usual every day
13. Yoyo receives money
14. Xoxo received goods
So in a nutshell, all the persons engaging in letter of credit consider UCP 600 issued by ICC as their rules of the game. These are basically rules in the areas like advising bank, expiry date, amount of letter of credit, place of expiry, place of presentation, name of seller, buyer, banks/financial institutions involved, when should payment be made,etc. which gives clarity to the bank and parties to the trade. What happens basically is, buyer’s bank issues letter of credit to seller’s bank undertaking that in case of receipt of promised goods payment will be made. Now in case, buyer on moods and fancies says no I do not want to make payment. Hold on! But our seller is protected by letter of credit issued by buyer. To what extent, depends on the terms of the L/C agreed and accepted between both the parties. Hence, banks are very cautious while issuing L/C because as a middleman to the transaction they are certainly at higher risk in case of default in the process.
Letter of credit is in a way document which has to be entered by the parties to mitigate the risk of fraudulent and various other risk associated with carrying on business. It has all these norms which helps each party to know traits of the trade. It is like writing the agreement of word/trust on paper to ensure terms of engagement are well read, communicated and understood by both the parties.
Do everyone use same/issue same type of L/C?
Once L/C is done, are we 100% secured?
Does there lies risk of non-compliance in L/C?
What if buyer defaults in the payment or rejects the goods?
What if seller goods are damaged?
There are many other points like types of L/C, major articles in L/C, how articles should be interpreted will be part of follow-on articles.
Thank you👍✔
To know the relevance of trade finance in short do read :
https://medium.com/@nilutjain/business-trade-finance-relevance-b901e29649c4
References :
1. ICC - https://iccwbo.org
