C. Haley 4/97
Letters of Credit
Commercial letters of credit appropriately can be considered the “backbone” of international trade
finance. As a payment mechanism, they are one of the most commonly utilized financial instruments in
international trade transactions.
A letter of credit (L/C) is defined as a written obligation by a bank (issuing bank), given to a seller
(beneficiary) at the request of a buyer (applicant or account party), to honor drafts or other demands for
payment upon the seller’s compliance with certain conditions specified in the L/C. The beneficiary must
understand, therefore, that the L/C is a conditional obligation of the issuing bank - conditional upon the
performance called for in the L/C.
Letters of credit are often referred to as “documentary” credits since the beneficiary must provide
documents which evidence performance prior to payment being made by the issuing bank. These
documents often include clean “on-board” ocean bills of lading, commercial invoices, marine insurance
policies, and certificates of origin. Such documents are usually prepared with the assistance of a
qualified freight forwarder or custom house broker.
The principal reason behind the widespread and successful use of L/C’s is that they offer both the
exporter and the importer a high degree of security not available with other forms of payment
The fundamental advantage of selling on letter of credit terms is that the issuing bank’s reputation is
substituted for that of the buyer. From the exporter’s point of view, he need only rely upon the issuing
bank for payment. As long as the exporter complies precisely with the terms and conditions of the L/C,
he can expect to receive payment. From the importer’s point of view, she has the ability and flexibility to
demand the exporter’s presentation of certain documents by specified dates, prior to payment being
authorized. As such, she can be assured that the seller has performed according to the terms and
conditions of the L/C - that is that shipment has been made and that documents describing the shipment
will be as she specified. Should “discrepancies” in the documents be noted by the bank reviewing, or
“negotiating”, the documents, it is the option of the importer, as recipient of those documents, to either
authorize or deny payment to the seller. Any amendments to letters of credit, if so desired by the
beneficiary, must be initiated by the importer through the issuing bank, and require the approval of all
parties to the transaction, including the issuing bank.
Thus, as long as the terms and conditions of the L/C are met, the risk to both the exporter and importer
are significantly reduced. It should be emphasized that banks negotiating documents to ensure
compliance with terms and conditions of an L/C deal only in documents which “on their face” describe a
particular transaction. Payment is made to the beneficiary on the basis of these documents alone; banks
cannot be responsible for fraudulently prepared documents and cannot physically inspect imported
merchandise. Most banks through the world which negotiate documents under L/C’s are guided
primarily by the “Uniform Customs and Practice for Documentary Credits,” as published in the
International Chamber of Commerce Brochure No. 290. Exporters and importers dealing with letters of
credit are advised to become familiar with this document.
TYPES OF LETTERS OF CREDIT
Most letters of credit can be classified as either “import” or “export” letters of credit. For all intents and
purposes, both import and export letters of credit are the same. The distinction lies solely in the side of
the transaction with which one is concerned. A buyer opening an L/C will refer to it as an import L/C. A
seller shipping against an L/C will refer to it as an export L/C.
Letters of credit can be issued in either “revocable” or “irrevocable” form. A “revocable” credit is one
which may be canceled by the issuing bank without the agreement of the beneficiary. As such, revocable
credits are not desirable from the beneficiary’s point of view, and in fact are seldom used. “Irrevocable”
credits can be canceled or amended only with the consent of all parties to the L/C, including the
Irrevocable credits may be either “confirmed” or “unconfirmed.” If an L/C is confirmed, it provides the
beneficiary with the assurance of payment of not only the issuing bank, but also the “confirming” bank,
which is usually located in the beneficiary’s home country. In other words, the confirming bank takes on
the risk of reimbursement from the issuing bank. If an L/C is “unconfirmed,” the beneficiary has only the
assurance of the bank which issued the L/C and cannot rely on any other bank for payment.
Unconfirmed L/C’s are referred to as “advised” credits, as the beneficiary’s bank will forward a copy of
the original credit to the beneficiary with no engagement on their part.
“Confirmed” credits are useful when the issuing bank’s creditworthiness is unknown or when the
political and economic conditions in the country of the issuing bank are unstable. Letters of credit can
only be confirmed when the request for confirmation comes directly from the issuing bank, which
necessitates that the buyer be aware of the beneficiary’s desire for a confirmed credit. The beneficiary
could not simply take an unconfirmed L/C to his local bank and ask them to confirm it. Moreover, a
credit with a request for confirmation does not automatically bind an advising bank to confirm. The bank
would need to carefully examine the terms of the credit and evaluate the creditworthiness of the issuing
Since they assume additional risks when adding their confirmation, banks charge a fee to confirm letters
of credit. Such fees are normally charged to the issuing bank who must in turn charge their customer -
the importer. As such, confirmation charges should be agreed upon during the sales negotiation.
Beneficiaries of letters of credit are usually authorized to draw drafts on the issuing bank or advising
bank in order to receive payment. Letters of credit are payable against either “sight” or “time” drafts.
“Sight” drafts are payable upon the seller’s presentation of fully-conforming documents, as required by
the L/C. “Time” or “usance” drafts are payable at a specified date in the future, such as 30, 60 or 90 days
after sight, or after some other specified date such as “on-board” bill of lading date. This date will be
speci- fied in the letter of credit. Letters of credit which provide for usance drafts involve an extension
of credit to the buyer. Rather than drawing a draft payable at sight, the seller would draw a draft payable
at up to 180 days after sight or “date”. Upon negotiation of conforming documents, the bank on which a
usance draft was drawn undertakes to “accept” the draft, which represents the bank’s promise to pay the
face amount of such draft to the holder at maturity. Drafts accepted by banks are referred to as banker’s
The seller will require a bank’s accepting the draft if he is to release goods to the buyer prior to receiving
payment. Once the draft is accepted, it becomes the property of the exporter who can either hold the
draft until maturity when he can collect the face amount, or request the accepting bank to discount the
draft at the prevailing banker’s acceptance discount rate. (See “Banker’s Acceptance Financing” below.)
Should the seller elect to discount the draft, he may or may not receive its full face amount, depending on
whether the buyer or seller is responsible for the discount and acceptance charges. If the seller is
responsible for these charges he will of course, receive less than the face amount of the draft. If the
buyer is responsible for these charges, the exporter will receive the draft’s full face amount and the
accepting bank will collect discount and acceptance charges from the issuing bank, which in turn collects
from the importer.
All usance L/C’s must stipulate who will pay for discount and acceptance charges. Although it is always
a matter of negotiation between a buyer and seller, these charges are normally for the account of the
Letters of credit will often stipulate to which bank the beneficiary is to present drafts for negotiation.
“Straight” credits restrict payment to the specified advising or confirming bank. This bank is called the
“paying” bank and is usually located near the beneficiary. Straight credits will expire at the counters of
the paying bank and are most commonly utilized for U.S. exports payable in dollars. Exporters should,
when possible, request that buyers open L/C’s to be payable at their bank of account. However, even
though an L/C may be payable at their bank’s counters, payment will be made only after receipt of good
funds from the issuing bank. Sellers should therefore be aware that the issuing bank’s reimbursement
instructions may significantly affect the timing of payment of the draft. To prevent delays in the payment
of drafts, exporters should instruct their buyers to open L/C’s which authorize the negotiating bank to
claim telegraphic reimbursement from the issuing bank.
“Negotiation” credits allow beneficiaries to negotiate drafts at banks other than the advising or
confirming bank. This type of L/C is most beneficial when the confirming bank is not located near the
beneficiary, or when the beneficiary prefers to present documents to his bank of account which may be
different from the confirming bank. When the negotiating bank verifies that documents have been
presented which comply with the terms of the L/C, it will pay the beneficiary and claim reimbursement
from the confirming or paying bank.
BANKER’S ACCEPTANCES ARISING UNDER “USANCE” LETTERS OF CREDIT
In L/C’s payable against time or usance drafts, the parties agree that final payment for the trade
transaction covered by the L/C will not take place immediately on presentation of documents, as is the
case under “sight” L/C’s, but rather on a specified future date. At the request of the applicant (buyer),
the bank issuing the L/C commits to the beneficiary (seller) that it will honor time drafts drawn on it, if
accompanied by documents conforming to the terms and conditions of the L/C. When such documents
are presented to the bank for negotiation, after verification that the documents conform to the
requirements of the L/C, the bank “accepts” the time draft drawn on it, and in so doing, creates a
negotiable bank obligation called a “banker’s acceptance” (BA).
Exhibit I on the following page is an example of a draft drawn by an exporter, under a usance L/C, which
has been accepted by XXXX Bank. “Acceptance” is indicated by the stamp and signature affixed to the
face of the draft.
In accepting a time draft, the bank converts its irrevocable but conditional commitment to honor demands
for payment, as stated in the L/C, to a likewise irrevocable but no-longer-conditional commitment to pay
the draft amount on the draft maturity date to whoever is the final holder (endorsee) of the accepted draft.
In compensation for the extended credit risk incurred by the bank in making this commitment, it collects
a separate fee, generally called a banker’s acceptance commission.
The first holder of the BA is the L/C beneficiary who drew the time draft which the bank had accepted.
If the beneficiary chooses to hold the BA until its maturity date, on that day he would present the
accepted draft to the bank in exchange for payment of the full draft amount. When it pays the beneficiary
on the BA maturity date, the bank simultaneously collects the same amount from the original L/C
applicant who, in effect, has been financed by the beneficiary for the period of the time draft.
If the beneficiary chooses not to hold the BA until maturity, he has the ability to sell his negotiable bank
obligation at a discounted price. This may be done immediately after the BA is created, or at any time
prior to maturity. Often, the first purchaser of the BA is the same bank that had accepted the draft. Since
a bank can purchase its own acceptance at a discount and collect the full draft amount at maturity, doing
so may represent a good investment for the bank. At some later date, based on various factors such as
investment portfolio mix and money-market fluctuations, the bank may, and in fact often does, resell at a
discount its own purchased BA’s to other investors in the marketplace. Such investors will then collect
the full draft amount at maturity. Since they are negotiable bank obligations, prime BA’s are popular
short-term investments, with very little or no risk to the investor.
It is the supply and demand for BA’s in the marketplace which determine the price paid by banks and/or
non-bank investors. At any give time on a business day, the market quotes a Banker’s Acceptance
Discount Rate for a particular bank’s acceptances. This is the base rate from which the BA purchase
price is calculated. Shown below is the formula used to determine the price paid for a bank’s BA:
BA Amt. x BA Disc. Rate
Price = BA Amt. -- # Days to Maturity
Note: The BA Discount Rate in this formula does not include the BA commission which is paid
at the time of acceptance. The BA commission, therefore, should be added to the BA
Discount Rate to yield an “all-in” discount rate. This “all-in” discount rate should then
applied in the above formula in order to determine the final discounted price of the
Through the sale of a BA, the L/C beneficiary, in effect, transfers the short-term financing of the L/C
applicant’s purchase of goods to the secondary investor(s). Since the beneficiary sells the BA at a
discount, he may bear the financing cost for the extended terms granted to the applicant. However, this
financing cost could be indirectly charged to the applicant by building it into the cost of goods sold to
him, or the cost could be charged directly to the applicant. In the latter case, the applicant would request,
and the issuing bank would state in the L/C, that “the discount charges and acceptance commission are
for the applicant’s account.” Among the various negotiable points in an international trade contract of
sale, an important one is the specification of which party bears the financing cost inherent in a time L/C.
The appeal of time L/C’s and their conversion into BA’s is that the financing cost on the basis of the BA
Discount Rate, including the commission, is often below the financing cost of other short-term forms of
borrowing, such as those based on the Prime Rate.
INTERNATIONAL TRADE TERMS OF PAYMENT
Method of Time of Payment Goods Available
Payment to Seller to Buyer Risk to Seller Risk to Buyer
1. Cash in Prior to shipment. After payment. None. Full reliance on the
advance exporter to ship
goods as ordered.
2. Sight Letter of When shipment Upon settlement of Very little or Has assurance of
Credit (L/C) is made. L/C. none, based on shipment, but relies
conditions in the on seller to ship
L/C. goods as described
in the documents.
3. Time Letter of Upon maturity of Upon his bank’s Same. Actual payment is
Credit (L/C) time draft, or acceptance of the due after possession
upon discounting time draft under of goods, but must
of the Banker’s the L/C. be made regardless
Acceptance. of product quality.
4. Sight Draft Upon After payment. Possible non- Same as Sight L/C.
for Collection presentation of payment of draft
(D/P) collection draft. due to
5. Time Draft Upon maturity of Upon acceptance Same, but buyer Same as Time L/C.
for Collection time draft, or of time draft. has possession
(D/A) Trade of the goods.
6. Open Upon payment of Upon delivery. Full reliance on None.
Account invoice. buyer to pay
BANKER’S ACCEPTANCES AS MULTI-PURPOSE FINANCING TOOLS
Bankers Acceptances can be created under other circumstances and for other purposes than usance letters
of credit. Regardless of the purpose for which it is used, acceptance financing is typically less costly
than more conventional methods of financing. By definition, a BA is any time draft drawn on a bank and
accepted by that bank. To qualify as a BA, as shown in Exhibit IV, the draft must bear the acceptance
stamp and authorized signature of the bank on which it is drawn; it must be for a specific amount of
money; it must be payable to a named payee or his endorsee; and it must have a stated maturity date.
By regulation of the Federal Reserve Board, BA’s created by U.S. banks may fall into one of two
categories - “eligible” or “ineligible” BA’s. In order to take advantage of the more favorable reserve
requirements for eligible BA’s, banks generally restrict their acceptance activity to this category.
In order to be considered eligible, a BA must meet certain requirements set forth by the Federal Reserve
Board in various of its regulations. The all-encompassing requirement is that the maturity of a BA may
not exceed 180 calendar days from its creation. Moreover, the requirement is that the tenor (length of
time) of a BA should conform to the normal trade cycle of the commodity being financed by the BA,
even if such a trade cycle is substantially less than 180 days. Only three types of commercial
transactions qualify for eligible acceptance financing. These are the following:
1) Export or import transactions, including those not involving U.S. companies;
2) The domestic shipment of goods, with documents conveying title attached to the draft at the
time of acceptance; and,
3) The storage of readily marketable commodities, both domestic and foreign, which are
secured by warehouse receipts issued by an independent third party.
The example described earlier of a BA transaction arising under a usance L/C clearly meets the
requirements for eligibility since it involves an export transaction. However, even if payment terms other
than an L/C are used in a trade transaction, financing on a BA basis may still be possible. A time draft
need not be drawn on a bank exclusively under authorization of a usance L/C, but may also be drawn
under another form of authorization such as a Banker’s Acceptance Agreement between the bank and the
drawer (borrower). Such an agreement specifies the conditions under which drafts could be drawn on the
bank for acceptance and discount, with repayment coming from the settlement of one of the three
underlying commercial transactions noted above. In lieu of the trade documents which are part of the
drawing procedure under an L/C, the borrower in a BA Agreement transaction must separately give
evidence of the underlying transaction so that the bank may be assured of meeting the eligibility
requirements of the Federal Reserve Board. Such evidence may even include purchase orders for near-
term future export shipments, against which eligible BA financing may be provided on a “pre-export”
A common use of BA Agreements is to allow the refinancing of imported goods under sight L/C’s. In
such transactions, the foreign seller may not be willing or able to provide extended terms in the form of
his willingness to accept a time L/C in his favor. Instead he might require that payment be made through
a sight L/C. In such a case, the importer may still be able to defer his payment for the purchased goods,
until he has resold them, by asking his bank to refinance its sight payment under the original L/C by
creating and discounting a new and separate time draft drawn by the importer on the bank under a BA
Agreement. Such an arrangement could also be utilized to refinance sight draft documentary collection
Export and import transactions represent the most frequent use of BA financing. BA’s to finance
domestic shipments, while qualifying for eligibility, are seldom used due to the difficulties associated
with the requirement that title be conveyed to the bank at the time of acceptance. Title to such domestic
shipments is usually in the form of a truck or rail bill of lading. These bills of lading must therefore be in
the possession of the bank prior to acceptance. The use of BA’s to finance readily marketable
commodities, such as grains, preserved seafood and fruit, lumber, steel, etc., is growing rapidly due to
greater awareness of such financing by potential users, and due to innovative warehousing arrangements
by independent warehousing firms which make the special Federal Reserve requirements less
cumbersome. Such firms can issue warehouse receipts for stored commodities in favor of accepting
banks in order to meet the eligibility requirement for such transactions.