Letters of Credit and Bills of Exchange

In international trade exporters very often cannot be sure that obligations of their business partners will be fulfilled and therefore seek guarantees from third parties. The most secure way to solve the problem of unknown creditworthiness of buyers is to require the purchaser to open a letter of credit - one of the most famous products in trade finance segment. It is also referred to as a documentary credit.

The sellers often insist that the contract’s terms of payment stipulate that the buyer provides a letter of credit to the exporter for the amount equal to the value of the goods or services. This document is issued by the buyer’s local bank called “issuing bank”. In fact, the letter is an order to another bank called “advising bank”, located most often in the country of the seller, to pay this amount to the exporter (called “beneficiary” or “payee”). But the payment can only be made after both banks make sure that the details of the letter are in accordance with the conditions of the contract and the shipment has already been made. The shipping documents, such as the Bill of Lading or the Air Waybill, are checked by the advising bank and sent to the issuing bank, which after checking releases them to the buyer and pays the contract amount.

A confirmed irrevocable letter of credit is considered to be the most reliable guarantee that payment for the goods will be made on time and in full. That is why almost all letters of credit are irrevocable, i.e. cannot be amended or canceled without the consent of the parties to the letter. By confirming the letter the advising bank guarantees that the beneficiary will get paid even if the issuing bank fails to meet its obligations.

Most letters of credit are governed by rules promulgated by the International Chamber of Commerce known as Uniform Customs and Practice for Documentary Credits.

Another instrument widely used to facilitate foreign commercial transactions is the bill of exchange. The most common bill of exchange is the cheque. The bill of exchange is an unconditional order in writing, a draft, issued by the seller of the goods (the drawer) requesting the buyer (the drawee) to accept the terms indicated on the draft. The buyer "accepts" the draft by writing "accepted" across the face of the note, thereby creating a "trade acceptance." This document requires the buyer to pay the stated amount to a third party, usually a bank, which then credits the seller`s account for the amount of the sale. Bills of exchange may be dated in such a way that the obligation is due immediately (in this case it is known as a sight draft), or at a specific date in the future (then it is considered to be a time draft).

When bills of exchange are utilized in international trade, the seller has to send to his bank shipping and possibly other documents, required to receive the shipment of goods, such as various insurance policies, export and import licenses. The bank releases these documents when the buyer gives the trade acceptance to the bill.

 

Discussion

Answer the following questions:

1. What is the most secure way to solve the problem of unknown creditworthiness of buyers?

2. What kind of order does the letter of credit actually give to the advising bank?

3. What is the name or the trade finance document giving the most reliable guarantee that payment for the goods will be made on time and in full?

4. What can be done with the letter of credit to make sure that the beneficiary will get paid even if the issuing bank fails to meet its obligations?

5. What must the buyer do if he has accepted a bill of exchange?

6. When are the buyers obliged to pay up bills of exchange?

7. When can a buyer receive shipping and other receiving documents from the bank, keeping the relevant bill of exchange?

 

Note 1:

Bill of Lading (B/L, BoL) is in fact a receipt issued by a shipping line or its agent (carrier) proving that the goods have been loaded onto the vessel. The document specifies the names of the consignor and consignee, the type of cargo, its quantity, the point of origin of the consignment and its destination, and route. It can be used for insurance and customs purposes. Bill of Lading assigns title to the goods, and requires the carrier to release the merchandise to the holder of the title or a named party at the destination port. If this document is issued to bearer, the title to the goods during shipment can be transferred to this person.

Waybill is a similar, but a lesser document, which is very often issued instead of B/L. In the case of an Air Waybill some additional items are listed, such as the flight number and departure time. The main difference of a Waybill is that it does not confer title of the goods to the bearer as a Bill of Lading does, so there is no need for the physical document to be presented for the goods to be released. The carrier will automatically release the goods to the consignee once the import formalities have been completed.

However, for Letter of Credit transactions it is important to retain title to the goods until the transaction is complete. That is why the Bill of Lading still remains a vital document within international trade.

Note 2:

Cash against Documents. In CAD transactions the seller retains ownership of the product until payment is made. The documents that specify the terms of the transaction are held by an intermediary, most often a bank, chosen by both the buyer and seller. Once payment is remitted, the bank releases the documents showing that the buyer can take ownership of the product.

The primary advantage of a CAD transaction is for the buyer. It is less expensive for him than a Letter of Credit since it does not tie up his bank line of credit, which could be used to pay other vendors. In some cases, the bank may even require a cash deposit from the buyer to secure the amount of the Letter of Credit.

A CAD is riskier for the seller: if the buyer refuses delivery, the seller does not receive payment. But the buyer must pay to have the product transported back to the port of origin.

Section B

Exercise 1. Read the following words and phrases and translate them into Russian:

Convertible currency; fluctuation; International Monetary Fund; collection of payment proceeds; beneficiary; fiduciary; method of settlement; remit payment; creditworthiness; risk mitigation; foreign exchange risk; shipping documents; customs clearance; tracking; air waybill; irrevocable confirmed letter of credit; to fulfill/meet one’s obligations; release documents.

 

Exercise 2. Part a) Fill in the gaps in the table below.

Noun	Verb	Person
		drawer; drawee
guarantee
	trade
	cash
collection
ship
	pay

Part b) Complete these sentences using the words from the table above.

1. The exporter preferred that _____ for the goods had to be made in his country’s currency.

2. The _____ accepted the draft by writing the word "accepted" on the face of the draft, signing it and indicating the date.

3. Clearing institutions in the leading financial centers are actively involved in financing international _____.

4. It was not easy for the exporter to find a _____, which could deliver his goods to this country.

5. The importer managed to _____ money on his insurance only after presenting all the relevant documents.

6. The bank had to pay the _____ amount to the exporter when the buyer failed to meet his obligations.

7. The buyer could not receive shipping documents before making payment for the goods because the contract was made on ” _____ against documents” terms.

8. The _____ insisted that the goods should be paid by a bill of exchange on sight draft terms.