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Every business transaction consist of at least two parties that are the importer and exporter. In addition, some of the transactions involve not only the buyer and seller, but also the banks of the parties, government customs agencies and freight forwarders as well. Profiting from the transaction and being exposed to the smallest risk are the common concern of both parties. However, in all transactions buyers and sellers exposed to the risk somehow.
Domestic transactions are stable, transparent, secure or reliable as compared to international transactions that are risky because of changing dynamics at the time of sale and expected time of payment.
Therefore, the seller always prefer to be paid at delivery or prior to it. The seller has made investment in the time of manufacturing the product and does not prefer bearing the cost of transportation as well.
On the other hand,the buyer aware of the fact that it can take one or two months before goods had arrived. Goods will be ready for export, trucked or sent by rail to the port, export cleared, shipped to the final port, warehoused awaiting customs clearance, inspected, customs cleared, sent overland to the final destination, and finally became inventory at warehouse of buyer Therefore, both buyer and seller prefer that other party finance the transaction and pay for the cost.
Domestic payments primarily use credit cards and checks. International payments primarily use Commercial Letters of Credit and Documentary Collections or open account.
Trade can be defined as the exchange of tangible goods or services between a seller and a buyer in another country for payment.
United Nations Convention on Contracts for the International Sale of Goods stands for regulating international contracts about sale of goods by emphasing payment conditions as well. International transaction payment terms depend on the relationship between the seller and the buyer, the nature of merchandise, norms of industry, the distance between parties, the potential for currency fluctuation, and economic and political stability in the countries.
Also, there are number of other factors that directly affect proper receipt of payment, including lost or damaged goods, default of the buyer and of course the broad area of contractual dispute as insurance cover for some of the risks.
All these factors must be taken into consideration before deciding on a method of payment that is acceptable to both parties.
The method of payment is the means that describes how money will be paid and the exporter has different options with varying degrees of security. The most common methods for international transaction are letter of credit, documentary collection, open account and cash in advance.
Open account can be least risky for the exporter that is followed by bills of exchange, documentary letter of credit and as a most secure cash in advance method. The trader has to make a choice as appropriate terms and method of payment right at the beginning of the process.
Cash in advance type of payment method requires that the buyer pay to the seller before the shipment of goods ordered in cash in advance type of payment method. It provides greatest risk for the buyer if the seller does not comply with all the terms of the contract. If the goods are delayed or inferior quality, the buyer take legal action on the basis of sales contract.
This payment method requires that the buyer have a high level of confidence in the ability and willingness of the seller to deliver the goods as ordered.
Therefore, cash in advance provides the seller with the most security but leaves the buyer at great risk. This type of payment constitutes a small proportion of payments made in international transactions.
Also called an advance payment bond.
A contract under which the issuer undertakes to be responsible for the fulfilment of a contractual obligation owed by one person to another if the first-person defaults.
The issuer's obligation may be primary (as in an on-demand obligation or indemnity) or secondary (as in a guarantee).
An advance payment guarantees, or bond is typically used to underpin or guarantee the performance of a commercial contract, such as a contract for the sale of goods (where the buyer is the beneficiary) or a construction contract (where the employer is the beneficiary).
For example, a buyer or employer may make down or advance payments to a seller or contractor to provide it with funds to purchase necessary materials or machinery or otherwise prepare itself to perform the contract.
The buyer or employer will wish to ensure that if the seller or contractor fails (perhaps because of insolvency) to deliver the goods or perform the services in accordance with the contract then, at the very least, it can recover the payments made to the seller or contractor.
The buyer or employer will, therefore, require the seller or contractor to provide an advance payment guarantee or bond for these payments.
The guarantee or bond will provide that if the seller or contractor fails to meet its contractual obligations, the issuer will refund the advance payments made by the buyer or employer.
A 'Pre-Advice' is a message sent by the Provider's bank advising of the anticipated assignment of a bank instrument to your client(s) account(s).
The Pre-Advice should be clear and concise, and provide the following information relating to each incoming payment:
• Customer Name and Account Number to be assigned
• Currency and Amount
• Value Date
• Name of Remitting Entity
• Name of Correspondent/Remitting Bank
The Pre-Advice of incoming assignment allows to optimize its aggregate funding requirements and maximize returns on long balances, as well as to meet regulatory requirements governing accounts in some jurisdictions. This, in turn, allows your client's bank to offer competitive interest conditions on accounts by taking advantage of optimum market liquidity, as well as providing further tangible benefits to your client.
The customer bank will match our Pre-Advice of incoming funds with the payment message received from the remitting banks.
This facilitates the posting of incoming funds to your account(s).
• Receipt of our Pre-Advice message, in advance of the instrument cut-off time, will ensure that good value is applied to incoming instrument.
• The client bank function is able to manage its liquidity position more effectively and, as a consequence, is able to maximize its return on funds, which is reflected in the competitive interest conditions offered to you.
In conclusion, Pre-Advising is an essential tool in your effective management of cash flows, ensuring that good value is applied to incoming instrument.
This is just general information about the Pre Advice. As in everything you do you should consult with your bank as to your specific situation and whether or not you require a pre advice.
The provider is ready to cover the expenses of the delivery of the pre-advice against the invoice for the leasing fees.
The Lessee can deduct the cost of the pre advice from the amount he must pay to lease the instrument for one year.
A bank confirmation letter (BCL) is a letter from a bank or financial institution confirming the existence of a loan or a line of credit that has been extended to a borrower. The letter officially vouches for the fact that the borrower—typically an individual, company, or organization—is eligible to borrow a specified amount of funds for a specified purpose.
• A bank confirmation letter (BCL) validates that a bank has a line of credit in place with one of its customers.
• The BLC is not a guarantee of payment, but an assurance of the borrower's financial resources to complete a purchase.
• Bank confirmation letters are typically issued to business customers vouching for their creditworthiness.
• Bank confirmation letters can also be issued for a company that is entering into a joint venture project with another company.
• Individuals may request a BCL during the purchase of a home or land in order to secure a mortgage or establish creditworthiness with the seller.
A bank confirmation letter's purpose is to assure a third party, generally a seller, that the borrower has access to sufficient financial resources to complete a transaction, such as the purchase of goods. The confirmation letter—sometimes known as a comfort letter—is not a guarantee of payment, but only an assurance of the borrower's financial resources to make payment.
Bank confirmation letters typically require the signature of representatives of the bank or the financial institution who are authorized to issue such correspondence.
Since a letter of confirmation is issued in regard to a particular transaction or project, it's not transferable to a different transaction or project. If the bank's customer decides to enter into a different deal or purchase, the customer usually is required to obtain a new letter of confirmation.
For example, a prospective home buyer decides to buy a different home than the one specified in the bank confirmation letter; a new BCL would be needed.
Regulations vary from country to country in terms of whether and to what extent a letter of confirmation must state the specific purpose for which a loan or line of credit is being extended to the borrower.
Bank confirmation letters are most commonly prepared for a business customer of the bank, vouching for the existence of a specified line of credit. The letters often serve to reassure sellers of a large number of goods.
They may also be issued for a company that is entering into a joint venture project with another company. While the letter does not guarantee payment or provision of funds, it does provide an assurance of a high probability of the company receiving payment from the bank's customer.
The most common use of a bank confirmation letter by an individual is during the purchase of a home or land. In such cases, the letter provides confirmation to a seller or realtor that the bank's customer is approved for a mortgage up to a specified amount for a proposed purchase.
The letter is not a commitment to buy the property; it is merely a reassurance that the bank’s customer has access to funds to complete a purchase. In most situations, a prospective buyer will not be able to close on a property without having a bank confirmation letter in hand.
A bank guarantee is a type of financial backstop offered by a lending institution. The bank guarantee means that the lender will ensure that the liabilities of a debtor will be met. In other words, if the debtor fails to settle a debt, the bank will cover it. A bank guarantee enables the customer, or debtor, to acquire goods, buy equipment or draw down a loan.
• A bank guarantee is when a lending institution promises to cover a loss if a borrower defaults on a loan.
• Parties to a loan choose direct guarantees for international and cross-border transactions.
• The guarantee provides additional risk to the lender, so loans with such a guarantee will come with greater costs or interest rates.
A bank guarantee is when a lending institution promises to cover a loss if a borrower defaults on a loan. The guarantee lets a company buy what it otherwise could not, helping business growth and promoting entrepreneurial activity.
There are different kinds of bank guarantees, including direct and indirect guarantees. Banks typically use direct guarantees in foreign or domestic business, issued directly to the beneficiary. Direct guarantees apply when the bank’s security does not rely on the existence, validity, and enforceability of the main obligation.
Individuals often choose direct guarantees for international and cross-border transactions, which can be more easily adapted to foreign legal systems and practices since they don't have form requirements.
Indirect guarantees occur most often in the export business, especially when government agencies or public entities are the beneficiaries of the guarantee. Many countries do not accept foreign banks and guarantors because of legal issues or other form requirements. With an indirect guarantee, one uses a second bank, typically a foreign bank with a head office in the beneficiary’s country of domicile.
Because of the general nature of a bank guarantee, there are many different kinds:
• A payment guarantee assures a seller the purchase price is paid on a set date.
• An advance payment guarantee acts as collateral for reimbursing advance payment from the buyer if the seller does not supply the specified goods per the contract.
• A credit security bond serves as collateral for repaying a loan.
• A rental guarantee serves as collateral for rental agreement payments.
• A confirmed payment order is an irrevocable obligation where the bank pays the beneficiary a set amount on a given date on the client’s behalf.
• A performance bond serves as collateral for the buyer’s costs incurred if services or goods are not provided as agreed in the contract.
• A warranty bond serves as collateral ensuring ordered goods are delivered as agreed.
For example, Company A is a new restaurant that wants to buy $3 million in kitchen equipment. The equipment vendor requires Company A to provide a bank guarantee to cover payments before they ship the equipment to Company A. Company A requests a guarantee from the lending institution keeping its cash accounts. The bank essentially cosigns the purchase contract with the vendor.
Banker's acceptance (BA) is a negotiable piece of paper that functions like a post-dated check. A bank, rather than an account holder, guarantees the payment. Banker's acceptances (also known as bills of exchange) are used by companies as a relatively safe form of payment for large transactions. BAs can also be short-term debt instruments, similar to U.S. Treasury bills, that trade at a discount to face value in the money markets.
• The banker's acceptance is a form of payment that is guaranteed by a bank rather than an individual account holder.
• The bank guarantees payment at a later time.
• BAs are most frequently used in international trade to finalize transactions with relatively little risk to either party.
• Banker's acceptances are traded at a discount in the secondary money markets.
• Thus, unlike a post-dated check, BAs can be investments that are traded, generally at a discounted price (similar to Treasury bills).
For the company that issues it, a banker's acceptance is a way to pay for a purchase without borrowing to do so. For the company that receives it, the bill is a guaranteed form of payment. A banker's acceptance requires the bank to pay the holder a set amount of money on a set date.
BAs are most commonly issued 90 days before the date of maturity but can mature at any later date from one to 180 days. They are typically issued in multiples of $100,000.
BAs are issued at a discount to their face value. Thus, like a bond, they earn a return. They also can be traded like bonds in the secondary money market. There is no penalty for cashing them in early, except for the lost interest that would have been earned had they been held until their maturity dates.
Banker’s acceptances have been around since the 12th century. Just like now, BAs were used as a method of facilitating trade. In the 18th and 19th centuries, BAs started to become an actively traded market in London.
The U.S. launched the Federal Reserve in the early 1900s to help create banker’s acceptances that compete with London’s. The Fed’s goal was to boost U.S. trade and it was given the authority to purchase certain BAs. While the Fed still buys government bonds, it no longer buys BAs.
If you are looking to obtain a BA, go to a bank that you have a good working relationship with. (Note that not all banks offer BAs.)
Banker's acceptances, like certified checks, are a relatively safe form of payment for both sides of a transaction. The money owed is guaranteed to be paid on the date specified on the bill.
The use of BAs is most common in international trade transactions. A buyer with an importing business can issue a banker’s acceptance with a date after a shipment is due to be delivered, and the seller with an exporting business will have the payment instrument in hand before finalizing the shipment.
The person who is paid with a banker's acceptance may hold onto it until its maturity date in order to receive its full value or can sell it immediately at a discount to face value.
Banker's acceptances are a relatively safe form of payment for both sides of a transaction.
Unlike a regular check, a banker’s acceptance relies on the creditworthiness of the banking institution rather than the individual or business that issues it. The bank requires that the issuer meet its credit eligibility requirements, typically including a deposit sufficient to cover the banker’s acceptance.
Banks and institutional investors trade banker's acceptances on the secondary market before they reach maturity. The strategy is similar to that used in trading zero-coupon bonds. The BA is sold below face value, at a discount determined by the length of time before the maturity date.
Banker's acceptances are considered to be relatively safe investments because the bank and the borrower are liable for the amount that is due when the instrument matures.
One of the key advantages of a banker’s acceptances is it’s backed by a financial institution (i.e., protected against default). This gives the seller assurances related to payment. Meanwhile, buyers are afforded the ability to make purchases in a timely manner and not worry about having to make payments in advance.
Now, the key risk is that the financial institution will have to make good on the promised payment. This is the key risk for the bank. To help hedge against this, the bank may require the buyer to post collateral.
• It provides the seller assurances against default.
• The buyer doesn’t have to prepay or pay in advance for goods .
• It provides the ability to purchase and sell goods in a timely manner.
• It has a relatively low cost compared to the hedge or benefit provided.
• The bank may require the buyer to post collateral before issuing the banker’s acceptance.
• The buyer may default, forcing the financial institution to make the payment.
How Does a Banker's Acceptance Work?
For a banker’s acceptance, the importer will seek to make a purchase from an exporter (generally in another country). The exporter wants assurance of payment, but the importer also wants assurance that the seller can deliver. Banker’s acceptance is a form of payment backed by a bank that eliminates transaction-related risks for the importer and exporter.
Is a Banker's Acceptance a Money Market Instrument?
Banker's acceptances are money market instruments and, like most money markets, are relatively safe and liquid, particularly when the paying bank enjoys a strong credit rating.
What Is a Banker's Acceptance Rate?
Banker’s acceptances are assumed to be safe investments as they’re backed by the bank, which means they often trade at a discount to face value. The banker’s acceptance rate is the market rate at which these instruments trade. It’s the return an investor would receive if they purchased today and held until the payment date.
What Is the Difference Between Banker’s Acceptance and Commercial Paper?
Commercial paper is a promissory note that pays a fixed rate. It’s unsecured and can be for a few days or years. Commercial paper is generally used to cover short-term obligations (such as the cost for a new project) or short-term receivables. BAs are also short-term promissory notes, although they have the unconditional guarantee of a bank and are often used for trade.
From an investment perspective, banker’s acceptances are relatively safe investments being money market investments and inline with T-bills from a risk-return perspective. For importers and exporters, BAs help boost trade by reducing transaction-related risks.
A bank guarantee and a letter of credit are both promises from a financial institution that a borrower will be able to repay a debt to another party, no matter what the debtor's financial circumstances.
While different, both bank guarantees and letters of credit assure the third party that if the borrowing party can't repay what it owes, the financial institution will step in on behalf of the borrower.
By providing financial backing for the borrowing party (often at the request of the other one), these promises serve to reduce risk factors, encouraging the transaction to proceed. But they work in slightly different ways and in different situations.
Letters of credit are especially important in international trade due to the distance involved, the potentially differing laws in the countries of the businesses involved, and the difficulty of the parties meeting in person.
While letters of credit are primarily used in global transactions, bank guarantees are often used in real estate contracts and infrastructure projects.
• A bank guarantee is a promise from a lending institution that ensures the bank will step up if a debtor can't cover a debt.
• Letters of credit are also financial promises on behalf of one party in a transaction and are especially significant in international trade.
• Bank guarantees are often used in real estate contracts and infrastructure projects, while letters of credit are primarily used in global transactions.
Bank guarantees are just like any other kind of financial instrument—they can take on a variety of different forms.
For instance, direct guarantees are issued by banks in both domestic and foreign business.
Indirect guarantees are commonly issued when the subject of the guarantee is a government agency or another public entity.
The most common kinds of guarantees include:
• Shipping guarantees: This kind of guarantee is given to the carrier for a shipment that arrives before any documents are received.
• Loan guarantees: An institution that issues a loan guarantee pledges to take on the financial obligation if the borrower defaults.
• Advanced payment guarantees: This guarantee acts to back up a contract's performance. Basically, this guarantee is a form of collateral to reimburse advance payment should the seller not supply the goods specified in the contract.
• Confirmed payment guarantees: With this irrevocable obligation, a specific amount is paid by the bank to a beneficiary on behalf of the client by a certain date.
Bank guarantees are commonly used by contractors while letters of credit are issued for importing and exporting companies.
Sometimes referred to as a documentary credit, a letter of credit acts as a promissory note from a financial institution—usually a bank or credit union.
It guarantees a buyer's payment to a seller or a borrower's payment to a lender will be received on time and for the full amount. It also states that if the buyer can't make a payment on the purchase, the bank will cover the full or remaining amount owed.
A letter of credit represents an obligation taken on by a bank to make a payment once certain criteria are met.
After these terms are completed and confirmed, the bank will transfer the funds. The letter of credit ensures the payment will be made as long as the services are performed. The letter of credit basically substitutes the bank's credit for that of its client, ensuring correct and timely payment.
For example, say a U.S. wholesaler receives an order from a new client, a Thai company. Because the wholesaler has no way of knowing whether this new client can fulfill its payment obligations, it requests a letter of credit is provided in the purchasing contract.
The purchasing company applies for a letter of credit at a bank where it already has funds or a line of credit (LOC).
The bank issuing the letter of credit holds payment on behalf of the buyer until it receives confirmation that the goods in the transaction have been shipped. After the goods have been shipped, the bank would pay the wholesaler its due as long as the terms of the sales contract are met, such as delivery before a certain time or confirmation from the buyer that the goods were received undamaged.
Just like bank guarantees, letters of credit also vary based on the need for them. The following are some of the most commonly used letters of credit:
• An irrevocable letter of credit ensures the buyer is obligated to the seller.
• A confirmed letter of credit comes from a second bank, which guarantees the letter when the first one has questionable credit. The confirming bank ensures payment in the event the company or issuing bank default on their obligations.
• An import letter of credit allows importers to make payments immediately by providing them with a short-term cash advance.
• An export letter of credit lets the buyer's bank know it must pay the seller, provided all the conditions of the contract are met.
• A revolving letter of credit lets customers make draws—within limits—during a certain time period.
Both bank guarantees and letters of credit work to reduce the risk in a business agreement or deal. Parties are more likely to agree to the transaction because they have less liability when a letter of credit or bank guarantee is active. These agreements are particularly important and useful in what would otherwise be risky transactions such as certain real estate and international trade contracts.
Banks thoroughly screen clients interested in one of these documents. After the bank determines that the applicant is creditworthy and has a reasonable risk, a monetary limit is placed on the agreement. The bank agrees to be obligated up to, but not exceeding, the limit. This protects the bank by providing a specific threshold of risk.
Another key difference between bank guarantees and letters of credit lies in the parties that use them.
Bank guarantees are normally used by contractors who bid on large projects. By providing a bank guarantee, the contractor provides proof of its financial credibility. In essence, the guarantee assures the entity behind the project it is financially stable enough to take it on from beginning to end. Letters of credit, on the other hand, are commonly used by companies that regularly import and export goods.
A blocked fund is defined as money or capital realized when a foreign operation involving the transfer of funds is blocked as a result of regulations imposed by the government of the country where the money was generated.
When a fund is suspected to be generated from illegal activities or criminal acts, the government can impose certain regulations hindering the money from being be transferred. The fund then becomes a blocked fund.
There are quite a number of reasons why foreign operations involving the transfer of funds may be blocked, thereby becoming blocked funds. The major reasons are trade violations, criminal or illegal activities, political reasons and regulations in foreign currencies.
When a nation is faced with a situation of emergency, blocked funds might occur, political reasons can also motivate regulations imposed on foreign operations resulting in blocked funds.
A financial institution might be mandated to hold particular funds if they are suspected to be generated from criminal activities.
Questionable transactions are investigated but funds involved are held until investigations are complete. For example, recently, the Justice Department in the U. S asked Visa and PayPal to block fund transfers to offshore gambling Web sites until it is satisfied that no illegality has occurred.
Funds can also be restricted when trade violations occur. If the government of a nation decides a certain funds should be blocked, financial institutions in charge of the funds are contacted to effect this.
The institution then freezes the funds until investigations are complete and it is certain that no illegality occurred. However, during this period, the funds are put in interest-bearing accounts where they can generate interests which are returned to the holder of the funds once they are unfrozen or unblocked. Some professionals specialize in trading blocked funds, they are mostly banks and brokers. They trade these funds in exchange for profits, they often request discounts or make profits through currency conversion rates.
The term collateral transfer denotes an arrangement by which one company lends its assets to another company for use as collateral in order for the borrowing company to access business loans.
The company which lends its assets is referred to as the provider. The company which borrows assets is referred to as the beneficiary. The two companies enter into a collateral transfer agreement. The collateral transfer agreement is normally mediated by a bank or specialized collateral transfer service provider.
Typically, the collateral used for collateral transfer is comprised of bank guarantees. For this reason, collateral transfer is often referred to as bank guarantee leasing.
The beneficiary pays the provider interest in the form of a contract fee.
The provider’s bank transfers its bank guarantees to the beneficiary’s bank. The beneficiary can then use the borrowed bank guarantee as collateral to obtain loans.
A fully funded documentary letter of credit (FFDLC) is a documented letter of credit that serves as a written promise of payment provided by a buyer to a seller. With a fully funded letter of credit, the buyer’s funds for the required payment are held in a separate account for use when needed, similar to the process for escrow. The seller receives payment when all of the terms of the agreement are fulfilled.
Letters of credit are commonly used in commercial, international transactions. They allow a buyer to manage risks of international business dealings while also obtaining support through the promise of borrowed funds. A letter of credit is documented by a bank who serves as a third party in the transaction.
A seller may have certain requirements for the financial institutions from which it will accept letters of credit. A letter of credit serves as a binding and legal document that the seller can accept and legally contest if payment is not made according to the detailed terms.
A fully funded documentary letter of credit is a letter of credit in which the funds necessary are held in a separate account which serves as a type of escrow account. Buyers using an FFDLC may deposit some of their own funds and require funding from a financial institution for the remainder of the funds.
Typically, in an FFDLC, the buyer will need to begin paying interest on the borrowed funds as soon as they are placed in the separate account.
Buyers and sellers will usually work with third parties to fully complete transactions involving all types of letters of credit and specifically FFDLC. The seller may hold documentary letters of credit with their own bank who then acts as their agent. The seller’s agent bank can manage the documentary collection process when appropriate and can help the seller to more easily receive payment into its account.
Other operational procedures may also be included in the documentary collection. Some documentary letters of credit may include an at sight provision, which requires that the buyer initiate the transaction as soon as they receive the specified goods and accompanying paperwork.
Overall, an FFDLC provides assurance to the seller that the buyer has the necessary funds for the transaction, as it proves the buyer has transferred cash to a separate account. With an FFDLC the buyer does not have to risk sending payment to the seller without knowing whether or not the goods have actually been shipped.
Fully funded documentary letters of credit include comprehensive provisions detailing all of the necessary business and operational provisions. Such terms may include clauses for proof of shipment, such as a bill of lading stamped by customs. The conditions under which funds may revert to the buyer, such as the seller's failure to provide a bill of lading within a set time, are also outlined in the FFDLC.
Letters of credit can be funded or unfunded. A fully funded documentary letter of credit will provide assurance that cash for the value necessary in payment has been moved to a separate account for payment when required. Unfunded letters of credit do not set aside funds specifically through a separate, escrow type of account.
In an unfunded letter of credit, the bank backing the letter of credit promises to pay if the buyer is unable to at the time payment is required. In an unfunded letter of credit, the bank may pay the full amount or a partial amount depending on the funds the buyer has available. If a bank must issue funds for an unfunded letter of credit, then interest on the funds being borrowed from the bank would usually not begin until transferred.
• An FFDLC is a letter of credit backed by funds in escrow.
• Businesses can use an FFDLC to obtain some or all of the funds moved to an escrow account for final payment.
• Letters of credit can come in many different variations and may be either funded or unfunded.
There can be numerous types of letters of credit. Each may or may not be funded. Some of the most common types of letters of credit include the following:
• Commercial/documentary letter of credit
• Standby letter of credit
• Secured letter of credit
• Revocable letter of credit
• Irrevocable letter of credit
• Revolving letter of credit
• Red clause letter of credit
• Green clause letter of credit
Companies may need to make special considerations for accounting for letters of credit. These considerations can depend on whether the letter of credit is funded or unfunded. Letters of credit serve as access to borrowed funds. Funded letters of credit may involve some fees or accumulating interest, depending on the agreement.
In general, a funded letter of credit may need to be reported on the balance sheet as a liability if funds are transferred to a separate account and begin accumulating interest. An unfunded letter of credit would not necessarily need to be reported as a liability on the balance sheet until the letter of credit has been utilized in exchange for borrowed funds.
Typically, funded and unfunded letters of credit are associated with a credit line. Large institutions using funded letters of credit will usually have a designated line of credit account tied to their letter of credit needs.
Monetization is the process of changing something that does not generate revenue into cash.
Monetization is a significant aspect of a company's business strategy for generating a profit and ensuring sustainability. In the U.S., the Federal Reserve monetizes debt to curb a potential financial crisis.
Monetizing a bank instrument (bg/sblc) means raising finance (or credit line) against it.
In order to receive cash funds or raise a credit line against a bank instrument, it is important that the bank instrument is worded specifically for the purpose of receiving cash funds for either viable projects, Platform Trading or securing a credit line.
Receiving cash funds or raising a credit line against a bank instrument issued for purposes other than these, may be difficult to monetize.
Monetizing bank instruments is the process of liquidating such instruments by converting them into legal tender. We can monetize or lend on credible bank instruments issued by rated banks to be used for project funding as well as move them into various trading platforms quickly and easily while creatively incorporating them into financing certain development projects.
THIS PROCESS ALLOWS YOU TO:
• Monetize instruments for cash as well as for raising a credit line
• Monetize instruments for buy/sell platform entry
• Monetize instruments for both cash and buy/sell platform entry
We offer monetization/discounting of bank instruments such as:
• Cash-backed Standby Letter Of Credit/Bank Guarantee (BG/SBLC).
• Medium- and Long-Term Notes (MTN & LTN).
• Our monetization rate (LTV) is excellent, and our procedure is seamless, stress-free and quick.
Monetization is the process of converting or establishing something into legal tender. While it usually refers to the coining of currency or the printing of banknotes by central banks, it may also take the form of a promissory currency.
The term “monetization” may also be used informally to refer to exchanging possessions for cash or cash equivalents, including selling a security interest, charging fees for something that used to be free, or attempting to make money on goods or services that were previously unprofitable or had been considered to have the potential to earn profits.
And data monetization refers to a spectrum of ways information assets can be converted into economic value.
Still another meaning of “monetization” denotes the process by which the U.S. Treasury accounts for the face value of outstanding coinage.
This procedure can extend even to one-of-a-kind situations such as when the Treasury Department sold an extremely rare 1933 Double Eagle, the amount of $20 was added to the final sale price, reflecting the fact that the coin was considered to be issued into circulation as a result of the transaction.
Such commodities as gold, diamonds and emeralds have generally been regarded by human populations as having intrinsic value within that population based on their rarity or quality and thus provide a premium not associated with fiat currency unless that currency is “promissory”.
That is, the currency promises to deliver a given amount of a recognized commodity of a universally (globally) agreed-to rarity and value, providing the currency with the foundation of legitimacy or value.
Though rarely the case with paper currency, even intrinsically relatively worthless items or commodities can be made into money, so long as they are difficult to make or acquire.
Debt monetization is the financing of government operations by the central bank.
 If a nation’s expenditure exceeds its revenues, it incurs a government deficit which can be financed by the government treasury by
1. money it already holds (e.g. income or liquidations from a sovereign wealth fund)
2. issuing new bonds
3. or by the central bank by
4. money it creates de novo
In the latter case, the central bank may purchase government bonds by conducting an open market purchase, i.e. by increasing the monetary base through the money creation process.
If government bonds that have come due are held by the central bank, the central bank will return any funds paid to it back to the treasury. Thus, the treasury may “borrow” money without needing to repay it.
This process of financing government spending is called “monetizing the debt.
In most high-income countries the government assigns exclusive power to issue its national currency to a central bank , but central banks may be forbidden by law from purchasing debt directly from the government.
For example, the Treaty on the Functioning of the European Union (article 123) forbids EU central banks’ direct purchase of debt of EU public bodies such as national governments.
Their debt purchases have to be from the secondary markets. Monetizing debt is thus a two-step process where the government issues debt (Government bonds) to cover its spending and the central bank purchases the debt, holding it until it comes due, and leaving the system with an increased supply of money.
DEBT MONETIZATION AND INFLATION
When government deficits are financed through debt monetization the outcome is an increase in the monetary base, shifting the aggregate-demand curve to the right leading to a rise in the price level (unless the money supply is infinitely elastic).
When governments intentionally do this, they devalue existing stockpiles of fixed income cash flows of anyone who is holding assets based in that currency.
This does not reduce the value of floating or hard assets and has an uncertain (and potentially beneficial) impact on some equities.
It benefits debtors at the expense of creditors and will result in an increase in the nominal price of real estate.
This wealth transfer is clearly not a Pareto improvement but can act as a stimulus to economic growth and employment in an economy overburdened by private debt.
It is in essence a “tax” and a simultaneous redistribution to debtors as the overall value of creditors’ fixed income assets drop (and as the debt burden to debtors correspondingly decreases). If the beneficiaries of this transfer are more likely to spend their gains (due to lower income and asset levels) this can stimulate demand and increase liquidity.
It also decreases the value of the currency – potentially stimulating exports and decreasing imports – improving the balance of trade. Foreign owners of local currency and debt also lose money.
Fixed income creditors experience decreased wealth due to a loss in spending power. This is known as “inflation tax” (or “inflationary debt relief”). Conversely, tight monetary policy which favors creditors over debtors even at the expense of reduced economic growth can also be considered a wealth transfer to holders of fixed assets from people with debt or with mostly human capital to trade (a “deflation tax”).
A deficit can be the source of sustained inflation only if it is persistent rather than temporary, and if the government finances it by creating money (through monetizing the debt), rather than leaving bonds in the hands of the public.
REVENUE FROM BUSINESS OPERATIONS
In some industry sectors such as high technology and marketing, monetization is a buzzword for adapting non-revenue-generating assets to generate revenue.
Web sites and mobile apps that do generate revenue are often monetized via advertisements, subscription fees or (in the case of mobile) in-app purchases. In the music industry, monetization happens when a recording artist puts a video on the Internet and the platform where it appears shows advertisements before, during, or after the video. For each public viewing, the advertising revenue is shared with the artist or others who hold rights to the video content. A previously free product may have premium options added thus becoming freemium.
Failure to monetize web sites due to an inadequate revenue model was a problem that caused many businesses to fold during the dot-com bust. David Sands, CTO for Citibank Equity Research, affirmed that failure to achieve monetization of the Research Analysts’ models as the reason the de-bundling of Equity Research has never taken hold.
MONETIZATION OF NON-MONETARY BENEFITS
Monetization is also used to refer to the process of converting some benefit received in non-monetary form (such as milk) into a monetary payment. The term is used in social welfare reform when converting in-kind payments (such as food stamps or other free benefits) into some “equivalent” cash payment. From the point of view of economics and efficiency, it is usually considered better to give someone a monetary equivalent of some benefit than the benefit (say, a liter of milk) in kind.
Inefficiency: in the latter situation people who may not need milk cannot get something of equivalent value (without subsequently trading or selling the milk).
Black market growth: people who need something other than milk may sell it. In many circumstances, this action may be illegal and considered fraudulent. For example, Moscow pensioners (see below for details) often give their personal cards that allow free usage of local transport to relatives who use public transport more frequently.
Changes on the market: supply of milk to the market is reduced by the amount distributed to the privileged group, so the price and availability of milk may change.
Corruption: firms that should give this benefit have an advantage as they have guaranteed consumers and the quality of the goods supplied is controlled only administratively, not by market competition. So, bribes to the body that choose such firms and/or maintain control can take place.
(A) any letter of credit, bankers acceptance, surety bond, performance bond, bank guarantee or other similar obligation issued for the account of such Person to support only trade payables or nonfinancial performance obligations of such Person,
(B) any letter of credit, bankers acceptance, surety bond, performance bond, bank guarantee or other similar obligation issued for the account of such Person to support any letter of credit, bankers acceptance, surety bond, performance bond, bank guarantee or other similar obligation issued for the account of a Subsidiary, a Joint Venture or a Consortium of such Person to support only trade payables or non-financial performance obligations of such Subsidiary, Joint Venture or Consortium, and...
(C) any parent company guarantee or other direct or indirect liability, contingent or otherwise, of such Person with respect to trade payables or non-financial performance obligations of a Subsidiary, a Joint Venture or a Consortium of such Person, if the purpose of such Person in incurring such liability is to provide assurance to the oblige that such contractual obligation will be performed, or that any agreement relating thereto will be complied with.
Proof of funds is a document or bank statement that showcases the financial capability of a person/company to undertake the transaction.
With this, the other party or the parties will easily be able to get ensured of financial capability required for the transaction is procurable and legitimate. POF is mostly used when large sums of money is involved in transactions like biddings and investments.
Also known as a bank comfort letter, RWA is a document issued by a bank or a financial institution on the clients’ behalf showcasing the capability and willingness of him or her to enter into the financial transaction.
A SWIFT code — sometimes also called a SWIFT number — is a standard format for Business Identifier Codes (BIC).
It’s used to identify banks and financial institutions globally. It says who and where they are — a sort of international bank code or ID.
These codes are used when transferring money between banks, in particular for international wire transfers or SEPA payments. Banks also use these codes to exchange messages between each other.
Society for Worldwide Interbank Financial Telecommunication (SWIFT) is a not for profit cooperative society formed by European Bankers to provide a network for a secure and standardized communication about transactions between the member banks. It was formed in 1973 with the support of 239 banks from across 15 countries.
Presently, it operates in 210 countries and connects more than 11,000 financial institutions. SWIFT is owned by its member financial institutions and uses a standardized propriety communication platform for sending and receiving information regarding financial transaction among its members, in a secure and reliable environment.
The SWIFT has its headquarters in Belgium and is formed under Belgian law.
It has offices in the United States, the United Kingdom, Sweden, Switzerland, Spain, Russian Federation, Spain, Germany, Italy, France, Austria, Japan, Korea, India, South Africa, Brazil, Australia, and UAE.
Submarine Communication cables are used by SWIFT for transmitting data.
The messaging network is run from three data centers, situated in the United States, Netherlands, and Switzerland.
They share data in near real time and if one data center fails, the others are able to handle the traffic of the total network. In 2009, a fourth data center was opened in Switzerland and since then European SWIFT members data are no more mirrored to the US data center.
SWIFT assigns a Bank Identifier Code (BIC) to each bank involved in an international transaction.
The name of the banks, the city, and the country in which the branch is located can be identified by this SWIFT code. This code is also known as the SWIFT ID or ISO9362 code. The SWIFT code can be of 8 characters or 11 characters.
The first four characters signify the institute code, the next two are country code and the last two is the code for the city/location.
The 11-character codes have three additional and optional characters that reflect individual branches. SWIFT doesn't hold any funds on its own. It simply provides the platform for communication regarding the international transaction.
If someone wants to transfer an amount from her account to someone living abroad, she needs to visit her bank to initiate a SWIFT transaction. In order to initiate the process, she must have the account details as well as the SWIFT code of the destination bank.
Once she registers the request her bank will send a SWIFT message for transferring the payment to the specific account through the SWIFT network. Upon receiving the SWIFT message about the incoming payment, the receiving bank will clear and credit the money to that specific account. Prior to the formation of SWIFT, all the messages regarding the international fund transfers were transmitted through Telex.
However, it had several issues including low speed, security issues, and free message format.
A key purpose of the widespread use of standby letters of credit to finance commodity transactions is the comfort it gives to the seller that it will receive payment.
The drafting of the SBLC/BG should provide that the presentation of a demand would be conclusive evidence that the amount claimed was “due and owing” to the Beneficiary of the SBLC/BG.
The beneficiary’s belief that payment was “due and owing” should activate payment.
Most banks will issue an SBLC/BG to any of its customers if they have sufficient (100% of Face Value of the Instrument) liquidity (cash) in their bank account or available balance in their credit line (if they are already availing a credit line from the bank).
It’s a complete myth that “Banks Do Not Issue SBLC/BG). This direct transaction between a client and his bank is the “Primary Market” transaction.
All SBLC/BG are Asset/Cash backed.
A newly created SBLC/BG is called "Fresh Cut" whereas an already existing SBLC/BG is called "Seasoned".
Whether purchased of leased, SBLC / BG is issued for a “term” having validity normally for 1 year and 1 day which may extend up to multiple years depending on the Provider’s own discretion and Provider’s level of comfort with the Beneficiary.
Banks, in general, will monetize only an “owned/purchased” SBLC/BG.
They will not monetize a “leased” SBLC/BG. In contrast to a purchased or owned SBLC where the buyer becomes the official owner of the instrument and in turn would be able to lease the SBLC out to a Third Party, a "leased SBLC" cannot be "leased out" any further.
Providers of SBLC/BG generally are a part of the “Secondary Market” transactions.
SBLC/BG Providers are high net worth corporations or individuals who hold bank accounts at the issuing bank that contain significant cash sums (assets).
SBLC/BG Provider would often be a collateral management firm, a hedge fund, or private equity company.
A standby letter of credit (SLOC) is a legal document that guarantees a bank's commitment of payment to a seller in the event that the buyer–or the bank's client–defaults on the agreement. A standby letter of credit helps facilitate international trade between companies that don't know each other and have different laws and regulations. Although the buyer is certain to receive the goods and the seller certain to receive payment, a SLOC doesn't guarantee the buyer will be happy with the goods. A standby letter of credit can also be abbreviated SBLC.
A SLOC is most often sought by a business to help it obtain a contract. The contract is a "standby" agreement because the bank will have to pay only in a worst-case scenario. Although an SBLC guarantees payment to a seller, the agreement must be followed exactly. For example, a delay in shipping or a misspelling a company's name can lead to the bank refusing to make the payment.
There are two main types of standby letters of credit:
• A financial SLOC guarantees payment for goods or services as specified by an agreement. An oil refining company, for example, might arrange for such a letter to reassure a seller of crude oil that it can pay for a huge delivery of crude oil.
• The performance SLOC, which is less common, guarantees that the client will complete the project outlined in a contract. The bank agrees to reimburse the third party in the event that its client fails to complete the project.
The recipient of a standby letter of credit is assured that it is doing business with an individual or company that is capable of paying the bill or finishing the project.
The procedure for obtaining a SLOC is similar to an application for a loan. The bank issues it only after appraising the creditworthiness of the applicant.
In the worst-case scenario, if a company goes into bankruptcy or ceases operations, the bank issuing the SLOC will fulfill its client's obligations. The client pays a fee for each year that the letter is valid. Typically, the fee is 1% to 10% of the total obligation per year.
The SLOC is often seen in contracts involving international trade, which tend to involve a large commitment of money and have added risks.
For the business that is presented with a SLOC, the greatest advantage is the potential ease of getting out of that worst-case scenario. If an agreement calls for payment within 30 days of delivery and the payment is not made, the seller can present the SLOC to the buyer's bank for payment. Thus, the seller is guaranteed to be paid. Another advantage for the seller is that the SBLC reduces the risk of the production order being changed or canceled by the buyer.
An SBLC helps ensure that the buyer will receive the goods or service that's outlined in the document. For example, if a contract calls for the construction of a building and the builder fails to deliver, the client presents the SLOC to the bank to be made whole. Another advantage when involved in global trade, a buyer has an increased certainty that the goods will be delivered from the seller.
Also, small businesses can have difficulty competing against bigger and better-known rivals. An SBLC can add credibility to its bid for a project and can often times help avoid an upfront payment to the seller.
When a merchant needs financing to buy products, suppliers often rely on the business’ reputation when deciding whether to extend it credit. This is relatively easy to do when the supplier has worked with the same buyers for years, or they have a strong standing in the industry.
When the business is half the world away, however, lending can be a riskier proposition. One way to resolve this issue is the use of a banker’s acceptance (BA).
• A banker's acceptance is a short-term issuance by a bank that guarantees payment at a later time.
• A banker's acceptance is often used in importing and exporting, with the importer's bank guaranteeing payment to the exporter.
• A banker's acceptance differs from a post-dated check in that it is seen as an investment and can be traded on a secondary market.
• Applying for a banker's acceptance is similar to applying for a short-term, fixed-rate loan; the borrower goes through a credit check and sometimes extra underwriting processes.
• Similar to buying a Treasury bill, an investor on the secondary market might buy the acceptance at a discounted price, but still get the full value at the time of maturity.
Banker's acceptances are time drafts that a business can order from the bank if it wants additional security against counterparty risk. The financial institution promises to pay the exporting firm a specific amount on a specific date, at which time it recoups its money by debiting the importer’s account.
A banker’s acceptance works much like a post-dated check, which is simply an order for a bank to pay a specified party at a later date. If today is Jan. 1, and a check is written with the date "Feb. 1," then the payee cannot cash or deposit the check for an entire month. This can be thought of as a maturity date for a claim on another's assets.
Perhaps the most critical distinction between a banker's acceptance and a post-dated check is a real secondary market for banker's acceptances; post-dated checks don't have such a market. For this reason, banker's acceptances are considered to be investments, whereas checks are not. The holder may choose to sell the BA for a discounted price on a secondary market, giving investors a relatively safe, short-term investment.
BAs are frequently used in international trade because of advantages for both sides. Exporters often feel safer relying on payment from a reputable bank than a business with which it has little, if any, history. Once the bank verifies, or “accepts,” a time draft, it becomes a primary obligation of that institution.
The importer may turn to a banker’s acceptance when it has trouble obtaining other forms of financing, or when a BA is the least expensive option. The advantage of borrowing is that the importer receives the goods and has the opportunity to resell them before making payment to the bank.
A banker’s acceptance is similar to a post-dated check which allows payment at a specified later date.
Banker's acceptances can be created as letters of credit, documentary drafts, and other financial transactions. If you are trying to obtain an acceptance, approach a bank with which you have a good working relationship. You need to be able to prove or offer collateral against, your ability to repay the bank at a future date. Many, but not all banks offer acceptances. A banker's acceptance operates much like a short-term, fixed-rate loan. You go through a credit check and possibly additional underwriting processes. You are also charged a percentage of the total acceptance to purchase it.
If you are looking to purchase a banker's acceptance for a short-term investment, there is a relatively liquid secondary market for partially aged banker's acceptances. They are normally sold at prices near or below benchmark short-term interest rates.
Like most money market instruments, a banker's acceptance is a fairly safe and liquid investment, especially if the paying bank is in good financial health with a strong credit rating.
To understand banker’s acceptances as an investment, it’s important to understand how businesses use them in global trade. Here’s one fairly typical example. An American company, Clear Signal Electronics, decides to purchase 100 televisions from Dresner Trading, a German exporter. After completing a trade agreement, Clear Signal approaches its bank for a letter of credit. This letter of credit makes the bank the intermediary responsible for completing the transaction.
Once Dresner ships the goods, it sends the appropriate documents — typically through its own financial institution — to the paying bank in the United States. The exporter now has a couple of choices. It could keep the acceptance until maturity, or it could sell it to a third party, perhaps to the very bank responsible for making the payment. In this case, Dresner receives an amount less than the face value of the draft, but it doesn’t have to wait on the funds.
When a bank buys back the acceptance at a lower price, it is said to be “discounting” the acceptance. If Clear Signal’s bank does this, it essentially has the same choices that Dresner had. It could hold the draft until it matures, which is akin to extending the importer a loan. More commonly, though, it replenishes its funds by rediscounting the acceptance – in other words, selling it for a discounted price on the secondary market. It could market the BAs itself, especially if it’s a larger bank, or enlist a securities brokerage to perform the task.
Since acceptance is a short-term, negotiable agreement, it acts much like other money market instruments. Like a Treasury bill, the investor buys the bank draft at a discounted price and gets the full face value upon maturity. The difference between the discount and face value determines the yield. In most cases, the maturity date is within 30 to 180 days.
Banker’s acceptances do not trade on an exchange, but rather through large banks and securities dealers. As such, most dealers don’t supply bid and ask prices, but rather negotiate the price with the prospective investor, often a fund manager.
The pricing of these drafts largely depends on the reputation and size of the paying bank. Those with a strong credit rating can usually sell their acceptances for a lower yield, as they’re believed to have little chance of defaulting on their obligation. Institutions that sell a large volume of BAs also enjoy an advantage in this regard.
While banks often sell their acceptances through dealers in New York and other major financial centers, they may use their branch network to supplement sales. The bank’s staff will often contact local investors, who are generally interested in smaller transactions, not those of $1 million or more that many fund managers pursue. Local investors often accept a smaller yield and, because the bank circumvents dealers, its selling expenses can be much less.
A banker's acceptance is a money market instrument and, like most money markets, it is relatively safe and liquid, particularly when the paying bank enjoys a strong credit rating. The bank carries primary responsibility for the payment. Because of the tremendous risk to its reputation, if it can’t fund an acceptance, most banks that provide acceptances are well-known, highly rated institutions.
However, even if the bank lacks the necessary cash to make the payment, the investor receives added protection from other parties involved in the transaction. The importer is secondarily liable for the acceptance, and the exporter has a contingent obligation. In fact, any investors that have bought or sold the instrument on the open market carry any obligation for the draft.
An acceptance provides the opportunity for a modest profit, with yields generally somewhere above those of T-bills. Liquidity generally isn't an issue because most banker's acceptance maturities are between one and six months. And since they don’t have to be held until maturity, holders have the flexibility to resell them if they so choose.
Banker's acceptances are issued at a discount to their face value and always trade below face value, much like a T-bills. The holder of a $100,000 acceptance might not want to wait until maturity to receive those funds, so the holder can sell the acceptance to another party for, say, $990,000. While some market risk could be involved for those operating in the secondary market, the high liquidity and short maturity of these instruments make that unlikely.
A banker’s acceptance can be a sound investment for those seeking to balance higher-risk investments in their portfolio, or for those focusing on asset preservation. On the risk/reward spectrum, a BA is toward the very bottom, just ahead of the Treasury bill.
Because banker’s acceptance pricing is negotiated between buyer and seller, investors who do their research stand the best chance of getting a competitive rate. This is especially true given the volatile nature of BA pricing. In the course of a single day, yields can go up or down significantly. As such, it’s important to look up yields on a reputable website before making a purchase. In light of the bank’s primary obligation for an acceptance, any quotes should reflect its reputation and credit rating.
An SBLC is frequently used as a safety mechanism for the beneficiary, in an attempt to hedge out risks associated with the trade. Simplistically, it is a guarantee of payment which will be issued by a bank on the behalf of a client. It is also perceived as a “payment of last resort” due to the circumstances under which it is called upon. The SBLC prevents contracts from going unfulfilled if a business declares bankruptcy or cannot otherwise meet financial obligations.
Furthermore, the presence of an SBLC is usually seen as a sign of good faith as it provides proof of the buyer’s credit quality and the ability to make payment. In order to set this up, a short underwriting duty is performed to ensure the credit quality of the party that is looking for a letter of credit. Once this has been performed, a notification is then sent to the bank of the party who requested the Letter of Credit (typically the seller).
In the case of a default, the counter-party may have part of the finance paid back by the issuing bank under an SBLC. Standby Letter of Credits are used to promote confidence in companies because of this.
There are many aspects that a bank will take into consideration when applying for a Standby Letter of Credit, however, the main part will be whether the amount that is being guaranteed can be repaid. Essentially, it is an insurance mechanism to the company that is being contracted with.
As it is insurance, there may be collateral that is needed in order to protect the bank in a default scenario – this may be with cash or assets such as property. The level of collateral required by the bank and by the size of the SBLC will largely depend on the risk involved, and the strength of the business.
Other Application steps
There are other standard due diligence questions asked, as well as information requests regarding assets of the business and even possibly the owners. Upon receipt and review of the documentation, the bank will typically provide a letter to the business owner. Once the letter has been provided, a fee is then payable by the business owner for each yeah that the Standby Letter of Credit remains outstanding.
What are the fees for Standby Letters of Credit?
It is standard for a fee to be between 1-10% of the SBLC value. In the event that the business meets the contractual obligations prior to the due date, it is possible for an SBLC to be ended with no further charges.
A Standby Letter of Credit is different from a Letter of Credit. An SBLC is paid when called on after conditions have not been fulfilled. However, a Letter of Credit is the guarantee of payment when certain specifications are met and documents received from the selling party. Letters of credit promote trust in a transaction, due to the nature of international dealings, distance, knowledge of another party and legal differences.
Where goods are sold to a counter-party in another country, they may have used an SBLC to ensure their seller will be paid. In the event that there is non-payment, the seller will present the SBLC to the buyer’s bank so that payment is received.
A performance SBLC makes sure that the criteria surrounding the trade such as suitability and quality of goods are met.
We sometimes see SBLCs in construction contracts as the build must fulfill many quality and time specifications. In the event that the contractor does not fulfill these specifications then there is no need to prove loss or have long protracted negotiations; the SBLC is provided to the bank and payment is then received.
Letters of credit are sometimes referred to as negotiable or transferrable. The issuing bank will pay a beneficiary or a bank that is nominated by the beneficiary. As the beneficiary has this power, they may ‘transfer’ or ‘assign’ the proceeds of a letter of credit to another company.
Yes – if it is a transferable letter of credit and it is a deferred instrument then this may be likely. This is so that the funder will provide the beneficiary with a discounted value just after the terms of the letter of credit have been fulfilled.
In order to issue a standby letter of credit, a bank will typically require a pledge of cash as collateral. There is a fee that is collected for this service, which is usually priced at a percentage of the letter of credit value.
The International Chamber of Commerce Uniform Customs and Practice for Documentary Credits governs the way in which these instruments operate.
An SBLC will be paid in the event that the bank providing the instrument is still in operation and the beneficiary meets the criteria under the letter.
When there is genuine worry that the bank will not pay out, then a confirmed letter of credit may be used. This will be where a ‘stronger’ bank confirms the letter of credit.
A letter of credit, or "credit letter," is a letter from a bank guaranteeing that a buyer's payment to a seller will be received on time and for the correct amount. In the event that the buyer is unable to make a payment on the purchase, the bank will be required to cover the full or remaining amount of the purchase. It may be offered as a facility.
Due to the nature of international dealings, including factors such as distance, differing laws in each country, and difficulty in knowing each party personally, the use of letters of credit has become a very important aspect of international trade.
• A letter of credit is a document sent from a bank or financial institute that guarantees that a seller will receive a buyer's payment on time and for the full amount.
• Letters of credit are often used within the international trade industry.
• There are many different letters of credit including one called a revolving letter of credit.
• Banks collect a fee for issuing a letter of credit.
Because a letter of credit is typically a negotiable instrument, the issuing bank pays the beneficiary or any bank nominated by the beneficiary. If a letter of credit is transferable, the beneficiary may assign another entity, such as a corporate parent or a third party, the right to draw.
Banks typically require a pledge of securities or cash as collateral for issuing a letter of credit.
Banks also collect a fee for service, typically a percentage of the size of the letter of credit. The International Chamber of Commerce Uniform Customs and Practice for Documentary Credits oversees letters of credit used in international transactions.1 There are several types of letters of credit available.
COMMERCIAL LETTER OF CREDIT
This is a direct payment method in which the issuing bank makes the payments to the beneficiary. In contrast, a standby letter of credit is a secondary payment method in which the bank pays the beneficiary only when the holder cannot.
REVOLVING LETTER OF CREDIT
This kind of letter allows a customer to make any number of draws within a certain limit during a specific time period.
TRAVELER'S LETTER OF CREDIT
For those going abroad, this letter will guarantee that issuing banks will honor drafts made at certain foreign banks.
CONFIRMED LETTER OF CREDIT
A confirmed letter of credit involves a bank other than the issuing bank guaranteeing the letter of credit. The second bank is the confirming bank, typically the seller’s bank. The confirming bank ensures payment under the letter of credit if the holder and the issuing bank default. The issuing bank in international transactions typically requests this arrangement.
REAL-LIFE EXAMPLE OF A LETTER OF CREDIT
Citibank offers letters of credit for buyers in Latin America, Africa, Eastern Europe, Asia, and the Middle East who may have difficulty obtaining international credit on their own. Citibank’s letters of credit help exporters minimize the importer’s country risk and the issuing bank’s commercial credit risk.2
Letters of credit are typically provided within two business days, guaranteeing payment by the confirming Citibank branch.3 This benefit is especially valuable when a client is located in a potentially unstable economic environment.
Often in international trade, a letter of credit is used to signify that a payment will be made to the seller on time, and in full, as guaranteed by a bank or financial institution. After sending a letter of credit, the bank will charge a fee, typically a percentage of the letter of credit, in addition to requiring collateral from the buyer. Among the various forms of letters of credit are a revolving letter of credit, a commercial letter of credit, and a confirmed letter of credit.
Consider an exporter in an unstable economic climate, where credit may be more difficult to obtain. The Bank of America would offer this buyer a letter of credit, available within two business days, in which the purchase would be guaranteed by a Bank of America branch. Because the bank and the exporter have an existing relationship, the bank is knowledgeable of the buyer's creditworthiness, assets, and financial status.
As one of the most common forms of letters of credit, commercial letters of credit are when the bank makes payment directly to the beneficiary or seller. Revolving letters of credit, by contrast, can be used for multiple payments within a specific time frame. Typically, these are used for businesses that have an ongoing relationship, with the time limit of the arrangement usually spanning one year.
A letter of credit or LC is a written document issued by the importer’s bank (opening bank) on importer’s behalf. Through its issuance, the exporter is assured that the issuing bank will make a payment to the exporter for the international trade conducted between both the parties.
The importer is the applicant of the LC, while the exporter is the beneficiary. In an LC, the issuing bank promises to pay the mentioned amount as per the agreed timeline and against specified documents.
A guiding principle of an LC is that the issuing bank will make the payment based solely on the documents presented, and they are not required to physically ensure the shipping of the goods. If the documents presented are in accord with the terms and conditions of the LC, the bank has no reason to deny the payment.
A letter of credit is beneficial for both the parties as it assures the seller that he will receive his funds upon fulfillment of terms of the trade agreement and the buyer can portray his creditworthiness and negotiate longer payment terms, by having a bank back the trade transaction.
Negotiability - A letter of credit is a transactional deal, under which the terms can be modified/changed at the parties assent. In order to be negotiable, a letter of credit should include an unconditional promise of payment upon demand or at a particular point in time. Revocability - A letter of credit can be revocable or irrevocable. Since a revocable letter of credit cannot be confirmed, the duty to pay can be revoked at any point of time. In an irrevocable letter of credit, all the parties hold power, it cannot be changed/modified without the agreed consent of all the people. Transfer and Assignment - A letter of credit can be transferred, also the beneficiary has the right to transfer/assign the LC. The LC will remain effective no matter how many times the beneficiary assigns/transfers the LC. Sight & Time Drafts - The beneficiary will only receive the payment upon maturity of letter of credit from the issuing bank when he presents all the drafts & the necessary documents.
• Bill of Lading
• Airway Bill
• Commercial Invoice
• Insurance Certificate
• Certificate of Origin
• Packing List
• Certificate of Inspection
LC is an arrangement whereby the issuing bank can act on the request and instruction of the applicant (importer) or on their own behalf. Under an LC arrangement, the issuing bank can make a payment to (or to the order of) the beneficiary (that is, the exporter). Alternatively, the issuing bank can accept the bills of exchange or draft that are drawn by the exporter. The issuing bank can also authorize advising or nominated banks to pay or accept bills of exchange.
There are various fees and reimbursements involved when it comes to LC. In most cases, the payment under the letter of credit is managed by all parties. The fees charged by banks may include:
• Opening charges, including the commitment fees, charged upfront, and the usance fee that is charged for the agreed tenure of the LC.
• Retirement charges are payable at the end of the LC period. They include an advising fee charged by the advising bank, reimbursements payable by the applicant to the bank against foreign law-related obligations, the confirming bank’s fee, and bank charges payable to the issuing bank.
Main parties involved:
Applicant - An applicant (buyer) is a person who requests his bank to issue a letter of credit.
Beneficiary - A beneficiary is basically the seller who receives his payment under the process.
Issuing Bank - The issuing bank (also called an opening bank) is responsible for issuing the letter of credit at the request of the buyer.
Advising Bank - The advising bank is responsible for the transfer of documents to the issuing bank on behalf of the exporter and is generally located in the country of the exporter.
Other parties involved in an LC arrangement:
Confirming Bank - The confirming bank provides an additional guarantee to the undertaking of the issuing bank. It comes into the picture when the exporter is not satisfied with the assurance of the issuing bank.
Negotiating Bank - The negotiating bank negotiates the documents related to the LC submitted by the exporter. It makes payments to the exporter, subject to the completeness of the documents, and claims reimbursement under the credit.
(Note:- Negotiating bank can either be a separate bank or an advising bank)
Reimbursing Bank - The reimbursing bank is where the paying account is set up by the issuing bank. The reimbursing bank honors the claim that settles the negotiation/acceptance/payment coming in through the negotiating bank.
Second Beneficiary - The second beneficiary is one who can represent the original beneficiary in their absence. In such an eventuality, the exporter’s credit gets transferred to the second beneficiary, subject to the terms of the transfer.
The entire process under LC consists of four primary steps:
Step 1 - Issuance of LC
After the parties to the trade agree on the contract and the use of LC, the importer applies to the issuing bank to issue an LC in favor of the exporter. The LC is sent by the issuing bank to the advising bank. The latter is generally based in the exporter’s country and may even be the exporter’s bank. The advising bank (confirming bank) verifies the authenticity of the LC and forwards it to the exporter.
Step 2 - Shipping of goods
After receipt of the LC, the exporter is expected to verify the same to their satisfaction and initiate the goods shipping process.
Step 3 - Providing Documents to the confirming bank
After the goods are shipped, the exporter (either on their own or through the freight forwarder) presents the documents to the advising/confirming bank.
Step 4 - Settlement of payment from importer and possession of goods
The bank, in turn, sends them to the issuing bank and the amount is paid, accepted, or negotiated, as the case may be. The issuing bank verifies the documents and obtains payment from the importer. It sends the documents to the importer, who uses them to get possession of the shipped goods.
Suppose Mr A (an Indian Exporter) has a contract with Mr B (an importer from the US) for sending a shipment of goods. Both parties being unknown to each other decide to go for an LC arrangement.
The letter of credit assures Mr A that he will receive the payment from the buyer and Mr B that he will have a systematic and documented process along with the evidence of goods having been shipped.
From this point on, this is how a letter of credit transaction would unveil between Mr A & Mr B:
• Mr B (buyer) goes to his bank that is the issuing bank (also called an opening bank) and issues a Letter of Credit.
• The issuing bank further processes the LC to the advising bank (Mr A's bank).
• The advising bank checks the authenticity of the LC and sends it to Mr A.
• Now that Mr A has received the confirmation he will ship the goods and while doing so he will receive a Bill of Lading along with other necessary documents.
• Further, he will send these documents to the negotiating bank.
• The negotiating bank will make sure that all necessary requirements are fulfilled and accordingly make the payment to Mr A (the seller).
• Additionally, the negotiating bank will send all the necessary documents to the issuing bank.
• Which again the issuing bank will send to Mr B (Buyer) to confirm the authenticity.
• Once Mr B has confirmed he will make the payment to the issuing bank.
• And the issuing bank will pass on the funds to the negotiating bank.
Following are the most commonly used or known types of letter of credit:
• Revocable Letter of Credit
• Irrevocable Letter of Credit
• Confirmed Letter of Credit
• Unconfirmed Letter of Credit
• LC at Sight
• Usance LC or Deferred Payment LC
• Back to Back LC
• Transferable Letter of Credit
• Un-transferable Letter of Credit
• Standby Letter of Credit
• Freely Negotiable Letter of Credit
• Revolving Letter of Credit
• Red Clause LC
• Green Clause LC
To understand each type in detail read the article, Types of letter of credit used in International Trade.
A Bank guarantee is a commercial instrument. It is an assurance given by the bank for a non-performing activity. If any activity fails, the bank guarantees to pay the dues. There are 3 parties involved in the bank guarantee process i.e the applicant, the beneficiary and the banker.
Whereas, a Letter of Credit is a commitment document. It is an assurance given by the bank or any other financial institution for a performing activity. It guarantees that the payment will be made by the importer subjected to conditions mentioned in the LC. There are 4 parties involved in the letter of credit i.e the exporter, the importer, issuing bank and the advising bank (confirming bank).
A key point that exporters need to remind themselves of is the need to submit documents in strict compliance with the terms and conditions of the LC. Any sort of non-adherence with the LC can lead to non-payment or delay and disputes in payment.
The issuing bank should be a bank of robust reputation and have the strength and stability to honor the LC when required.
Another point that must be clarified before availing of an LC is to settle the responsibility of cost-bearing. Allotting costs to the exporter will escalate the cost of recovery. The cost of an LC is often more than that of other modes of export payment. So, apart from the allotment of costs, the cost-benefit of an LC compared to other options must also be considered.
1. Is Letter of Credit safe?
Yes. Letter of Credit is a safe mode of payment widely used for international trade transactions.
2. How much does it cost for a letter of credit?
Letters of credit normally cost 1% of the amount covered in the contract. But the cost may vary from 0.25% to 2% depending on various other factors.
3. Can a letter of credit be cancelled?
In most cases letters of credit are irrevocable and cannot be cancelled without the agreed consent of all parties.
4. Can a letter of credit be discounted?
A letter of credit can be discounted. While getting an LC discounted the supplier or holde of LC should verify whether the issuing bank is on the approved list of banks, with the discounting bank. Once the LC is approved, the discounting bank releases the funds after charging a certain amount as premium.
5. Is a letter of credit a not negotiable instrument?
A letter of credit is said to be a negotiable instrument, as the bank has dealings with the documents and not the goods the transaction can be transferred with the assent of the parties.
6. Are letters of credit contingent liability?
It would totally depend on future circumstances. For instance, if a buyer is not in a condition to make the payment to the bank then the bank has to bear the cost and make the arrangement on behalf of the buyer.
7. A letter of credit is with recourse or without recourse?
A 'without recourse' letter of credit to the beneficiary is a confirmed LC. Whereas an unconfirmed or negotiable letter of credit is 'with recourse' to the beneficiary.