A.J. Anderson
International Trade Specialist
U.S. Dept. of Commerce
515-288-8614

What Is a Letter of Credit?

A Letter of Credit (LC) is an instrument issued by a bank, whereby a bank substitutes its credit for that of its customer (applicant) and agrees to pay a specified sum of money to the seller (beneficiary) upon receipt of required documents which are found to be in compliance with the terms and conditions spelled out in the Letter of Credit. 

Import/Export LC Characteristics

1. Letters of credit substitutes bank’s credit for that of a buyer. 
2. Irrevocably commits that the issuing bank to make payment against documents that comply with the letter of credit (governed by UCP500) 
3. Letters of credit can be either sight or usance (time)
4. Bank does not deal in merchandise or contracts, documents only.
5. Does not protect against unscrupulous sellers
6. Issuance requires extension of credit similar to a loan

Trade Related Standby Letter of Credit

1. Most often used as a payment mechanism in cases of default.
2. Uses: financial (for payment default), bid, performance, warranty, advance payment and residual payment bonds
   • Many sizable international tenders require bid bonds
   • Performance bonds used in many long term contracts
3. Used by importers as an alternative to import letters of credit
   • May be less expensive than import letters of credit
   • Vehicle for obtaining open account terms

Documentary Collections

1. Alternative payment method to open account or letter of credit
2. Used by companies having long term relationships and proven track records
3. Payment terms can be sight (D/P) or time (D/A)
4. Assures document protection until compliance by buyer
5. Enhances obligation of buyer versus open account
6. Seller takes greatest risk of refusal by buyer to pay
7. No credit risk to the banks

Export Working Capital – Factors

1. Export sales often create inordinate working capital burdens
2. Banks are at times are unwilling to lend to support international sales
3. Foreign A/R and inventory are often not viewed as acceptable collateral
4. Foreign sales often require standby letters of credit
5. Long term contracts generate high levels of WIP

Export Import Bank of the United States (EximBank)

1. EximBank Working Capital Guarantee Program
   • U.S. Government guarantee for 90% principal/interest to the LENDER
   • Asset based lending program to support exports
   • Up to 90% on foreign A/R (on terms up to 180 days)
   • Up to 75% on inventory (including WIP)
   • Standby letters of credit require only 25% collateral
   • Many banks have delegated authority of up to $10M per deal from EXIM (borrower deals with the bank)

Export Working Capital – Benefits

1. Customers can obtain greater credit amounts with more flexible terms
2. Enables expansion of export sales
3. Provides financing for inventory
4. Standbys at reduced collateral requirement
5. Sales terms can be offered to buyers

Bankers Acceptances

1. A time draft drawn on a bank by either a buyer or seller which is “accepted” by the bank committing them to pay at a specified future date, usually no more than 180 days from the shipment date.

• Typically initiated under letters of credit requiring a “time” draft (e.g. 60 days), but can be tied to a time documentary collection or open transaction

• Allows the exporter to offer competitive extended repayment terms to the importer and still receive prompt payment by discounting the acceptance with the bank at the cost of funds plus an interest spread

Structured Trade Finance

Buyers often seek extended repayment terms of up to several years for such items as capital equipment

1. Banks can provide short to medium term financing on these transactions (usually 2-5 years)
2. Banks purchase the short to medium term receivable usually with some type of credit enhancement, EXIM or private insurance and then discount the receivable paying the seller up front and collecting over time from the buyer.

1. Increased sales
2. Avoids contract loss from competitors
3. CAUTION: deals such as these are often difficult to approve due to their size, tenor and  portion of the transaction not insured.