Financial Instruments

Financial Instruments
There are two basic forms of letters of credit, Standby and Documentary.

STANDBY LETTER OF CREDIT (SBLC)
• A stipulation that states a letter of credit will be called back, if the payer defaults
• A letter of credit is typically used in international transactions
• Standby letters of credit are issued by banks to stand behind monetary obligations, to insure the refund of advance payment, to support performance and bid obligations, and to insure the completion of a sales contract.
• The credit has an expiration date.
• The standby letter of credit is often used to guarantee performance or to strengthen the credit worthiness of a customer.
• A bank will issue a standby letter of credit on behalf of a customer to provide assurances of his ability to perform under the terms of a contract between the beneficiary.
• The parties involved with the transaction do not expect that the letter of credit will ever be drawn upon

DOCUMENTARY LETTER OF CREDIT (DLC)
• A letter of credit is a document issued mostly by a financial institution which provides an irrevocable payment undertaking to a beneficiary against complying documents as stated in the credit.
• Letter of Credit is abbreviated as an LC or L/C, and often is referred to as a documentary credit, abbreviated as DC or D/C, documentary letter of credit, or simply as credit (as in the UCP 500 and UCP 600).
• Once the beneficiary or a presenting bank acting on its behalf, makes a presentation to the issuing bank or confirming bank, if any, within the expiry date of the LC, comprising documents complying with the terms and conditions of the LC, the applicable UCP and international standard banking practice, the issuing bank or confirming bank, if any, is obliged to honor irrespective of any instructions from the applicant to the contrary. In other words, the obligation to honor (usually payment) is shifted from the applicant to the issuing bank or confirming bank, if any
• Non-banks can also issue letters of credit however parties must balance potential risks
• The LC can also be the source of payment for a transaction, meaning that an exporter will get paid by redeeming the letter of credit
• Letters of credit are used nowadays primarily in international trade transactions of significant value, for deals between a supplier in one country and a wholesale customer in another
• The parties to a letter of credit are usually a beneficiary who is to receive the money, the issuing bank of whom the applicant is a client, and the advising bank of whom the beneficiary is a client.
• Since nowadays almost all letters of credit are irrevocable, (i.e. cannot be amended or cancelled without prior agreement of the beneficiary, the issuing bank and the confirming bank, if any)
Documentary letters of credit can be either Revocable or Irrevocable, although the first is extremely rare

Revocable (rare)
DOCUMENTARY REVOCABLE LETTER OF CREDIT
• Revocable credits may be modified or even canceled by the buyer without notice to the seller
• Therefore, they are generally unacceptable to the seller

Irrevocable
DOCUMENTARY IRREVOCABLE LETTER OF CREDIT (ILOC)
• This is the most common form of credit used in international trade
• Irrevocable credits may not be modified or canceled by the buyer
• The buyer's issuing bank must follow through with payment to the seller so long as the seller complies with the conditions listed in the letter of credit
• Changes in the credit must be approved by both the buyer and the seller
• If the documentary letter of credit does not mention whether it is revocable or irrevocable, it automatically defaults to irrevocable
• See Credit Administration, Sample Procedure for Administration of a Documentary Irrevocable Letters of Credit for a systematic procedure for establishing an irrevocable letter of credit
• This is often used in international transactions
There are two forms of irrevocable letter of credits:
Irrevocable letters of credit can be Confirmed or Not Confirmed
• Each type of credit has advantages and disadvantages for the buyer and for the seller
• Charges for each type will also vary
• The more the banks assume risk by guaranteeing payment, the more they will charge for providing the service

Confirmed credit (the irrevocable confirmed credit)
In a confirmed credit, the advising bank adds its guarantee to pay the seller to that of the buyer's issuing bank
Once the advising bank reviews and confirms that all documentary requirements are met, it will pay the seller

The advising bank will then look to the issuing bank for payment
Confirmed Irrevocable letters of credit are used when trading in a high-risk area where war or social, political, or financial instability are real threats
Also common when the seller is unfamiliar with the bank issuing the letter of credit or when the seller needs to use the confirmed letter of credit to obtain financing its bank to fill the order
A confirmed credit is more expensive because the bank has added liability.
Unconfirmed credit (the irrevocable credit not confirmed by the advising bank) In an unconfirmed credit, the buyer's bank issuing the credit is the only party responsible for payment to the seller
The seller's advising bank pays only after receiving payment from the issuing bank
The seller's advising bank merely acts on behalf of the issuing bank and, therefore, incurs no risk.

TRANSFERABLE LETTER OF CREDIT
This type of credit allows the seller to transfer all or part of the proceeds of the original letter of credit to a second beneficiary, usually the ultimate supplier of the goods

The letter of credit must clearly state that it is transferable for it to be considered transferable
This is a common financing tactic for resellers and middlemen
It is common in East Asia

REVOLVING LETTER OF CREDIT
With a Revolving Letter of Credit, the issuing bank restores the credit to its original amount once it has been used or drawn down.

Usually, these arrangements limit the number of times the buyer may draw down its line over a predetermined period

RED CLAUSE LETTER OF CREDIT
Red Clause Letters of Credit provide the seller with cash prior to shipment to finance production of the goods
The buyer's issuing bank may advance some or all of the funds
The buyer, in essence, extends financing to the seller and incurs the risk for all advanced credits

DEFERRED PAYMENT (Usance) LETTER OF CREDIT
In Deferred Payment Letters of Credit, the buyer accepts the documents related to the letter of credit and agrees to pay the issuing bank after a fixed period. This credit gives the buyer a grace period for payment.

BACK-TO-BACK LETTER OF CREDIT
This is a new letter of credit opened based on an already existing, nontransferable credit used as collateral.

Traders often use back-to-back arrangements to pay the ultimate supplier.
A trader receives a letter of credit from the buyer and then opens another letter of credit in favor of the supplier.

The first letter of credit serves as collateral for the second letter of credit.

ASSIGNMENT OF PROCEEDS
The beneficiary of a letter of credit may assign all or part of the proceeds under a credit to a third party (the assignee)

However, unlike a transferred credit, the beneficiary maintains sole rights to the credit and is solely responsible for complying with its terms and conditions

For the assignee, an assignment only means that the paying bank, once it receives notice of the assignment, undertakes to follow the assignment instructions, if and when payment is made

The assignee is dependent upon the beneficiary for compliance, and thus this arrangement is riskier than a transferred credit

Before agreeing to an assignment of proceeds arrangement, the assignee should carefully review the original letter of credit

SPECIAL LETTER OF CREDIT The following is a brief description of some special letters of credit.

Common Problems with Letters of Credit
Most problems result from the seller's inability to fulfill obligations stated in the letter of credit

The seller may find these terms difficult or impossible to fulfill and, either tries to fulfill them and fails, or asks the buyer to amend to the letter of credit

As most letters of credit are irrevocable, amendments may at times be difficult since both the buyer and the seller must agree

Sellers may have one or more of the following problems:
• The shipment schedule cannot be met;
• The stipulations concerning freight costs are unacceptable;
• The price becomes too low due to exchange rates fluctuations;
• The quantity of product ordered is not the expected amount;
• The description of product is either insufficient or too detailed; and,
• The stipulated documents are difficult or impossible to obtain.

Even when sellers accept the terms of a letter of credit, problems often arise late in the process.

When this occurs, the buyer's and seller's banks will try to negotiate any differences. In some cases, the seller can correct the documents and present them within the time specified in the letter of credit. If the documents cannot be corrected, the advising bank will ask the issuing bank to accept the documents despite the discrepancies found. It is important to note that, if the documents are not in accord with the specifications of the letter of credit, the buyer's issuing bank is no longer obligated to pay.

‘BANK GUARANTEE’ (BG)
A guarantee from a lending institution ensuring 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 (debtor) to acquire goods, buy equipment, or draw down loans, and thereby expand business activity.

What's the difference between a bank guarantee and a letter of credit?
A bank guarantee and a letter of credit are similar in many ways but they're two different things.

The main difference between the two credit security instruments is the position of the bank relative to the buyer and seller of a good, service or basket of goods or services in the event of the buyer's default of payment

These financial instruments are often used in trade financing when suppliers, or vendors, are purchasing and selling goods to and from overseas customers with whom they don't have established business relationships

A bank guarantee is a guarantee made by a bank on behalf of a customer (usually an established corporate customer) should it fail to deliver the payment, essentially making the bank a co-signer for one of its customer's purchases

Should the bank accept that its customer has sufficient funds or credit to authorize the guarantee, it will approve it

A guarantee is a written contract stating that in the event of the borrower being unable or unwilling to pay the debt with a merchant, the bank will act as a guarantor and pay its client's debt to the merchant

The initial claim is still settled primarily against the bank's client, and not the bank itself. Should the client default, then the bank agrees in the bank guarantee to pay for its client's debts

This is a type of contingent guarantee
A bank guarantee is more risky for the merchant and less risky for the bank. But this is not the case with a letter of credit

While a letter of credit is a similar, the principal difference is that it is a potential claim against the bank, rather than a bank's client

For example, a seller may request that a buyer be provided with a letter of credit, which must be obtained from a bank and which substitutes the bank's credit for that of its client. In the event that the borrower defaults, the seller would go the buyer's bank for the payment

The seller's risk is mitigated because it is unlikely that the bank will be unable to pay the debt

A letter of credit is less risky for the merchant, but more risky for a bank
Banks accept full liability in both cases

With a bank guarantee, a client can default and the bank assumes the liability
With a line of credit, liability rests solely with the bank, which then collects the money from its client.

What are the different modes of payment?
There are many ways to make and receive payment in international trade, such as prepayment via telegraphic transfer, open account, documentary collection and letter of credit. Due to the long distance between the buyer and seller, it is important to use a method which is relatively safe and easy for both parties.

What is a telegraphic transfer (T/T)?
Telegraphic transfer is the most widely used method that requires the use of cable or telegraph to transfer funds. The importer sends the payment through a bank after accepting an order. Although the easiest and cheapest form of payment, it is typically used to receive samples or low volume order by air. It normally takes three to four days for a wire transfer anywhere in the world.

What is a letter of credit?
The letter of credit is a guarantee given by the buyer’s bank that they will pay for the goods exported provided that the exporter can provide a given set of documents specified in the L/C. The technical term for letter of credit is documentary credit. Letters of credit deal in documents, not goods. The process works in favor of both the buyer and the seller.

What is a back-to-back letter of credit?
This type of credit transaction takes place when a seller/manufacturer has to purchase a component or subcontract part of manufacturing, but may not have the cash flow to do so. The seller/manufacturer then applies to his bank for a letter of credit, identical to the original letter of credit, except that it is of a lesser value. This second letter of credit, called a back-to-back, is sent to the subcontractor’s bank so that the subcontractor is assured of the payment.

What is the difference between transferable LC and non-transferable LC?
A transferable letter of credit is a type of a letter of credit under which a beneficiary (exporter/seller) has the right to give instruction to the paying or accepting bank to make the credit (funds) available to one or more third parties, sometimes referred to as secondary beneficiaries. A non-transferable letter of credit is when the bank makes credit available to the beneficiary only and cannot be transferred to any other party.
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International Settlement Service
I. Remittance
It is a way of settlement in which remitter entrusts bank to transfer the funds to receiver, including the following three forms:
1. Telegraphic Transfer or T/T, a remittance method in which to instruct the remitted bank to pay the remittance to the remittee through telegraphic or SWIFT manners based on the application by remitter.
Its features are: fast, secure, convenient and high cost, generally applied to the remittance with large sum or urgent remittance.

2. Mail Transfer or M/T, a remittance method in which the remitting bank, based on the application by the remitter, sends the mail transfer trust deed to the receiving bank through post office or express companies, and authorizes the receiving bank to pay the remittance to the receiver.

Its features are: low cost but slowly delivery of remittance.

3. Banker's Demand Draft, or D/D, is a remittance method in which upon the application of remitter, the remitting bank issues the demand draft taking its overseas branch bank or collecting bank as the paying bank, and gives it to the remitter for sending by his own or going abroad in person and withdrawing the remittance upon the draft. Banker's demand draft is very flexible and simple but there are risks of losses or damages of the draft, applicable for mail order or payment for all kinds of expenses.

II. Collection Settlement
It means that principal (creditor) submits financial bills or/and commercial bills to bank (remitting bank) for requiring the collecting bank to collect funds from the payer (debtor) through connected or agency bank (collecting bank).
Collection belongs to commercial credit. Remitting bank and collecting bank will bear no liabilities for whether to receive the funds or not.

1. Categorized by payment gathering bills:
Clean collection is a sort of collection settlement method in which principal only issues the bills with no shipping documents and consigns bank to collect the funds. Clean collection in trading is usually used for collection of the balance of payment for goods, fill-up of payments, commission, sample expenses or other trading subordinate expenses.

Documentary collection is a sort of collection settlement method in which principal issues the draft with freighting documents and consigns bank to collect the funds.

2. Categorized by document delivery methods
Documents Against Payment, D/P, means that principal requires the remitting bank and collecting bank to pass the documents to the payer after paying the collection funds. Delivery against payment is all payment at demand.

Documents Against Acceptance, D/A, means that after payer examines and accepts the documents, and accepts the bank's draft, the remitting and collecting bank keeps the draft after examining the acceptance procedure, the documents are handed to the payer. Whether the accepted draft shall be returned to the remitting bank or not will be determined according to the trust deed.

D/P XX Days After Sight, means after examining documents, payer shall determine the expiry date and the promise for payment to the collecting bank, and the documents will be passed to payer only after it expires and payment is made.

3. According to different clients we serve, it can be divided into export collection service and import collection service.

III. Letter of Credit
L/C is a sort of guarantee document issued by the issuing bank to the beneficiary applied by applicant to make sure that the issuing bank will perform the payment liabilities in accordance with the defined documents.

1.Varieties of Letter of Credit:
(1) As for whether the draft under the Letter of Credit is enclosed with shipping documents or not, it can be divided:
Documentary letter of credit is a sort of letter of credit for payment by right of documentary draft or commercial bill which represents real rights. Most of Letters of Credit used in international settlement are documentary letter of credit.
Clean letter of credit is a sort of draft payment without documents.

(2) As for the responsibility for letter of credit borne by issuing bank, it can be divided:
Revocable letter of credit is the letter of credit, which can be recalled at anytime by the issuing bank with no need to ask for beneficiary's consent. But, in case of advising bank has negotiated the letter of credit before receiving the notice, the issuing bank shall still be responsible for repayment.
Irrevocable letter of credit means that once the letter of credit is issued, in the validity period, the issuing bank cannot modify or recall the letter of credit without consents by all concerned parties.

(3) By different payment time, it can be divided:
Sight letter of credit, means that upon receiving the bills that conform to the terms and conditions of the letter of credit, the issuing bank or payment bank immediately performs the payment obligations.

Forward letter of credit, means that after receiving the bills which conform to the terms and conditions of the letter of credit, the issuing bank or paying bank will not make the payment immediately until the term as defined in the letter of credit expires, including acceptance forward letter of credit and deferred payment of letter of credit. The acceptance forward letter of credit means that the issuing bank (bank acceptance) or importer (commercial acceptance) will accept and collect the bills as the forward draft payer. The deferred payment of letter of credit means that under the letter of credit, the payment is made after the defined goods being laded or paid several days after receiving the bills. Generally, the deterred payment of letter of credit does not need draft.

Anticipatory letter of credit is that which allows exporter to withdraw all or part of the loan prior to loading and delivery. It is also called "Red Provision letter of credit".

(4) As for whether the beneficiary can assign the rights under the letter of credit or not, it can be divided:
Transferable letter of credit is, as requested by beneficiary, the whole or part of the letter of credit can be transferred to the second beneficiary. After the transfer of the letter of credit, the second beneficiary transacts the delivery of Goods, but the original beneficiary still bears the responsibility as the seller under the trading contract.

Non-transferable letter of credit, means the beneficiary cannot transfer the right under the letter of credit to others, unless specifically indicated with the word of "Transferable".

(5) Varieties of other special letters of credit
Back to back letter of credit means that middleman requires importer to issue a letter of credit which makes him as the beneficiary and takes the letter of credit as guarantee to ask bank to issue the letter of credit for the actual supplier of the goods. It's usually used in the entrepot trade settlement.

Revolving letter of credit is the letter of credit which can be reused by resuming to the original amount after all or part of the credit is used out. It's usually used for the settlement of long-term contract under which goods are split to deliver for several times.

Counter letter of credit means that both parties of the transaction issue letters of credit mutually, the beneficiary of the first letter of credit is just the applicant for issuing of the second letter of credit, while the issuing applicant of the first letter of credit is just the beneficiary of the second letter of credit. It's usually used for settlement of barter trade.

2. Standard charges for Letter of Credit service
(1) The standard rate for issuing the import letter of credit in ICBC is 0.15% with the minimum of 300 Yuan and validity term of 90 days; In case of validity term more than 90 days, 0.05% will be additionally charged every more 90 days; as for the added term less than 90 days, it will be calculated as 90 days; no additional fee is charged in case the security is fully collected.

(2) The acceptance rate of ICBC to import letter of credit is: As for the payment term less than 90 days, it will be charged by 0.1% in a lump sum with the minimum of 200 Yuan for each; as for the payment term more than 90 days, another 0.03% will be charged for each month and 200 Yuan is charged in case the security is fully collected.

(3) The pre-advising charges for ICBC's export letter of credit is 100 Yuan for each; the advising or forwarding rate is: 200 Yuan for advising of L/C if paid by beneficiary, 0.1% of the amount and 200 Yuan at least, 1000 Yuan at most if paid by applicant. Charges on L/C negotiated against document in ICBC could be free. Charges on letters with the amount less than USD 5,000 to ICBC could not be free. SWIFT telegraph fee will also be charged as actually cost. The forwarding rate of L/C is 300 Yuan for each. SWIFT telegraph fee will also be charged as actually cost. Charge rate on confirmed letter of credit (including advising fee) is 0.15% and 300Yuan at least. It will be charged quarterly and period less than a quarter, it will also be charged as a quarter.

(4) The export-handling fee of ICBC is 0.125% and 300 Yuan at least for each. For letters with handling amount less than or equal to USD 5,000, additional fee of 100 Yuan for each will also be charged.

(5) The charge for transfer of letter of credit in ICBC is 0.1% and 200 Yuan at least for each.

(6) The charge for cancellation of export letter of credit within the validity term in ICBC is 100 Yuan for each. SWIFT telegraph fee will also be charged as actually cost.

IV. Non-trading settlement business
ICBC provides services of traveler check, foreign currency bill collection, agent issuing of credit card in foreign currency, foreign currency exchange, etc.
ICBC conducts the exchange and payment service for the following credit card in foreign currency: American Express Card, Visa Card, Master Card, JCB card and Diners Club Card.