As we discussed in our ‘payment methods in international trade‘ article, a letter of credit offers an exporter protection against the risk of non-payment by a foreign buyer. Under a letter of credit, the issuing bank in the buyer’s country agrees to pay the agreed amount of money on the condition that the exporter presents certain documents and complies with the terms of the letter of credit. This article elaborates on the mechanics of a letter of credit.
A Documentary Credit Explained
A letter of credit is also referred to as an (L/C), documentary credit, a letter of undertaking or a banker’s commercial credit. When a documentary credit is used, it significantly reduces the risk of non-payment for a particular transaction because it transfers the risk of your buyer not paying you to the bank in question. However, a documentary credit does not eliminate an exporter’s risk of non-payment entirely. An exporter still bears the risk of the bank going bust and not paying them.
A Confirmed Letter of Credit
Although rare, the 2008 financial crisis taught us that banks could go bankrupt. However, you can further enhance the protection offered by a letter of credit by requesting another bank (usually in another country) to confirm the credit. When another bank confirms a documentary credit, it adds a second guarantee of payment. The confirming bank undertakes to pay you if the issuing bank refuses or cannot pay you the necessary funds. Importers and exporters use letters of credit widely in international trade. However, there are several sub-varieties of L/Cs, and you must understand how they work as an exporter. A strong understanding of the intricacies of a letter of credit could go a long way to mitigating your international financial risk and ensuring you get paid!
Your ability to manage financial risk and maximise opportunities heavily influences your international success. However, very few exporters know the full extent of the danger they face in the global market. When doing business internationally, you must understand how to mitigate your risk. Thankfully, Trade Forward Southern Africa, in collaboration with the International Trade Institute of Southern Africa, has created a free and comprehensive online training course on various aspects of global trade, including identifying and mitigating international financial risk. The modules provided include training on international finance, foreign exchange rates, documentary credit, international payment methods and Incoterms®. Click the links below to sign up for free and get started.
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