Advantages and Disadvantages of Letter of Credit

A letter of credit is highly customisable and enables new trade relationships by reducing credit risk, but it can add to the cost of doing business in the form of bank fees and formalities.

Advantages of Letter of Credit

A letter of credit enjoys various advantages over other means to do international trade transactions. Some of the major ones are listed below:

  • A letter of credit gives the trade partners an ability to transact with unknown partners or in newly established trade relationships. It helps in expanding their business quickly into new geographies.
  • A letter of credit is highly customisable. Both the trading partners can put in terms and conditions as per their requirements and arrive at a mutually exclusive list of clauses. It can also be customised from one transaction to another with the same trading partners.
  • A letter of credit makes the issuing bank independent of the trading partners’ obligations and any disputes arising out of those obligations. The bank has to just check whether the documents submitted by the beneficiary satisfy the terms and conditions specified in the letter of credit, and pay the full amount.
  • A letter of credit transfers the credit-worthiness from the importer or buyer to the issuing bank. The importer can do multiple transactions at the same time when he is backed by an established and larger institution such as a bank.
  • A letter of credit is safer for the seller or exporter in case the buyer or importer goes bankrupt. Since the creditworthiness of the importer is transferred to the issuing bank, it is the bank’s obligation to pay the amount as agreed in the letter of credit. Thus, a letter of credit insulates the exporter from the importer’s business risk.
  • A letter of credit is quick to execute. As per the initial terms and conditions, the seller or exporter has to present the proof of material type and quantity along with the shipping documents supporting his claim that the goods have been shipped. The advising bank will verify the documents the give the full payment instantly.
  • In the case of a dispute between the trading partners, the exporter can withdraw the fund as agreed upon in the letter of credit and resolve the disputes later in the court. The beneficiary’s right to the full amount is described in the phrase ‘pay now, litigate later’ by the courts.
  • The importer cannot hold or deny the payment to the exporter by raising objections on the quality of goods because the bank just needs to see the documents satisfying the shipping terms and conditions as put in the letter of credit.
  • A letter of credit provides certainty to the amount and timing of the exporter’s cash flows. He can plan his financing needs well in advance which reduces his risk.
  • The exporter can avail pre-shipment financing against a letter of credit. This helps him in plugging the financing gaps if any.

Disadvantages of Letter of Credit

As with any financial instrument, even letter of credit has disadvantages as listed below:

  • A letter of credit adds to the cost of doing business. Banks charge a fee for providing this service, and it can increase steeply if the parties want to put some additional features.
  • The required documentation and formalities may be more in a letter of credit. This may also add to the cost of doing business.
  • A letter of credit has complex governing rules and can be misused to take advantage of the applicant.
  • A letter of credit poses a material fraud risk to the importer. The bank will pay the exporter upon looking at the shipping documents and not the actual quality of goods. Disputes can arise if the quality is different from what was agreed upon.
  • A letter of credit also carries forex risk. There will be an agreed upon currency in the letter of credit. At least one of the parties will have a different currency than that, and hence they will face a risk due to currency fluctuations. It can also work in favour.
  • A letter of credit has an expiration date and must be used before it.
  • A letter of credit essentially transfers the credit-worthiness from the importer to the issuing bank. So, if the issuing bank defaults, there is still a payment risk to the exporter. Though this can be circumvented if the advising bank guarantees the payment, which will add to the cost of the letter of credit.

References:

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Last updated on : June 27th, 2017
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