A particularly interesting fact highlighted by the result of this research is that only large companies with a long time dealing with L/C can frequently use different kinds of L/C in the
INTRODUCTION
Rationale of the research
Many enterprises in third-world countries struggle with a lack of experience in documentary credit, limiting their ability to fully leverage the benefits of this payment method Inexperienced banks often lack the necessary knowledge to handle letter of credit (L/C) transactions effectively Notably, the diversity of L/C types offers unique advantages tailored to various contexts However, only large companies with extensive experience can utilize these different types, while smaller enterprises tend to resort to high-risk payment methods or simpler L/C options, such as irrevocable or at sight L/Cs, which do not optimize their transactions Vietnamese small and medium-sized companies illustrate this issue, as many choose to open ordinary L/Cs multiple times instead of using a revolving L/C, resulting in unnecessary costs This thesis aims to analyze various L/C types, providing enterprises and commercial banks with a comprehensive understanding of their applications and the specific contexts in which each should be employed By emphasizing the effective use of specialized documentary credit types, this research seeks to equip businesses and banks with practical guidelines for optimizing their L/C transactions.
Literature review
1- Gabriel, H D (1988) Standby Letters of Credit: Does the Risk Outweigh the Benefits Colum Bus L
This study examines the differing risks and benefits associated with the Standby Letter of Credit (L/C) payment process, providing insights into these conflicting aspects for various parties involved, including exporters, importers, and bankers It highlights the importance of understanding potential issues that may arise during Standby L/C transactions while also analyzing the advantages these credits can offer Although the research acknowledges that the benefits of standby credits can outweigh the risks, it does not thoroughly address strategies for risk mitigation or emphasize how these advantages can surpass the associated risks.
2- John Dolan (2016) The Domestic Standby Letter of Credit Desk Book for Business Professionals, Bankers and Lawyers
This study aims to demonstrate that the standby letter of credit is a versatile and practical tool for business professionals, including bankers and lawyers, enabling them to facilitate various business activities without the need for extensive legal expertise While the legal framework surrounding standby letters of credit is distinctive, it remains accessible to educated professionals who can leverage it to strengthen commitments in business transactions However, the research primarily targeted academic and professional audiences, which may pose challenges for novices and newcomers in grasping the guidelines effectively.
3 - Michael Stern (1985), The University of Chicago Law Review, The Independence
This journal explores the legal frameworks governing standby documentary credits and their impact on standby credit transactions The thesis identifies various features and aspects of standby letters of credit, providing essential legal guidelines for enterprises to utilize standby credit effectively However, it also highlights a downside, noting that these guidelines tend to favor legalism For further reading, refer to "Problem Children: Standby Letters of Credit and Simple First Demand Guarantees," published in 4 Ariz L Rev (1982).
This study aims to provide an in-depth analysis of standby letters of credit (L/C) and demand guarantees, focusing on the unique characteristics of standby L/Cs and the various risks associated with them While the thesis identifies these risks, it does not delve into the mechanisms of risk emergence or strategies for risk avoidance and mitigation.
5- Justin Pritchard (2019), “Standby Letter of Credit: A Backup Plan for Payment”
This study aims to introduce the Standby Letter of Credit (SBLC), highlighting its features and providing specific examples The findings indicate that SBLCs serve as a reliable backup for parties involved, enhancing payment security in transactions However, the article primarily outlines various risks faced by participants in the L/C payment process without offering an in-depth analysis or recommendations to mitigate potential fraud.
The journal highlights instances where companies incur significant costs due to their lack of experience with Letters of Credit (L/C) It offers recommendations to enhance the transferability of L/Cs, which can be advantageous for their usage Furthermore, it examines the origins of the rule against transfer to facilitate the assignment of proceeds However, the journal provides a general analysis of the risks associated with L/Cs, lacking detailed solutions to these challenges.
7- Libardo Quintero Salazar (2016), “Documentary Credit Transfer and Other Financing from What Can Match as Product of Credit”
This article outlines legal alternatives for exporters not covered by the UCP, enabling them to utilize potential funds from documentary credits to finance the production or acquisition of goods from other traders, which can then be resold to the importer It concludes that exporters can secure immediate funding—similar to the benefits of transferring documentary credits—by leveraging relationships with suppliers through mechanisms such as future credit assignments, banker’s acceptances, and contractual terms.
8- Chris Lidberg (2017), “Two alternatives to a Back-to-Back L/C”
The journal identifies two remedies for situations where a Back-to-Back Letter of Credit (L/C) is deemed ineffective However, this article does not address the discrepancies that may arise in various contexts and types of L/Cs.
9- Paul R Verkuil (1972-1973), Bank Solvency and Guaranty Letters of Credit
This study aims to provide a detailed examination of Letter of Credit (L/C) transactions from a bank's perspective in the payment process It highlights the fundamental aspects of documentary transactions, with a particular emphasis on documentary credit as managed by banks While the author outlines various points regarding the bank's processing of L/C transactions and the criteria to consider, the implications for businesses and enterprises have not been thoroughly explored.
10- Richard A Wiley (1964-1965, How to Use Letters of Credit in Financing the Sale of Goods
This research provides a comprehensive overview of letters of credit (L/C), exploring their nature, benefits, and legal implications Key topics include the foundational information about L/Cs, types of letters of credit, and the legal framework governing them, including the Uniform Commercial Code The paper highlights the importance of strict compliance regulations and the security measures taken by issuing banks against applicants Additionally, it addresses the risks associated with L/Cs and offers insights on mitigating these risks, making it a valuable resource for understanding the application and utilization of documentary credit.
11- Vladimir Anatolevich Ermakov (2018), “A letter of credit as an instrument to mitigate risks and improve the efficiency of foreign trade transaction”
This study aims to analyze the use of letters of credit (L/C) in international trade and identify effective strategies to enhance payment methods for importers and exporters Utilizing empirical research methods, indicator systems, and secondary analysis from a global survey of financing experts, the research highlights the adaptability of L/Cs in international settlements It emphasizes the importance of securing financing and deferred payments from leading European and global banks at competitive rates, specifically within the European currency market The findings are particularly relevant for the Russian Federation, CIS countries, Eastern Europe, and other emerging markets characterized by high currency market rates However, while the study presents various risk mitigation strategies for L/C transactions, these solutions are primarily applicable to Russia and Europe, limiting their global relevance.
12- Finny Redjeki- Sugihartanti- Vip Paramarta (2017),“Documentary credit as a bank instrument that can provide payment insurance for exporters”
This study highlights the importance of Documentary Credit (DC) as a secure payment method for exporters involved in international transactions The findings indicate that DC serves as a reliable banking instrument, ensuring payment assurance for exporters by securing funds with the Issuing Bank and providing access to export financing facilities Additionally, the research demonstrates that the advantages of using DC outweigh those of alternative payment methods However, it is important to note that the study primarily focuses on the most commonly used Letters of Credit (L/C) within a specific geographical region, examining how L/C can mitigate risks in international trade rather than exploring strategies to avoid risks associated with L/C transactions.
13- Finny Redjeki- Sugihartanti- Vip Paramarta (2017), “The content of documentary credit as a bank instrument that can ensure security for both beneficiary and applicant”
This study aims to ensure security documentary credit payment method between using “with” or “without” D/C and contents The thesis has found that “The
The seven key components of D/C (Documentary Credit) in the DC payment method significantly reduce potential risks in international trade transactions These components include the Promise to Pay, Payment Obligation Substitution, Complying Presentation, Payment Tenure, Parties involved, Time, and Terms and Conditions Each element plays a crucial role in ensuring security and protection for both the beneficiary and the applicant, although the discussion primarily focuses on the content without addressing the responsibilities of each party.
14- Baxter, Michael (1997), Letters of Credit and the Powerine Preference Trap, The Business Lawyer
This article explores the challenges creditors face when holding a standby letter of credit to secure a debtor's obligations, particularly if the debtor fulfilled those obligations within the 90-day preference period leading up to bankruptcy It also outlines strategies creditors can employ to navigate and potentially avoid falling into the preference trap.
15- Hamed Alavi (2016), “Mitigating risk of fraud in documentary letters of credit”.
This article aims to highlight various types of fraud and discrepancies encountered in international trade and propose effective risk mitigation strategies The research demonstrates a comprehensive understanding of fraud and discrepancies associated with Letter of Credit (L/C) transactions, offering suitable solutions to address these issues However, the study primarily examines general frauds and discrepancies in international trade, and the proposed solutions may not be tailored to specific contexts.
16- Zsuzsanna Tóth,(2006),“DOCUMENTARY CREDITS IN INTERNATIONAL TRADE TRANSACTIONS WITH SPECIAL FOCUS ON THE FRAUD RULE”
Research methodology
The research utilized a qualitative methodology, incorporating private interviews and data collection to explore international business practices in Hanoi Interviews were conducted with board members from various companies, including large and small to medium-sized enterprises, alongside insights from L/C issuing banks A well-prepared open-ended questionnaire was administered to randomly selected organizations, focusing on their current payment methods, specifically Letters of Credit (L/C), and the challenges faced during L/C transactions The responses gathered will be analyzed in conjunction with standard bank practices throughout the L/C process.
1 What kinds of commodity are you internationally trading?
2 Do you use L/C payment in your company frequently?
3 In your opinion, when comparing with other methods, will the L/C provides the ease to cross-border trade?
4 Do you have any difficulties during the time applying L/C in your international trade transactions? If your answer is “yes”, please tell me what are they?
5 Do you frequently use different kinds of Documentary Credit or just use only one type for all of your transaction?
6 Why do you choose to use only several types of L/C to be your payment term?
Is it because your payment contexts not differing?
7 What kinds of L/C are you currently applying in your payment process?
8 Why do you choose those kinds of L/C instead of the other kinds?
9 Do you want to learn more about features of each distinctive L/C in order to apply different kinds to your business?
During the interviews conducted with managers in export-import and foreign trade companies in Hanoi, open-ended questions were utilized to gather insights The responses were subsequently analyzed using thematic analysis, a method preferred for its effectiveness in interpreting interview data To ensure the trustworthiness of the collected information, the findings were cross-verified through colleague confirmation.
Purpose of the Research and Research questions
This research aims to explore the characteristics and applications of various types of Letter of Credit (L/C) payment terms, providing valuable insights for export-import companies and commercial banks By understanding these features, stakeholders can effectively utilize different L/C types to minimize fraud risks and enhance benefits for applicants, beneficiaries, and banks involved The study seeks to address key questions related to the optimal use of L/Cs in international trade.
Question number 1: What is Documentary Credit and kinds of Documentary Credit are frequently used in international trade transactions?
Question number 2: When each kind of L/C should be used?
Question number 3: How parties involved in the L/C transaction can take full advantages of this payment method?
Objectives and Scope of the Research
Based on the aforementioned research questions, the following aspects were investigated in this thesis:
1 Documentary Credit: its features and applying contexts
2 Remarks for importers, exporters, and banks when using different kinds of L/C The goal of this journal is to accomplish an empty space in the contemporary literature regarding to business processes under L/C payment procedure leading to high rates of fraud and loss It seems that the formulation of Documentary Credit in Vietnam has been previously undertaken; however, this research considers new aspects of L/C that have not been explored before, different kinds of Documentary Credit from the view of entrepreneurs and bankers This study can be of great advantage to the entrepreneur community Given a chance to understand the distinctive feature of each kind of L/C and the reasons for the discrepancies and risks incurred during the L/C process, international dealers can be well-prepared for problems and differing payment contexts Hence, entrepreneurs can choose the appropriate kind of L/C as a part of their strategy to avoid risk and foster a successful international trade venture Banking industry will be able to a better grasp of business viewpoint in this thesis and thus bettering their cooperation with enterprises Along with this provide bankers with guidelines and remarks to help them broaden their professional experience about Documentary Credit
This study explores the role of Letters of Credit (L/C) as a crucial instrument for facilitating international trade and payments It serves as a guideline for businesses and banks utilizing various types of L/C, while also addressing potential fraud and discrepancies that may arise during transactions The findings offer valuable insights for all parties involved in documentary credit transactions, enhancing their understanding and application of this payment method.
This thesis is structured into five main chapters, alongside the abstract, references, and appendix Chapter 1 provides an introduction, while Chapter 2 outlines the fundamentals of documentary credit Chapter 3 offers an analysis of various types of documentary credit Chapter 4 addresses critical issues and presents recommendations for Vietnamese enterprises and banks engaged in documentary credit transactions Finally, Chapter 5 concludes the thesis and discusses its limitations.
Structure of the Research
A documentary credit is an irrevocable commitment from a bank to honor documents presented that meet the specified terms and conditions, in accordance with UCP 600 regulations.
An Issuing Bank provides an irrevocable undertaking on behalf of a buyer, ensuring that the terms of the documentary credit cannot be amended or canceled without the beneficiary's consent or that of a Confirming Bank, if applicable Upon the issuance of this documentary credit, the buyer is referred to as the 'applicant'.
Sellers should always require an irrevocable documentary credit for payment, as revocable credits are rarely used and can be canceled without the beneficiary's consent An irrevocable credit provides a guaranteed payment method, which is preferred by sellers The Issuing Bank can honor a presentation through various means, such as immediate payment, deferred payment undertakings, or accepting drafts for future payment It's important to note that banks only handle documents, not the actual goods or services According to UCP 600 sub-article 14a, banks evaluate presentations solely based on the documents provided, ensuring they comply with the credit terms, which typically include invoices and transport or insurance documents.
The phrase "in accordance with the terms and conditions of the documentary credit" signifies that payment obligations are contingent upon fulfilling the credit's specific terms Banks are obligated to review documents solely based on the credit's stipulated conditions, rather than any additional terms found in related contracts, pro forma invoices, or purchase orders.
THEORETICAL REVIEW FOR DOCUMENTARY CREDIT
Definition
Documentary credit is a binding commitment from a bank to honor documents presented in line with its specified terms and conditions, adhering to UCP 600 regulations.
An Issuing Bank provides an irrevocable undertaking on behalf of a buyer, ensuring that the terms of a documentary credit cannot be amended or canceled without the beneficiary's or Confirming Bank's consent Upon issuance of the documentary credit, the buyer is referred to as the 'applicant'.
Sellers should always demand an irrevocable documentary credit for payment, as revocable credits, which can be canceled without the beneficiary's consent, are rarely used and not referenced in UCP 600 An irrevocable credit provides a guaranteed payment method preferred by sellers The Issuing Bank can honor a presentation through various means, including immediate payment, deferred payment undertakings, or accepting drafts for future payment Importantly, banks focus solely on the documents presented, not the actual goods or services According to UCP 600 sub-article 14a, banks assess the documents to ensure they meet the credit's specifications, which typically include invoices and transport or insurance documents.
The phrase "in accordance with the terms and conditions of the documentary credit" signifies that the payment obligation is contingent upon fulfilling the specified terms of the credit Banks are obligated to review documents solely based on the credit's terms, rather than any stipulations found in associated contracts, pro forma invoices, or purchase orders.
Basic features of a Documentary Credit transaction
A Letter of Credit is an independent contract between the Issuing Bank and the Beneficiary, distinct from the sales contract between exporters and importers The Issuing Bank represents the Applicant's requests and instructions, but the Applicant's influence is not reflected in the Documentary Credit While the sales contract outlines the obligations and payment terms between the parties, the Letter of Credit ensures the Issuing Bank's payment obligation to the Beneficiary upon compliance with the specified documents Importantly, the banks involved are not bound by the sales contract, even if the Letter of Credit relates to it.
In Letter of Credit (L/C) transactions, banks operate solely based on the documentation provided, assessing whether the documents comply with the agreed terms If the documentation is compliant, banks will release payment to the presenter regardless of whether the goods have been delivered or match the commitment Conversely, if the documents are deemed non-compliant and the banks still choose to release payment, the applicant retains the right to refuse payment to the banks.
Documentary credit is strictly tied to the document package, requiring the beneficiary to present a compliant set of documents to receive payment This package must closely align with the terms of the Letter of Credit (L/C), including the specific types, quantities, and content of each document, all of which must fulfill the necessary functions.
A Letter of Credit (L/C) serves as a payment and risk mitigation tool, but it can also be misused to refuse payment and commit fraud Banks typically focus solely on the documentation presented, leading to frequent disputes over document accuracy Additionally, the independent nature of L/Cs allows exporters to deliver subpar goods or fail to dispatch items altogether, yet payment can still be processed if the documentation appears compliant.
2.3 IMPORTANCE OF DOCUMENTARY CREDIT TO GROUPS OF COUNTRIES
According to “ICC Global Trade Finance Survey 2015”, the magnitude of trade conducted by different payment terms is statistically recorded in the following chart
Chart 2.1: The magnitude of trade conducted by different payment terms
In 2015, letters of credit represented 45% of total international payment transactions, comprising 17% from standby letters of credit and 38% from commercial letters of credit This highlights the crucial role that letters of credit play in facilitating trade across nations worldwide.
International trade in developing and underdeveloped countries often faces significant challenges due to a lack of experience with international payments, leading to various risks and discrepancies in transactions To mitigate these risks, tools like documentary credit, specifically Letters of Credit, can be invaluable By sharing the inherent risks equally between exporters and importers, this payment method fosters a low-risk environment, encouraging international trade and facilitating smoother transactions for both exporting and importing nations.
In this way, national trade surplus will have a chance to increase
The significance of Letters of Credit (L/C) for both developed and developing nations lies in their standardized legal framework, primarily governed by international practices like UCP and ISBP This standardization reduces legal risks associated with differing laws, leading to a decrease in litigation and disputes, thereby enhancing bilateral and multilateral relations among countries Furthermore, the high costs associated with L/C fees contribute to the income generated from issuing, advising, and discounting activities of commercial banks, which in turn supports GDP growth and fosters robust economic development.
Both developed and developing countries can reap significant commercial, financial, and legal benefits from utilizing letters of credit This payment method is particularly advantageous for developing and under-developed nations, as it helps to level the playing field in international trade by mitigating risks associated with cross-border transactions.
2.4 ADVANTAGES AND DISADVANTAGES OF DOCUMENTARY CREDIT 2.4.1 Advantages of Documentary Credit
- The importer can specify documentation that fulfills the requirements of the enterprises and companies
- They may be able to obtain a better price or more favorable credit terms
- The Issuing Bank guarantees importers will not have to pay until the complying documents are not received
- Timing of shipments and presentation of documents may be more tightly controlled by the wording of the documentary credit
Payment is assured by the Issuing Bank or a Confirming Bank, contingent upon the fulfillment of the documentary credit's terms and conditions, thereby enhancing the certainty of cash flow.
- Applicant risk is transferred to the Issuing Bank (and the risk of Issuing Bank is transferred to the Confirming Bank, if the credit is confirmed)
- Pre-shipment finance may be available from its bankers on the strength of the L/C from the Issuing Bank
- There will be an opportunity to have accepted drafts or deferred payment undertakings discounted
- The credit creates a contingent liability with its bankers and, therefore, utilizes part of a credit facility
- If the Letter of credit is revocable, the credit cannot be cancelled or amended without the beneficiary’s consent
- Fees in issuing the L/C and handling documents in the issuing nation are charged for the applicant and will be more expensive compared with other methods
The applicant must promptly reimburse the Issuing Bank if the documents are compliant, as there will be no opportunity to delay payment to the beneficiary.
- As banks working with the document package (not with commodity), a compliant presentation will lead to payment regardless of if merchandise is of the committed quality or not
To ensure timely payment, the beneficiary must submit compliant documents within the validity period of the Letter of Credit (L/C) Failure to do so can result in payment delays, forcing the beneficiary to reduce the price of the commodity or service, or potentially leading to non-payment unless the Issuing Bank accepts the documents despite discrepancies.
- The beneficiary may need to train specialized officer to prepare documents
- The expenses of advising or confirming the Letter of credit are mostly borne by the exporters
This chapter provides a comprehensive overview of Documentary Credit transactions, highlighting their advantages and disadvantages for all parties involved It emphasizes the significance of Documentary Credit as a preferred payment method in cross-border trade, particularly for developing and undeveloped countries, thereby enhancing readers' understanding of its value in international commerce.
Advantages and Disadvantages of Documentary Credit
- The importer can specify documentation that fulfills the requirements of the enterprises and companies
- They may be able to obtain a better price or more favorable credit terms
- The Issuing Bank guarantees importers will not have to pay until the complying documents are not received
- Timing of shipments and presentation of documents may be more tightly controlled by the wording of the documentary credit
Payment is assured by the Issuing Bank or a Confirming Bank as long as the terms and conditions of the documentary credit are met, ensuring a more reliable cash flow.
- Applicant risk is transferred to the Issuing Bank (and the risk of Issuing Bank is transferred to the Confirming Bank, if the credit is confirmed)
- Pre-shipment finance may be available from its bankers on the strength of the L/C from the Issuing Bank
- There will be an opportunity to have accepted drafts or deferred payment undertakings discounted
- The credit creates a contingent liability with its bankers and, therefore, utilizes part of a credit facility
- If the Letter of credit is revocable, the credit cannot be cancelled or amended without the beneficiary’s consent
- Fees in issuing the L/C and handling documents in the issuing nation are charged for the applicant and will be more expensive compared with other methods
The applicant must promptly reimburse the Issuing Bank if the documents are compliant, as there will be no opportunity to delay payment to the beneficiary.
- As banks working with the document package (not with commodity), a compliant presentation will lead to payment regardless of if merchandise is of the committed quality or not
To ensure timely payment, the beneficiary must submit compliant documents within the validity period of the Letter of Credit (L/C) Failure to present the required documents can result in payment delays, potentially forcing the beneficiary to discount the price of the commodity or service, or even leading to non-payment if the Issuing Bank does not accept documents with discrepancies.
- The beneficiary may need to train specialized officer to prepare documents
- The expenses of advising or confirming the Letter of credit are mostly borne by the exporters
This chapter provides a comprehensive overview of Documentary Credit transactions, highlighting their advantages and disadvantages for all parties involved It emphasizes the significant benefits of using Documentary Credit as a payment method in cross-border trade, particularly for developing and underdeveloped countries, thereby enhancing readers' understanding of its value in international commerce.
ANALYSIS OF KINDS OF DOCUMENTARY CREDIT
Ordinary Letters of Credit
“A revocable letter of credit is uncommon because it can be changed or cancelled by the bank that issued it at any time and for any reason.”
A revocable letter of credit (L/C) allows the applicant to request amendments, supplements, or cancellations without prior approval from the beneficiary If the goods have already been delivered, any order to cancel or amend the L/C becomes invalid, ensuring that the Issuing Bank remains obligated to fulfill its payment commitment as if no changes were made.
Due to uncertainties and the lack of guaranteed rights for exporters, revocable letters of credit (L/C) are rarely utilized in practice, as they are not governed by the Uniform Customs and Practice for Documentary Credits (UCP) A revocable L/C allows one party to unilaterally cancel the agreement, which further diminishes its appeal for secure transactions.
Revocable letters of credit (L/C) can be altered or canceled at any time without the consent of the involved parties, such as the applicant or issuing bank, which may act unilaterally without the knowledge or agreement of the beneficiary, advising bank, or confirming bank As a result, revocable documentary credits are rarely utilized in modern transactions.
An Irrevocable Letter of Credit is a type of financial instrument that cannot be altered, modified, or canceled by the Issuing Bank during its validity period without the agreement of both the beneficiary and any Confirming Bank involved This form of documentary credit offers greater security compared to revocable letters of credit.
In international transactions, irrevocable Letters of Credit (L/Cs) are essential as they guarantee the rights of exporters, with the Uniform Customs and Practice for Documentary Credits (UCP) governing all types of these L/Cs An L/C is considered irrevocable even if it does not explicitly state the term, unless otherwise specified Unlike revocable L/Cs, irrevocable L/Cs cannot be unilaterally canceled or amended by any party without mutual consent, rendering any such unilateral actions legally invalid However, if all parties agree to cancel the L/C, it can be deemed invalid, provided that the applicant negotiates with the Issuing Bank and, if applicable, the Confirming Bank to secure the necessary authentication for cancellation It is a common misconception among customers that the agreement between the buyer and seller suffices for cancellation, neglecting the critical role of banks, which may refuse to cancel the L/C due to their financial commitments to the applicant or beneficiary, potentially leading to losses for the banks involved.
In the field 40A “Form of documentary credit”, the L/C often clearly stated
“Irrevocable” On top of this, as mentioned above, an L/C without the word
“Irrevocable” in the filed 40A is still regarded as an irrevocable Letter of Credit
The request to cancel a Letter of Credit (L/C) typically comes from applicants who wish to release their deposit at the Issuing Bank before the expiry date For beneficiaries, a lack of delivery equates to the cancellation of the L/C This is why buyers often require sellers to provide a "Contract Performance Guarantee" to mitigate potential damages from exporters canceling the L/C due to non-delivery or failure to deliver as agreed The Irrevocable Letter of Credit is the most widely used type of L/C in trade payments, with its irrevocability being a crucial and essential characteristic in international trade The general procedure for an irrevocable Letter of Credit involves a series of well-defined steps that facilitate secure transactions.
Chart 2.2: Possibility 1: The L/C is paid at Issuing Bank
Step 1: The buyers and sellers sign a sales contract with L/C payment terms Step 2: Based on the terms and conditions of the foreign trade contract, the importer submits an application to his bank, asking the bank to issue an Letter of Credit to the beneficiary
Step 3: Based on the L/C opening application, if accepted, Issuing Bank will open the L/C and through its correspondent bank or branches in the exporting country to notify the L/C to the exporter
Step 4: Upon receiving L/C, the Advising Bank will check if L/C is true or not
When a Letter of Credit (L/C) is authentic, the bank will inform the exporter However, if the authenticity of the L/C cannot be verified, the Advising Bank will refrain from notifying the exporter and will instead communicate this uncertainty to the Issuing Bank.
Step 5: Exporter checks the L/C whether it is in accordance with the signed contract or not If L/C is compliant will the contract, the beneficiary will dispatch the commodity, if not compliant, it is recommended to amend the L/C to suit foreign trade contract
From the step 5, there are two different possibilities can happen due to the bank and the location where the documents are presented to receive payment
+ Possibility 1: If the letter of credit is valid in the Issuing Bank (payment received in the importing country)
Step 6 and Step 6 ': After delivery, the exporter sets up the L/C's required documents and presents to the Issuing Bank to be paid
Step 7 and Step 7 ': Issuing Bank, after checking documents on its face, if the presentation is compliant, payment will be released; If the presentation is concluded non-complying, the documents will be returned to the exporter intact without any payment released
Step 8: Importers reimburse payment for Issuing Bank
Step 9: Issuing Bank releases documents to importers
Chart 2.3: Possibility 2: The L/C is paid at Nominated Bank Possibility 2: If the letter of credit is valid in the Nominated Bank (payment received in the exporting country)
Step 6: After the delivery, the exporter prepares the set of documents as required by the L/C and presents it to the Nominated Bank for payment
Step 7: Nominated Bank checks the document package if it is compliant with L/C to payment release payment; if the presentation is not compliant, the documents will be returned to the exporter intact without any payment released
Step 8: Nominated Bank send documents to the Issuing Bank to be refunded Step 9: Issuing Bank checks the documents, if it is compliant to the L/C condition, the bank will make payment to the Nominated Bank, if it is non-complying, the documents will be returned to the Nominated Bank intact
Step 10: The importer checks the documents, if it is compliant to the L/C condition, the applicant will pay or accept the draft If the documents have discrepancies, the applicant has the right to refuse to pay
Step 11: The Issuing Bank releases documents to importers after receiving payment or acceptance, and the importers can receive the shipment
The outlined procedures are applicable to all types of irrevocable documentary credits, with minor adjustments made for specific variations to highlight unique transaction characteristics Nonetheless, the fundamental process of the letter of credit remains largely consistent across different types.
Special Letters of Credit
A confirmed letter of credit is a financial instrument in which a second bank, typically located in the exporter’s country, guarantees payment, enhancing security for the exporter This type of credit is often utilized when the exporter perceives risks associated with the issuing bank or the political and economic stability of the importer’s country as inadequate.
A confirmed letter of credit (L/C) enhances security for beneficiaries by involving a confirming bank that guarantees payment even if the issuing bank defaults This dual commitment from both the issuing and confirming banks makes confirmed L/Cs more secure than unconfirmed ones, as both banks are obligated to pay upon presentation of compliant documents The issuing bank typically pays a confirmation fee and may deposit up to 100% of the L/C value with the confirming bank The necessity for L/C confirmation is influenced by the issuing bank's creditworthiness, its financial stability, and the political and economic conditions of its country Beneficiaries benefit from the added assurance of two banks, while importers face minimal disadvantages, primarily related to the potential obligation to cover the confirmation fee if not specified.
In a confirmed letter of credit, it is essential that field 49, labeled "Confirmation instructions," does not state "without." Instead, it should indicate "may add" or "confirm," allowing the Confirming Bank the option to add its confirmation to the credit Additionally, in field 41D, the letter of credit should specify "ANY BANK BY NEGOTIATION." A sample confirmed letter of credit is available in the appendix of this thesis.
The demand for this type of Letter of Credit (L/C) arises from exporters' concerns about the reliability of their customers and the banks issuing the L/C, especially for transactions involving significant amounts This mechanism provides assurance and protection for exporters, ensuring their financial interests are safeguarded.
Exporters benefit from enhanced financial security due to two key guarantees: one from the Issuing Bank and another from the Confirming Bank This dual assurance provides the beneficiary with the highest level of protection and confidence in receiving payment.
3.1.3 Red Clause Letter of Credit
A red clause documentary credit is a type of credit that includes a special provision allowing the Confirming Bank or any nominated bank to provide advances to the beneficiary prior to the submission of required documents This unique feature enhances liquidity for beneficiaries, facilitating smoother transactions in international trade.
The term "Red Clause," also known as "Advance Clause" or "Special Clause," refers to a provision in Letters of Credit (L/C) that allows for immediate funding to exporters upon the L/C's opening Under this clause, the Issuing Bank commits to pay a specified amount upon receipt of relevant documents, such as drafts for advance payments, invoices, or delivery commitments Often, the applicant provides advances to beneficiaries backed by an Advance Guarantee from the beneficiary's bank, allowing the beneficiary to negotiate a guarantee before receiving funds Historically, this term originated when Letters of Credit were issued on paper, with advance payment conditions noted in red ink The 'Red Clause' enables the Issuing Bank to instruct the Negotiating/Advising Bank to advance a portion of the commodity's value to cover production costs, facilitating prompt payments to beneficiaries.
A Red Clause Letter of Credit is characterized by specific terms in fields 47A or 78, which stipulate that 30% of the letter of credit amount is payable in advance upon receipt of an advance payment guarantee, while the remaining 70% is payable upon the receipt of conforming documents An example of this can be found in the appendix.
Red Clause is increasingly utilized in import and export transactions, particularly for agricultural products such as coffee, rice, corn, and cashews To stabilize the market and ensure a reliable supply, importers and exporters often establish commercial contracts two to three months before harvest These contracts must clearly outline the quantity, price, timing, and delivery conditions The importer then enters into an agreement with their bank to specify the terms for opening a Red Clause Letter of Credit (L/C) in line with the sales contract Typically, the buyer's bank requires a margin deposit or a credit line to facilitate the opening of the Red Clause L/C, depending on the established relationship between the buyer and the bank.
This kind of L/C will be advantageous to the exporters as beneficiaries because the advances can help them in managing their working capital cycle
3.1.4 Green Clause Letter of Credit
A green clause letter of credit enables pre-shipment advances similar to a red clause L/C, but specifically requires that these advances are made only against goods stored under the Advising Bank's order until shipment occurs The lending bank provides funds based on warehouse receipts issued in its name.
The Green Clause Letter of Credit (L/C) extends the benefits of the Red Clause L/C by providing exporters with advances not only for sourcing raw materials and processing but also for covering storage and insurance costs at the port until shipping space becomes available Typically, these advances are granted once the commodities are stored in bonded warehouses, with warehouse receipts serving as security and documentary evidence until the final shipment occurs.
The green clause is utilized by importers seeking enhanced guarantees for their goods, as it mandates that advances be secured against commodities stored in warehouses, in addition to the benefits offered by red clause credits.
A green clause letter of credit (L/C) is less advantageous for exporters, as it necessitates proof of goods being stored In contrast, it offers greater security to importers, since they can provide an advance based on the document of title.
“A transferable documentary credit is a credit under which the beneficiary
The first beneficiary has the right to request the authorized bank to undertake deferred payment, accept, or negotiate with the transferring bank In cases of freely negotiable credit, the bank designated in the credit as the transferring bank can make the documentary credit available, either fully or partially, to one or more additional beneficiaries, referred to as the second beneficiary.
Transferable Letters of Credit (L/C) allow the first beneficiary to transfer their rights to make L/C payments and claim proceeds, but this transfer can only occur once and must adhere to the original L/C terms The initial beneficiary remains responsible for the importer, even if a second beneficiary is involved, and must ensure proper delivery of goods and documents Two types of transfers exist: Full Transfer, where the entire L/C value is transferred to a second beneficiary, often seen in buyer-seller relationships or brokerage scenarios, and Partial Transfer, where only a portion of the L/C value is transferred, requiring document replacements and maintaining rights over L/C amendments Intermediaries may choose partial transfers to manage price differences or accommodate multiple suppliers for a single shipment.
Critical Issues and Recommendations for Vietnamese Exporters and
4.1.1 Remarks on using Transferable Documentary Credit
In Transferable L/C transactions, exporters face significant risks that must be carefully considered One major concern arises when the commercial contract is signed with an intermediary who is not responsible for payment, placing the onus entirely on the Issuing Bank and Applicant If issues arise, such as market price declines or signs of buyer insolvency, the Issuing Bank may reject documents over minor discrepancies, leaving exporters without recourse against the intermediary or Transferring Bank Additionally, discrepancies between the original and transferable L/C can jeopardize payment; if the original L/C is modified without the intermediary informing the exporter, compliance with the transferable L/C may not suffice for payment approval To mitigate this risk, exporters should require intermediaries to notify them of any amendments to the original L/C Furthermore, delays or errors in document replacement by intermediaries can lead to payment refusals from the Issuing Bank, making the choice of a reliable and experienced intermediary crucial Ultimately, exporters must ensure that their intermediaries are trustworthy to avoid the adverse consequences of discrepancies and potential fraud in Transferable L/C transactions.
Importers using a Letter of Credit (L/C) must be aware of several important considerations Typically, importers cannot inspect goods before payment, which increases the risk of receiving subpar or nonexistent products if exporters attempt to defraud them Additionally, the costs associated with litigation can exceed the value of the L/C, often forcing applicants to accept unsatisfactory outcomes In the case of transferable Letters of Credit, the risks multiply due to complex transfer procedures and the lack of familiarity with the exporter, raising concerns about their credibility and capability Therefore, it is crucial for importers to carefully consider these factors when engaging in transactions involving transferable Letters of Credit.
4.1.2 Remarks on using Back-to-Back Documentary Credit
Back-to-Back Letters of Credit (L/C) provide exporters with better payment assurance compared to transferable L/Cs, as intermediaries rely on the original L/C to issue a Back-to-Back L/C This structure allows exporters to be paid upon meeting the conditions of the Back-to-Back L/C, independent of the intermediary's payment from the Issuing Bank However, exporters must be cautious of potential risks, particularly when the original L/C is governed by a Bill of Lading (B/L) In such cases, the Back-to-Back L/C must explicitly reference the Master L/C Issuing Bank If goods arrive at the port without original shipping documents, the importer may request their Issuing Bank to release the goods, which poses a risk for exporters Failure to prepare compliant documents for the Back-to-Back L/C can lead to payment refusal by the Back-to-Back L/C Issuing Bank, which is not liable for payment since it does not conduct document availing Moreover, intermediaries and the original L/C Issuing Bank also evade payment obligations due to the absence of proper document presentation Therefore, the key takeaway is the critical importance of preparing compliant documents, despite the challenges that may arise unexpectedly.
Understanding the roles of the applicant and intermediary in a Back-to-Back Letter of Credit (L/C) is crucial for exporters, as any fraudulent intentions can significantly increase the risks they face.
In Back-to-Back L/C, the applicant does not have any distinctive kind of risk should beware of
4.1.3 Remarks on using Standby Documentary Credit
The Standby Letter of Credit (L/C) is crucial for exporters, as it requires adherence to both the original contract and the terms of the Standby L/C for payment Contrary to popular belief, a Standby L/C does not automatically guarantee the fulfillment of contractual obligations Therefore, exporters must meticulously follow L/C regulations alongside their sales contracts to ensure payment Additionally, understanding the validity period of the Standby L/C is essential; beneficiaries should be aware of the performance timeline, the deadlines for document preparation and submission to the Issuing Bank, and the time needed to rectify any document issues to accurately assess the Standby Letter of Credit's validity.
In standby Letter of Credit (L/C) transactions, importers must be vigilant against potential abuses by beneficiaries, who may exploit loopholes in the original contract and L/C provisions to demand payment despite the applicant fulfilling their obligations or only making minor violations It is crucial for applicants to exercise caution when entering contracts with unfamiliar partners Additionally, beneficiaries may engage in fraudulent activities, such as submitting forged or altered documents to secure payment To mitigate these risks, applicants should ensure that the standby L/C aligns with the original contract and assist their bank in verifying the authenticity of documents presented by the beneficiary.
4.1.4 Remarks on using Reciprocal Documentary Credit
Exporters face minimal risks in Letter of Credit (L/C) transactions; however, higher fraud levels are often seen with applicants involved in reciprocal L/Cs In these transactions, the beneficiary, acting as an outsourcer, risks non-payment even after draft acceptance if the processor fails to process the products This occurs because the processor's Issuing Bank will only pay the accepted draft upon receiving payment from the outsourcer's Issuing Bank To mitigate this risk, the processor should seek to amend the payment terms of the reciprocal L/C, allowing the Issuing Bank to commit to the statement: "This L/C is reciprocal to L/C."
ABC Bank, under L/C No 123, will accept and pay drafts upon receiving compliant documents If the beneficiary fails to ship or present documents by the draft's maturity date, payment will occur on the third banking day following that date.
4.1.5 Remarks on using Revolving Documentary Credit
When issuing revolving credit, whether cumulative or non-cumulative, the risk for the importer is the total value of all revolutions For example, if 5000 tons of iron ore is valued at $450,000, a 6-month revolving credit poses a risk of $2,700,000, reflecting the total potential shipment value over that period While revolving letters of credit are effective in managing commodity transactions, the oversight on the beneficiary remains insufficient Even with a non-cumulative revolving letter of credit, the beneficiary can postpone shipments, potentially dispatching goods in the final months while still receiving payment To mitigate this risk, it is advisable to enforce a strict shipping schedule through an installment credit arrangement.
4.1.6 Remarks on using Red Clause Documentary Credit
On the exporters’ side, red clause document can be regarded as a privilege to them, in the ground of the advance of payment from the bank
Buyers must open the Letter of Credit (L/C) shortly before delivery, which involves costs and risks for the beneficiary However, this process offers buyers the advantage of lower prices and a reliable source of imports, even amidst fluctuating international prices To mitigate the risks associated with advance payments, it is essential for buyers to closely monitor counterparties and carefully consider the advance releasing process.
4.1.7 Remarks on using UPAS Documentary Credit
The UPAS Letter of Credit (L/C) is a highly beneficial option for exporters, allowing them to receive immediate payment while the buyer can settle on deferred terms In this arrangement, the Issuing Bank finances the buyer, enabling them to enjoy credit terms of 90, 180, or 365 days, while the seller is paid at sight The Issuing Bank assumes the risk, charging the buyer interest for the financing provided until the end of the usance term Importers can access UPAS facilities through offshore units of local banks, which act as both foreign reimbursing and discounting banks, without imposing excessive fees This arrangement helps importers mitigate exchange rate risks during the payment credit period However, the UPAS L/C is best suited for transactions with fewer complexities, while transferable or Back-to-Back L/Cs remain ideal for more intricate scenarios.
Critical Issues and Recommendations for Vietnamese Commercial Banks
4.2.1 Remarks on using Confirmed Documentary Credit
When utilizing a confirmed letter of credit, the Issuing Bank must select a reliable and financially stable bank to act as the Confirming Bank, ideally one that has a strong relationship with the Beneficiary This selection maximizes the benefits of the documentary credit Once a bank confirms the letter of credit, it is responsible for assessing whether the submitted documents meet the terms and conditions of the letter and is obligated to honor and make payments to the L/C beneficiary.
4.2.2 Remarks on using Back-to-Back Documentary Credit
In the context of Back-to-Back Letters of Credit (L/C), intermediary banks must enforce specific conditions to safeguard their business interests, ensuring that all documents—excluding drafts and invoices—omit details such as the L/C number, date, amount, and issuing bank's name Given the complexity and risks associated with Back-to-Back L/C transactions, banks are advised to assign experienced personnel to oversee the process A thorough comparison of clauses between the original and counter L/Cs is essential, evaluating factors like negotiation limitations, amount discrepancies, signatories, and document requirements The risk for intermediary banks diminishes when both L/Cs align in content As intermediaries, these banks assume significant risk and must act as Advising, Paying, and Issuing Banks to ensure meticulous document management While Back-to-Back L/Cs are often discouraged in favor of Transferable L/Cs, intermediary banks must maintain control over the original L/C, assess its confirmation needs based on transaction risk, and be well-informed about the required documents prior to opening a Back-to-Back L/C This proactive approach allows them to manage amendments effectively and ensures all relevant documents are submitted simultaneously To further mitigate risks, intermediary banks frequently scrutinize the original L/C and may request modifications to align with their procedures, such as stipulating that payments are only processed through them, thus enhancing transparency throughout the transaction process.
4.2.3 Remarks on using Transferable Documentary Credit
In Transferable Letters of Credit (L/C), banks often hesitate to negotiate documents due to the inherent risks faced by exporters Although some intermediaries suggest adding phrases like "Documents are available by negotiation at exporters' banks," this does not mitigate the risks for exporters or the negotiating bank, especially if the original L/C restricts document negotiation to the transferring or issuing bank The primary risk lies with the first Advising Bank, which may inadvertently honor a negotiation without detecting discrepancies that the Issuing Bank could refuse to pay Additionally, errors in transcribing conditions between the original and transferred L/C can exacerbate risks Therefore, banks must carefully choose correspondent banks with whom they have strong relationships, as discrepancies can lead to complications In cases of transferred L/Cs, the transferring bank can only honor compliant documents from its correspondent and should avoid reimbursement through T/T to prevent complications with the master credit Ultimately, it is advisable for transferring banks to stipulate reimbursement upon receipt of documents to ensure a smooth transaction.
4.2.4 Remarks on using Standby Documentary Credit
In the distribution stage of a Standby Letter of Credit (SBLC), banks must thoroughly evaluate the financial viability of customers to avoid incurring compensation payments to beneficiaries Negligence in document verification can lead to beneficiaries engaging in deceptive practices, resulting in legal disputes for banks Therefore, meticulous document checks are essential The risk of non-payment by the applicant is heightened in these transactions, as banks are obligated to reimburse damages if the applicant fails to fulfill their commitments This risk may stem from careless examination during the opening of the Standby L/C or from a lack of comprehensive information regarding the client's financial situation.
4.2.5 Remarks on using Red Clause Documentary Credit
When opening a Red Clause Letter of Credit (L/C), banks encounter several risks, including the potential misuse of advances by beneficiaries who may fail to deliver goods or present required documents as per L/C regulations Additionally, beneficiaries might receive advance payments and sell the goods to other buyers, particularly if commodity prices increase, thus breaching the contract There is also the risk of beneficiaries disappearing after receiving the advance To mitigate these risks, banks employ two main strategies: first, the Issuing Bank provides funds before confirming orders, allowing beneficiaries to draw drafts against the L/C value as advance payments, contingent upon a letter of guarantee ensuring shipment compliance Second, the Issuing Bank authorizes the Advising or Negotiating Bank to disburse advance payments, with the understanding that these amounts, along with any interest, will be recovered from the seller's invoice or goods bill This arrangement allows for pre-paid loans to exporters while ensuring repayment guarantees from the Issuing Bank in case of contract violations.
4.2.6 Remarks on using Green Clause Documentary Credit
In a green clause letter of credit, the operating bank retains full control over the merchandise, managing approvals, issuing release notes for shipments, and consigning goods to the carrying vessel under its name It is crucial for the bank to meticulously oversee each stage of the process to maintain title to the goods, as all advances made to the beneficiary are secured against items stored in the bank's name.
This chapter provides exporters, importers, and banks with practical insights into special letters of credit, addressing common critical issues associated with various types of documentary credit The recommendations outlined herein are essential for the parties involved to effectively mitigate risks and utilize documentary credit with greater flexibility.
CONCLUSION AND LIMITATIONS
Conclusion
Payment methods in global trade are crucial for international traders and commercial banks, with the security of trade activities closely linked to payment terms The Documentary Credit, particularly the Letter of Credit (L/C), has long been a preferred payment method for export-import companies in Vietnam and worldwide According to the Swift Institute and IMF, Letters of Credit facilitated approximately $2.30 trillion in international trade in 2011, accounting for 12.5% of global goods trade, especially for larger transactions Despite its advantages, many entrepreneurs struggle with the complexities of documentary credit, which can hinder their international ventures A thorough understanding of the technicalities, benefits, and drawbacks of L/C is essential before making commitments This study aims to analyze various types of L/C, including transferable, back-to-back, revolving, and UPAS documentary credits, to assist international traders in effectively integrating these instruments into their business strategies.
Export-import enterprises can gain valuable insights into payment methods, helping them reduce risks and discrepancies in business transactions Bankers receive clear guidelines for handling various types of Letter of Credit (L/C) transactions, ensuring they can effectively process these transactions With tailored advice for each specific type of documentary credit, bankers are equipped to provide informed recommendations to their customers on selecting the most suitable L/C options for their payment terms.
Documentary credit, or letter of credit (L/C), is a widely utilized payment method in international trade To fully leverage the advantages of this technologically advanced payment option, it is essential to consider key tips and insights for its effective use.
Limitations
This research on Letters of Credit (L/C) in Vietnam faces challenges due to restricted access to official L/C data and trade volumes, as international commerce authorities prioritize privacy The findings primarily rely on interviews with international trade enterprises, providing a representative but not exhaustive view of L/C usage Additionally, personal biases from interviewees may influence the research outcomes, as responses were validated by colleagues Furthermore, the lack of publicly available studies on Letters of Credit limits the diversity of the literature review, impacting the comprehensiveness of the research.
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A model At-sight Letter of Credit
Source: Hoa Thuan Company Limited
A model irrevocable Letter of credit
Source: Bao Minh Dat Trading Company Limited
Source: HANAKA Group Joint Stock Company
Source: Ningbo plastic machinery company limited
A model revolving Letter of credit:
Source: HANAKA Group Joint Stock Company
A model Standby Letter of credit:
Source: Ozgur Eker, CDCS Bank, N.A
A model UPAS Letter of Credit:
Source: Bao Minh Dat Trading Company Limited