TRADE FINANCE

Letters of Credit (LCs)

Trade Dilemma
• Exporters want money before despatch
• Importers want to defer the payment as much as possible
• Credibility gap/distrust between buyer and seller
• Larger is the gap in the international transactions of export
and import due to:
• Distances involved
• Different legal environments and legal recourse
• Jurisdiction and place of arbitration
• Exorbitant cost of litigation

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Trade Dilemma
• Despatch of goods and payment is not possible
simultaneously in international transactions
• Banks help resolve the trade dilemma by serving
as intermediary and reduce credibility gap
• Intervention by the bank in international trade
transactions helps in
1. Reducing risk of non-completion,
2. Reducing foreign exchange risk,
3. Providing means of financing

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Contract Completion
• Banks facilitate decide the terms of trade
including the payment terms
– Sellers like to retain title till paid/or assured
– Buyers like to pay only after receipt of goods
• Banks hold “title of the goods in the interim” till
fulfillment of commitments from both sides
• The risks of non completion of the contractual
obligation are defined meticulously at every
stage of the transaction till it is complete
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Managing Exchange Rate Risk
• Once paid the amount needs to be
converted from one currency to another
– Exporter – need to convert foreign currency in local
currency
– Importer – need to convert local currency to foreign
currency
• Exchange rates change so does the cash flow
in local currency causing risk of cash flow
– Exchange rate risk depends upon the whether
country had fixed or floating rate system

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Financing Trade
• Time lag involved in international trade also
provides business opportunities to the bank for
lending and financing the trade.
• Parties to the trade also need to find means of
raising finance for the time lag in international
trade.
– Exporters need funds/credit to produce
goods
– Importers need funds/credit to buy
• Banks fulfill credit needs for both.
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LC Mechanism

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Meaning of Letter of Credit
• Commitment on part of a bank to place agreed
amount as per the applicant (buyer/importer) at
the disposal of other (seller/exporter) party.
• Tripartite agreement:
– Contract between buyer and seller
– Contract between buyer and Issuing bank
– Contract between issuing bank and
beneficiary’s bank

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Benefits of LC
Benefits/Need for Letter of Credit:
• Assures payment and delivery
• Eliminates mistrust between buyer and seller
• Eliminates commercial credit risk
• Eliminates political risk
• Provides legal protection: Governed by UCP 600
PARTIES TO LETTER OF CREDIT
• Applicant: Buyer
• Beneficiary: Seller

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Banks and Their Roles in LC
• Issuing Bank: Bank opening the LC
• Advising Bank: Advising the beneficiary bank
• Confirming Bank: Bank adding confirmation is liable to
pay in addition to opening bank
• Paying Bank: Authorised to make on-behalf payment
• Negotiating Bank: Nominated to negotiate the
documents; must add confirmation
• Accepting Bank: Negotiate drafts of the beneficiary
• Reimbursing Bank: Reimburse the paying bank

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Types of Letters of Credit
• According to risk:
– Revocable
– Irrevocable
– Irrevocable and confirmed
• According to tenor of payment:
– Sight
– Deferred/Usance
– Revolving
• Part shipment and transhipment allowed or
not allowed.
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Types of Letters of Credit
• Revolving: Where original credit is restored upon
negotiation of part amount.
• Back-to-back: Another LC established on the strength of
first LC on similar terms and conditions as that of original
LC
• Transferable: Beneficiary can transfer to another party.
• Stand-by: Financial guarantee to repay the money
advanced. Utilisation is on ‘non-performance’ rather than
‘performance’.
• Anticipatory credit: For part amount to be adjusted at the
time of final submission of documents. Used for providing
advance. Also referred as Red clause LC
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Documents Under Letter of Credit
FIVE DIFFERENT TYPES OF DOCUMENTS
• Financial: Bill of Exchange
• Commercial: Invoice, Packing List, Inspection certificate,
• Transport: Bill of Lading,
• Insurance: Insurance Cover Note
• Regulatory: Certificate of origin

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 Advantages and Disadvantages of LCs
• Reduces risk for both exporter and importer
– Exporter supplies on the strength of the bank rather
than on the promise of the unknown customer,
– Customer pays upon bank confirming the evidence
of shipment
• Exporter can avail credit facilities on the strength of LC
• Importer is reasonably sure that the terms of the
contract have been met.

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Bill of Exchange
• Negotiable instrument : Four Conditions:
1. In writing and signed by drawer (exporter)
2. Unconditional promise to pay a definite sum
3. Payable on demand
4. Payable to order or bearer
• Drawn in multiple set (usually two), Nos. of Bills drawn are
mentioned
• All sets are negotiable.
• Can be SIGHT or USANCE (DP and DA basis)
• Evidences trade transaction, receipt of payment or
promise to pay (if usance)

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Negotiability
Nemo dat quod non habet
• No one can give what he does not own
• Does not apply to negotiable instruments
• Transferee can acquire better title than transferor
• Transferability by delivery alone or by delivery
and endorsement

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Typical Bill of Exchange - Sight

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 Bill of Exchange
• A non-interest-bearing written order used in international
trade that binds one party to pay a fixed sum to another party
at a predetermined future date.
• Investopedia Commentary: Bills of exchange are generally
transferable by endorsements. The difference between a
promissory note and a bill of exchange is that BE is
transferable and binds one party to pay a third party that was
not involved in its creation.
• Bank Draft vs Trade Draft; BoE also called draft.
– Bank draft: When issued by a bank,
– Trade draft: When issued by issued by individuals

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Types of Bills of Exchange
• Sight draft and Usance (time) draft
– When usance – acceptance required
1. by drawee (trade acceptance)
2. by Bank (Bankers’ acceptance)
– If accepted by bank it is extremely liquid
• Clean vs Documentary
– Clean – Not accompanied by any other document –
used for advance payments
– Documentary - Payment requires documents of
underlying trade with BoE
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Parties To Bill of Exchange
• Bill of Exchange is a written promise of payment from one
person to another that is legally binding. Initially, there are
3 parties:
1. the drawer (usually exporter)
2. the drawee (usually importer or importer’s bank) –
the person to whom the bill is addressed - becomes
the acceptor when he signs the bill. (usually a bank)
3. the payee: Should the bill be negotiated (i.e.
transferred) then anyone holding or endorsing it
becomes a party to the bill and liable upon it.
(holder in due course)
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Features of Bill of Exchange
• Acceptance by the drawee is indicated by his /her
signature. BoEs are widely used in internationally trade. In
domestic trade they are replaced by cheques.
• Order in writing – instruction must be an order and not a
request. Cheque is pre-printed ‘Pay…………………. or order’
• It is a means of payment

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Features of Bill of Exchange
• Requiring the person to whom it is addressed to pay on
1. demand or at a fixed or determinable date.
On demand – expressed to be payable on demand,
at sight,
or on presentation
2. or when time for payment is not stated it must be
determinable.
3. Fixed future date – pay on January 10, 2009.
Determinable future date – 60 days from the date the
goods are dispatched, 30 days after sight.

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Bill of Lading
Purposes:
1. Evidence of execution of contract:
BL contains detailed terms and conditions of the carrier
on which it has accepted the goods
2. Receipt for the goods:
Carrier declares that the goods mentioned are received
for delivery to specified person.
3. Document to the title of goods:
Carrier delivers to the person specified or his orde

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Types of Bill of Lading
“CLEAN” “ON BOARD” BILL OF LADING
• Clean vs. Claused:
Clean:
Bears no super imposed clause which declares defective
condition of the goods. Shipper is a bailee and has to deliver
the goods in the same condition as received by them.
Claused:
Also called Dirty/Foul BL contains super imposed clause
explicitly declaring the defective condition of the goods
received.

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Types of Bill of Lading
• On Board vs. Received for shipment:
Received for shipment : “Received in apparent good condition…..” No
guarantee that the goods will be carried by the vessel named.
On Board: Acknowledges goods have been put on board a ship. “Shipped on
Board” must bear the name of the vessel.
• Short Form vs. Long Form:
It is contract with the shipper and must have terms/conditions of the
contract.
Short form: where terms and conditions are not stated: Charter parties and
not shippers issue such bills of lading.
Long Forms: Terms and conditions are printed on the BL

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 Straight or Order Bill of Lading
• Requires delivery to  Directs carrier to deliver
consignee only – goods to the order
typically of exporter –
• Not a title of goods –  Negotiable – can be traded
Not a good instrument with endorsement and
for financing – delivery
• Used when payment  Good for financing
already received or
financed by exporter
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Official Documents
• For compliance of laws of the land
• Consular Invoice/Legalised Invoice:
Issued or stamped by consular by the embassy of importer
nation. For statistical purposes, for determination of duty etc.
• Certificate of Origin:
– Issued by authorised independent agency certifying
country of manufacture.
– Facilitates determination of status of exporting
country, applicability of concessional rate of duty
• Certificate of sea-worthiness
Issued by Llyod chamber.

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