Bill of exchange Vs Letter of Credit

A bill of exchange is a written instrument that obliges one party to make payment to a
second party on a fixed date and agreed amount. A bill of exchange closely resembles
a bank cheque. It is a type of promissory note. It can be transferred to a third-party
with endorsement, and the first party will be bound to make the payment to the bill of
exchange presenter.

A bill of exchange is a negotiable financial instrument that can be traded on the

secondary market. It can be issued by individuals, companies, or financial institutes
like banks.

A letter of credit is a form of bank guarantee that the beneficiary will receive the
payment if the applicant fails to make the payment.

In the case of the buyer’s default, the bank covers the amount of the letter of credit.
The bank can issue the facility as a loan facility to the applicant. A letter of credit is
by default irrevocable, non-confirmed, and non-transferable.

Working Mechanism – Bill Of Exchange And A Letter Of Credit

A bill of exchange can be arranged by two parties directly or with the help of a bank.
It usually involves three parties; a drawee, payee, and the drawer. Both parties agree
on trade terms and conditions and decide to use a bill of exchange as a payment
method. A bill of exchange issued by a bank, known as a bank draft, can be issued
immediately with a later maturity date.

The beneficiary party (seller) can discount the bill of exchange to its bank and receive
the funds immediately. A bill of exchange can be a sight draft that becomes payable as
soon as the contract terms are fulfilled and the draft is presented. Usually, a time draft
is used that becomes payable at a certain date. A bill of exchange can be forwarded to
any third-party with endorsement on the back.
A letter of credit is issued by a bank on the request of the buyer. The bank requires
cash or assets as a form of collateral to issue a letter of credit. It includes the terms
and conditions of the payment mechanism aligned with the trade contract. However, a
letter of credit is a separate legal document from a trade contract.

In case of buyer’s default, the bank obliges the payment with both instruments.
However, a bill of exchange does not include any specific legal terms to be met
before the payment can be released. A letter of credit is a more binding contract
that reduces performance and financial non-compliance risks.

A bill of exchange is means of payment in trade contracts for both international and
domestic transactions. It offers several advantages and limitations as well.

Advantages of using A bill of exchange Are:

1. It is a simple documented payment instrument. With no interest charges.

2. The Beneficiary party can trade the bill of exchange on secondary markets.
3. It mitigates the exchange rate risk for both parties in international trade without
using complex instruments such as Futures.
4. Both parties can save on bank costs, interest costs, and other fees if issued on
mutual terms.
5. Both parties have the option of involving their banks for further financial security.

Disadvantages

1. It is an unsecured form of financial payment without the involvement of banks.

2. It does not fully cover the default risk of the issuer.
3. It lacks the financial guarantee or legal binding to both parties in international
trade.

A letter of credit is a widely used instrument in international trade. It offers

greater financial security and reduces the risks for both parties.

Advantages Of Using A Letter Of Credit:

1. It provides financial security to both parties in international trade.

2. It comes with several features and it is a highly customizable instrument.
3. It acts as facilitating instrument for payment, working capital, and financial
security simultaneously.
4. Enables businesses to plan better for large cash flow projects.
Disadvantages

1. The bank cannot fully ensure the payment to the beneficiary, in case there is
litigation or other factors in a trade dispute.
2. It does not remove the financial currency risk for the beneficiary.
3. It is a costly and sophisticated instrument that may not be accessible for small
businesses easily.

Conclusion

A bill of exchange is a payment instrument while a letter of credit acts as a legal

contract. A bill of exchange can be arranged without a bank. It is a transferable
and negotiable instrument and can be traded on the secondary markets. A letter
of credit provides greater financial security with several types as it is a highly
customizable instrument.