Characteristics

Credit function

The documentary credit, even it contains the word credit, is no credit in the sense of law, but still today in times of strict separation in law exists an important economic connection between letters of credit and credit transactions. Both, importer and exporter possibly needs financing for buying or producing goods, and both can be debtors or creditors to each other regarding the terms and conditions for payment. But also the banks which are involved in the letter-of-credit-transaction can be creditors next to the letter of credit.

The issuing bank could finance the price of the goods and receive the money back after sale of the goods in the home market of the importer. The bank of the exporter on the other side could finance the production of the goods in the expectancy that it receives the money back after handing-over of the documents.

A documentary credit makes it easier for banks to finance goods. In the case of an acceptance letter of credit, when a draft was signed by the issuing bank, the exporter can also sell this bill of exchange at a discount to a bank and receive immediately money instead of waiting. He needs not to finance over a long period.

Security function

If there is no reliance between exporter and importer, if they do not know each other, the seller requires security for payment. It is hard possible to claim the payment in the state of the importer.

A letter of credit is called “child of distrust between seller and buyer”. It secures the change of the performances of buyer and seller. The importer can be sure that the exporter only receives a payment if he proofs his delivery in accordance with the contract through handing-over of documents to the bank and the exporter on the other side, can be sure that he receives payment if he handed over the documents.

The contract parties are secured against solvency risks of the other side because the letter of credit makes it possible to match payment with delivery what else would be impossible. There is nearly no economic risk for the exporter. The stipulated documents can be a security for financing banks because the goods are at their disposal. In the case of an acceptance credit, the exporter can not only rely on the reputation of the bank and its promise to pay; a bill of exchange is also independent from other contracts and offers therefore and because of its binding to strict forms and rules security. The bank, if it financed goods for the importer, receives by the documents the shipped goods as security. If a letter of credit lapsed because of wrong documents or documents not presented in time, the seller could still insist on payment because of the sale contract.

A letter of credit is a second performance additionally, but not instead, of the first one. Some political risks for the exporter can be avoided by an irrevocable, confirmed letter of credit. Measures of government like a moratorium or restrictions in conversion of currency in the importer´s country do not cause losses to the exporter if he can claim payment from a bank in his own state. Currency risks caused by governmental measures can be reduced if the letter of credit is issued in a free floatable currency.

But of course, letters of credit cannot avoid of all risks: transport risks can be covered by special transport insurance, currency risks resulting from floats can be avoided with special bank transactions on the currency market like derivative currency transactions, for example swaps or currency options. Also it is possible to fix the currency rate in the contract.

One of the main risks a letter of credit cannot avoid is that a fraudulent seller delivers documents which appear clean, but delivers rubbish or goods not in accordance with the contract.