Global financing mechanisms and international capital markets

Global Financing

Report on the Letter of Credit payment mechanism

The aim of this study is to define and describe the payment mechanism of the letter of credit, its usage and importance in international financing, as well as the contribution of this financial tool to the risk reduction in commercial and non-commercial transactions. This paper will be concluded by the ending thoughts of the author regarding the above mentioned topic.

Definition of the term letter of credit (400)

According to the Regulations and provisions of the International Commercial Chamber, the letter of credit defines any payment arrangement of the issuing bank, upon the request and the instructions received by the Client, to the beneficiary of the letter of credit or the bank where this individual has opened a bank account. The mechanism of this payment method is very practical - the issuer of the letter of credit (ussually the Importer in international transactions) orders its bank to open such a payment arrangements, in which the issuing bank takes the payment responsibility in favor of the beneficiary of the letter of credit (usually Exporter in the international transactions), this party has the obligation to submit the required documentation, based on which the payment can be realized. In most of the cases, the payment is made in the bank account of the Beneficiary's account, which has the role to notify the Importer when the funds resulting from the financial transactions have arrived into his bank account. For their services, both the issuing bank and the bank of the beneficiary take a percentage fee and commission. The letter of credit put at the disposal of the payer a certain amount of money so that this party may submit the sum of money to the beneficiary, upon the presentation of the desired documentation (invoices, certificates of conformity, etc.) the letter of credit can be classified into two categories: revocable letter of credit - instrument can be modified within the period in which it is still in force and irrevocable letter of credit - a payment instrument which remains constant for the entire above mentioned period. In the next paragraphs, we shall tackle the subjects regarding the importance of the letter of credit within International transactions and the issue of this payment tool's contribution in risk management for the parties involved.

Importance in International Transactions (400)

Due to its fundamental characteristics, the letter of credit, under different forms, is the most used financial instrument in international transactions. As it was mentioned above, the beneficiary of the letter of credit is represented by an exporter in an international transaction, while the payer within the transaction is the importer. This international operation is created following the signing of an import-export contract, with binding rights and obligations for every party of the transaction. The letter of credit enables the development of international trade and conducts in the sense of economic growth. First of all, the letter of credit mechanism is an easy to use tool that favors the movement of merchandise across national boundaries. International trade permits the companies that interact in the international commercial environment to explore other opportunities existent on the market, and the letter of credit gives advantages for every interested party. Economic growth is enhanced by increased commercial activity, due to some extent to the development of these payment instruments, like the letter of credit.

The letter of credit is used by many commercial players in the world market, especially for the individual advantages and benefits it brings. From the seller's point-of-view, the letter of credit promotes certainty that all the conditions mentioned in the import-export contract are integrally observed, within the established period and the amounts stipulated in the documentation. The Seller may also offer the buyer a supplier credit, having a specific financing method: the submitted documentation is discounted under the particular export letter of credit - in this way, the payment will be made by the payer's bank soon after the date of the shipment, and not on maturity like in the usual case. In case the exporter is an intermediary among an international transaction, it can transfer the letter of credit to other subcontractors, or can cede the encashment resulted from this particular payment instrument. The importer has the certainty that the payment is realized only if the shipment of merchandise is performed only in the stipulated conditions, as these conditions must be demonstrated using the documents submitted by the exporter. Also the importer entitled to receive a supplier credit, from his bank.