Letters of Credit
Letters of credit, including sight letters of credit, rely on documentation. To get paid, the beneficiary (often an exporter or service provider) needs to submit documents to specific banks. Those documents typically include the letter of credit itself, as well as additional documents proving that the exporter met their obligations to the buyer. Letters of credit are tools for payment, separate from a purchase or sales agreement. LCs help to ensure that the person on the other side of the deal performs specific actions. Banks guarantee payment and hold onto the money until it can be proven that those requirements are satisfied. To set up a documentary letter of credit, the party making the payment typically applies for a letter of credit with a local bank. If you’re selling something (to a buyer overseas, for example), you can gain confidence by using a letter of credit. With a properly designed agreement, you’ll get paid as long as you ship the goods as agreed. If you’re buying something, a letter of credit can help you avoid paying for something that never arrives. Instead of sending money and hoping for the best, your funds are held in escrow until the seller can produce documents proving that they shipped goods to you or completed a task. For example, the seller might need to provide a bill of lading and other documents. That said, you can’t eliminate risk using a letter of credit. The seller could potentially ship low-quality goods or even commit fraud and ship a box of rocks. Still, you can reduce your risk with letters of credit. Banks will release funds as long as they receive the documents listed in the letter of credit on time and in good order. The bank will not ensure that the shipper fulfilled the order exactly as specified in the purchase agreement. However, you can require an inspection certificate for the letter of credit, allowing somebody to review the shipment’s contents before your payment is released.
What Does “Immediately” Mean?
Although payment with a sight LC is relatively quick, it is not necessarily instant. The seller’s bank (which might be the negotiating or advising bank) must review the documents you submit and make sure they meet the requirements in the letter of credit. That process may take several business days. In some cases, the documents must be forwarded to another bank for review. Once each bank verifies compliance, payment takes place, but don’t expect all of that to happen in one day. Finally, although wire transfers are a quick form of payment, it can take one or two days for funds to end up in a beneficiary’s account (especially if the transfer comes from overseas).
Alternative Letters of Credit
To understand how an LC at sight works, it might help to review how it doesn’t work. An alternative form of LC is a deferred payment letter of credit or a usance (or “term”) letter of credit. With those instruments, payment happens at some future point in time, potentially long after the documents have been submitted (perhaps 30, 90, or 180 days after). Deferred payment gives the buyer more time to come up with funds. As a result, that approach can work as a form of seller-financing. The strategy could even attract buyers that otherwise have to pay more quickly (but prefer not to). The buyer also has a chance to sell the imported goods and generate revenue before the payment is due, making it easier to fund the payment (or shortening the amount of time that the buyer has to borrow from a bank). Letters of credit can have a variety of features. For example, irrevocable letters of credit are harder to cancel unilaterally. Confirmed letters of credit add even more security because a bank that both parties trust can guarantee the payment. That approach provides more confidence than just using an unknown bank in the buyer’s country.
Why Use a Sight LC?
A letter of credit that pays at sight is beneficial for sellers. Payment arrives more quickly than it would with a deferred payment letter of credit. Exporters spend money to produce and ship goods, so getting funds back quickly helps them avoid a cash-flow crunch. Plus, if you’re dealing with a buyer (and bank) in a volatile nation, you might prefer to get paid as quickly as possible. Political unrest could lead to financial turmoil, resulting in currency changes, asset seizures, and other outcomes that might affect your buyer’s (and any related banks’) ability to pay.
