The world economy is interdependent. The resiliency of international trade and access to trade finance are key contributors to the development of any country’s economy. According to the world trade organization, some 80 to 90 per cent of world trade relies on trade finance. To understand what trade finance is all about, it is important to know what exactly is an international trade.
International trade is a trade between two countries i.e. an exchange of good and services among countries. It allows countries expand their markets out of the shores of their country into another country. Companies from different geographical locations that wants to trade with foreign companies must have an appropriate payment method, this is where trade finance comes in.
Trade Finance represents the financial instruments and products that are used by companies to facilitate international trade. Trade finance is for both domestic and international trade. It is a way for manufacturers to export their goods knowing the importer who may be on the other side of the world and someone they’ve never met but only corresponded with will pay them. Below are the various methods of payment in trade finance among others;
1. Open Account
2. Documentary collection
3. Letter of credit
The major focus of this article is on letter of credit as on the secured method of payment in an international trade.
What Is A Letter Of Credit And How Does It Work?
Letter of credit is a written undertaking by a bank (the issuing bank), to the beneficiary (the seller), in accordance with the instruction of the applicant(buyer), to effect a payment within a certain period of time, against a prescribed documents provided the documents are in compliance with the terms and condition of the agreement. In a simple term, it is a commitment by a bank to pay a certain amount of money on behalf of a buyer (importer) to the seller (exporter) against the presentation of documents with terms and conditions. The major participants in letter of credit are as follows;
- Issuing Bank – the bank that issues the credit on behalf of the applicant
- Applicant – the party who requests for the credit to be issued.
- Advising/confirming Bank – the bank that receives the credit on behalf of the seller/exporter and advises the credit at the request of the issuing bank. It becomes the confirming bank when the credit is confirmed upon the request of the issuing bank.
- Beneficiary – the party in whose favour the credit is issued.
Nigeria's economy is largely dependent on importation of goods from other parts of the world as a result of various socio-economic factors. In the last three years, a more popular mechanism for facilitating international payments in Nigeria is through the use of letters of credit. Letter of credit is one of the most secured instruments available for to international trade. The guiding principles for the operation of documentary credits can be found in the International Chamber of Commerce's UCP 600. The Uniform Customs & Practice for Documentary Credits (UCP 600) is a set of rules agreed by the International Chamber of Commerce, which apply to finance institutions which issue Letters of Credit in helping companies finance trade.
Types Of Letter Of Credit
The most common types of LCs are;
1. Irrevocable Letter Of Credit
This is where the agreement can not be amended or canceled without the consent of all the parties.
2. Confirmed Letter Of Credit
This requires another bank (most times the advising bank) guarantees the payment.
3. Unconfirmed Letter Of Credit
A letter of credit which has not been guaranteed or confirmed by any bank other than the bank that opened it. The advising bank merely informs the beneficiary of the letter of credit terms and conditions.
Advantages Of Letter Of Credit
The advantages of letter of credit abound for both buyer and seller.
- The safety of expanding the business internationally is one the major advantage of LC for both parties.
- Also the LC is customizable in the sense that both parties can mutually agree on the terms and conditions as per their requirements.
- The buyer’s creditworthiness is being backed by the issuing bank, where the seller is free from credit risk.
Disadvantages Of Letter Of Credit
As there are advantages to letter of credit, so also there are disadvantages of the instrument.
- Additional cost of bank charges is added to the cost of doing business.
- Letter of credit might be time consuming as there are various documentation and formalities required.
- Foreign exchange risk is also one the major challenges to letter of credit.
In Nigeria, the major provider of this instrument (letter of credit) are majorly commercial banks.