Letters of credit facilitate international trades between unknown parties. An LC reduces the trust deficit between the seller and buyer.
However, the clearance of funds with documentary credit often takes a long time. The sellers use the discounting of LC in their favor to receive short-term financing.
What is the discounting of a Letter of Credit?
Discounting is the process of paying the beneficiary of documentary credit earlier than stated terms. The seller gets partial or full payment in advance and before the documentary credit is processed.
Sellers with reputable credit profiles can avail of such discounting from their banks or intermediary financial institutes.
Approval of the Letter of Credit Discounting Facility
The risk of approving the LC discounting shifts from the seller to the bank. Hence the bank appraises the seller’s credit profile as with other short-term financings.
The bank may approve discounting as they normally keep the LC as collateral. The issuing bank of the buyer or an intermediary financial institution may also work as advisors on the original documentary credit.
The delayed payment risk for the bank is covered by additional interest and service charges. However, presenting an LC does not qualify for a discounting facility in itself. The seller’s bank would require certain official documents before approval.
- Acceptance of letter of credit from the issuing bank.
- Delivery notes, bills of lading, shipment documents, etc.
- Bill of exchange and other trade document copies.
- A formal request letter for the discounting.
How does it work?
Buyers can issue one of several types of documentary credit in favor of the seller. Often buyers attach covenants with LCs that delay the payment for sellers. The delayed payments can cause severe cash crunches for the sellers. One way of reducing the cash problem is to utilize discounting of letters of credit.
A buyer issues a commercial LC in favor of the seller normally. However, if the sellers require the payments quickly, they can use a discounting facility. The typical workflow with a discounting process in documentary credits goes in the following steps.
- Both parties in the trade contract agree on trade terms as usual.
- The buyer applies for a documentary credit with the issuing bank.
- The issuing bank issues a letter of credit as specified by the buyer.
- The seller receives advice from its bank of financial advisory institutes.
- The sellers then ship the goods as in normal LC conditions.
- The seller applies for discounting of LC amount from its bank.
- The bank releases the funds partially or in full after appraising the risk profile of the seller and the documentary credit terms.
The seller’s bank receives the funds with payment at maturity terms of the LC. The bank offering discounting charge interest and processing fees as with other short-term financing facilities.
Advantages of Letter of Credit Discounting
The biggest advantage for the seller is to receive payments quickly and alleviate the cash needs. The seller may also use the facility to smoothen the operations and proceed with other trade contracts with the same buyer.
The sellers can use LC discounting as currency risk hedging as well. Once they get the approval from the bank, they can receive funds incurring nominal charges.
Some key advantages to all three parties in trade with discounting LCs include:
- It offers an alternative short-term financing facility to the seller.
- The seller receives payment earlier than LC funds at maturity.
- The buyer may feel comfortable with confirmation of goods and payment at maturity.
- The issuing banks for discounting charge premium and interest to their clients.
- It helps reduce the credit risk of the buyer as with other documentary credit arrangements.
- The seller can negotiate longer LC payment dates if they get approved for discounting. It can help both parties to arrange better trade deals.
The seller’s bank issue discounting after appraisal of their credit profile and verification of the LC documents. Thus the biggest advantage with discounting is to mitigate the credit risk involved with delayed Letter of Credit payments.
Limitations of Letter of Credit Discounting
Discounting facility does not mean the direct qualification for the applicant. The banks verify the documentary credit and the applicant’s creditworthiness. It may not be approved for all applicants as the credit risk shifts from the beneficiary to the bank.
Some limitations of using discounting LCs can include:
- Sellers need to qualify for the discounting and the LC works as collateral.
- The banks charge interest and service fees for offering discounting facilities.
- The process of discounting may take longer than expected as it involves several issuing and advisory banks.
