Letter of Credit is not used in Domestic Trade Discuss

Why A Letter of Credit is not used in Domestic Trade?-Discuss

1. Introduction:

In the age of globalization, international trade is growing rapidly. In mainly international trade, letter of credits are commonly used as method of payment. The Letter of credit, as we know the term today, existed in England by the time of the 17^th century when the bill of exchange had matured into an instrument similar to the drafts used today. While the letter of credit was developed to facilitate international commercial transaction involving the sale of goods, there is nothing about letter of credit which limits their application to international trade. Letters of Credit have been a cornerstone of international trade dating back to the early 1900s. They continue to play a critical role in world trade today. For any company entering the international market, Letters of Credit are important payment mechanisms which help eliminate certain risks. In Bangladesh, L/C is the chief legal method of international transactions. Lack of real time information on the transactions and goods clearance with the Central Bank is the primary reason behind the existence of a conventional payment mechanism such as the L/C.

I would analyze the above topic in two parts; firstly what are a Letter of Credit and its need, secondly, letter of credit and its relation with international trade and domestic trade.

2. Letter of Credit:

A. Definition of Letter of Credit

Letter of credit means “An instrument under which the issuer (usually a bank), at a customer’s request, agrees to honor a draft or other demand for payment made by a third party (the beneficiary), as long as the draft or demand complies with specified conditions, and regardless of whether any underlying agreement between the customer and the beneficiary is satisfied. In international sales transaction, a contract for the sale of goods is usually executed in conjunction with a banker’s documentary credit to secure the prompt payment of the contract price. The arrangement to pay through banker’s documentary credit is called letter of credit.” A standard, commercial letter of credit (LC) is a document issued mostly by a financial institution, used primarily in trade finance, which usually provides an irrevocable payment undertaking. Letters from a bank which give guarantee that a buyer’s payment to a seller will be received on time and for the correct amount. In the event that the buyer is unable to make payment on the purchase, the bank will be required to cover the full or remaining amount of the purchase.

Letters Of Credit, also called documentary credits, are the most frequent methods of payments for goods in the export trade. They have been described by English judges as “the life blood of international commerce”. Donaldson L.J., with the occurrence of Ackner L.J., said:

“Irrevocable letter of credit and bank guarantees given in circumstances such that they are equivalent to an irrevocable letter of credit have been said to be the life blood of commerce. Thrombosis will occur if, unless fraud is involved, the courts intervene and therapy disturbs the mercantile practice of treating rights there under as being equivalent to cash in hand.”

The feature common to all type of letter of credit is that the buyer arranges with a bank to provide finance for the exporter in the country of the latter on delivery of the transport documents. On presentation of the transport documents, the banker pays the purchase price, often by accepting a sight draft or time bill drawn by the buyer (acceptance credit) or by paying cash (Cash Credit). A letter of credit has been described in these terms:

“The Banker acting on behalf of the buyer and either directly or through the intervention of a banker in the seller’s country, assumes liability for payment of the price, in consideration, perhaps, of the security afforded to him by an implied pledge of the documents of title to the goods or of his being placed in funds in advance or of an undertaking to reimburse, and of a commission.”

This description reveals the essence of the transaction, viz. that where the goods are represented by the bill of lading, this document of title is used as a means of financing the transaction. Lord Wright describes the function of the letter of Credit as follows:

The general course of international coerce involves the practice of raising money on the documents so as to bridge the period between the shipment and the time of obtaining payment against documents.

A comprehensive delimitation of the letter of credit is to be found in the Uniform Custom and practice for Documentary Credit (1983 Revision) where it is provided:

For the purpose of these articles, the expressions “documentary credit(s)” and “standby letter(s) of credit” used (hereinafter referred to as “credit(s)”), mean any arrangement, however named or described, whereby a bank (the issuing bank), acting at the request and on the instructions of a customer (the applicant for the credit),

i. is to make a payment to or to the order of a third party (The beneficiary), or is to pay or accept bills of exchange (drafts) drawn by the beneficiary, or

ii. Authorizes another bank to effect such payment, or to pay, accept or negotiable such bills of exchange (drafts).

B. The stages of a letter of credit transaction:

When payment under a letter of credit is arranges, four stages can normally be distinguished-

i. The exporter and the overseas buyer agree in the contract of sale that payment shall be made under a letter of credit.

ii. The overseas buyer instructs a bank at his place of business (known as the “issuing bank”) to open a letter of credit for the United Kingdom exporter on the terms specified by the buyer in his instructions to the issuing bank.

iii. The issuing bank arranges with a bank at the locality of the exporter (known as the “advising bank”) to negotiate, accept or pay the exporter’s draft upon delivery of the transport documents by the seller.

iv. The advising bank informs the exporter that it will negotiate, accept or pay his draft upon delivery of the transport documents. The advising bank may do so either without its own engagement or it may confirm the credit opened by the issuing bank.

From these transaction steps we can understand that it is mostly used for international trade because in the domestic trade these terms would not be applicable.

C. Laws governing international letter of credits:

There are mainly two intergovernmental institutions that make rules governing international letter of credits

1) United Nations Commissions of International Trade Law (UNCITRAL),

2) International Chamber of Commerce (ICC) and National and Local Laws. Guidelines or model law published by intergovernmental institutions are not binding to any of its member states but businesses can adopt this law as governing law

Apart from these intergovernmental institutions national and local governing laws are very important in deciding issues. Particularly in deciding jurisdiction of court and governing laws, local and international laws are very important factors. Most governmental allows parties to the contract to decide what law will apply in case of disputes with some restriction and after checking validity of contract.

D. Needs of Letter of Credit:

The letter of credit advance international trade by assuring sellers that they will receive prompt payment for goods they ship overseas to unknown buyers. In international trade neither seller nor buyer knows credibility of each other. How buyer, when placing order of goods over the seas, be assured that the goods is according to his need and how seller, when shipping goods over the seas, be confident that he will get payment. In such contract the question is who will perform his obligation of contract first- should buyer pay first or should seller ships the goods first. Here the role of financial institutions and banks comes to focus. Usually information about credibility of financial institution and banks are easily available across the world. So instead of relying on credibility of contracting party, it is safer to rely in credibility of foreign banks and financial institutions.

E. Reason for using letter of credit:

Letter of credit are used for the following reasons-

To protect against buyer risk

To protect against country risk

• A Credit risk from change in the credit of an opposing business.
• An Exchange risk is a risk from a change in the foreign exchange rate.

To protect against these risks, a confirmed letter of credit will be necessary- a bank in the seller’s country will (for a fee) add its own payment undertaking to that of the issuing bank.

Letters of credit are also used as part of exchange control or import control regimes operating in the buyer’s country. In such cases the use of letter of credit is mandatory, even if not required by the seller for security reasons.

3. Letter of Credit and International Trade vs. Domestic Trade

A Letter of Credit is a payment term mostly used for long-distance and international commercial transactions. Letters of credit are essential for international transactions since they ensure that payment will be received. Using documentary letters of credit allows the seller to significantly reduce the risk of non-payment for delivered goods, by replacing the risk of the buyer with that of the banks. Letters of credit have become a crucial aspect of international trade, due to differing laws in each country and the difficulty of knowing each party personally

A. International Trade:

Before talking more about letter of credit, let’s look at broader picture of international trade. International trade is the exchange of goods and services between countries. This type of trade gives rise to a world economy, in which prices, or supply and demand, affect and are affected by global events.

B. Domestic trade:

Domestic trade, also known as internal trade or home trade, is the exchange of domestic goods within the boundaries of a country. The importance of domestic trade in a country is that it facilitates exchange of goods within the country.

C. Differences between international business and domestic business:

An international business is a business whose activities are carried out across national borders. This differs from a domestic business because a domestic business is a business whose activities are carried out within the borders of its geographical location.

A domestic company is one that confines its activities to the local market, be it city, state, or the country it is in. The international company on the other hand deals with businesses and governments in one or more foreign countries.

International trade is more difficult and risky for a firm than is domestic trade. In foreign trade, the exporter may not be familiar with the buyer, and thus not know if the importer is creditworthy<href=”#_ftn4″ name=”_ftnref4″ title=””>[4]. If merchandise is exported abroad and the buyer does not pay, it may prove difficult, if not impossible, for the exporter to have any legal recourse. Additionally, political instability makes it risky to ship merchandise abroad to certain parts of the world.

D. Reason for using L/C in International Trade:

A Letter of Credit is a payment term mostly used for long-distance and international commercial transactions. Letters of credit are indispensable for international transactions since they ensure that payment will be received. “Letters of credit have become a crucial aspect of international trade, due to differing laws in each country and the difficulty of knowing each party personally.” After trade between countries made it impossible to do business by traditional payment methods, Letters of credit make it possible to do business worldwide.

International trade laws sound good and look good on paper, but are often difficult to enforce when dealing with a foreign party. So most international transactions are secured using a financial tool known as a Letter of Credit. A Letter of Credit may be required in cases when a party does not have sufficient financial history, assets, or credit to support good faith credit terms.

The typical letter of credit is not very familiar in purely domestic transaction as a form of payment. The cost and the lengthy process make the letter of credit an unappealing form of payment for domestic transaction. In contrast, the popularity of letter of credit, as a tool of payment in international business transactions, increased because it is comparatively safe and speedy method of payment in lake of unified law. Additionally, International Chamber of Commerce (ICC) is actively participating in unifying the rules regarding the letter of credit. Today, the 6^th edition of Uniform Customs and Practice for Commercial Documentary Credit (UCP 500), published by ICC, generally familiar to regulate the transactions involving letter of credit.

Letters of Credit are now outdated with international trade occurring everyday and many multinational companies located all over the world, Letters of Credit have become a burdensome time consuming task. Companies have developed trust in each other and consider it very important to honor contracts or purchase agreements. A letter of credit is a promise to pay. Banks issue letters of credit as a way to ensure sellers that they will get paid as long as they do what they’ve agreed to do

Letters of credit are common in international trade because the bank acts as an uninterested party between buyer and seller. For example, importers and exporters might use letters of credit to protect themselves. In addition, communication can be difficult across thousands of miles and different time zones. A letter of credit spells out the details so that everybody’s on the same page.

E. Reason for not using L/C in Domestic trade:

In the case of domestic trade, the need for L/C gets less importance. L/C is basically a bank guarantee which ensures payment so in domestic trade where the parties knows each other or can get credit references easily don’t go for L/C procedure as it is a long and costly method. Moreover, L/C is used for minimizing the risk of default payment so it is more in international trade then in domestic trade because one can use the domestic court if the buyer fails the payment. So, in particular, it can be said that the relative risk is more in international trade then in domestic trade which indicate a clear reason for using a letter of credit exclusively for international trade. In addition, the exclusive use of a letter of credit in international transactions exacerbates a collapse in trade during a financial crisis.

Exchange takes time. For example, when a seller receives a purchase order that stipulates payment after delivery, the seller has to produce and ship a product before the buyer pays. This requires financing over short horizons because the seller may need to borrow working capital to complete the order or may purchase credit insurance to protect against counterparty defaults. That is the essence of trade finance.

International trade is more costly than domestic trade; hence the volume of international transactions will be smaller than domestic transactions. Firms borrow from local banks. Banks need to gather information about whether loans will be repaid. They need not only worry about the firm they loan to, but also any other firm on whose solvency repayment depends. Banks invest more in learning about firms with which they have a larger volume of transactions, which in turn makes them more knowledgeable about these firms. Since banks have larger transactions with domestic than foreign firms, they will also be more knowledgeable about them. This makes international trade finance loans riskier than domestic finance loan.

Banks assess this overall transaction risk through screening tests for the borrower’s trading partner as well as the borrower. By investing in information acquisition, banks can improve the precision levels of screening tests, and hence the loan repayment probability of the transactions that pass the screening tests. The optimal precision levels of screening tests are determined by comparing costs and benefits. All else being equal, since costly trade results in a larger volume of domestic transactions than international transactions, banks will maintain a higher accuracy level of screening test for domestic firms than foreign firms. Accordingly, the screening of foreign firms yields a less accurate outcome than domestic screening, making international transactions a relatively higher risk with lower loan repayment probability. Therefore, costs of financing international transactions will be higher.

The asymmetric nature of the screening tests for domestic and foreign firms gives rise to a letter of credit system exclusively for international transactions. Under a letter of credit system, both a buyer’s bank and a supplier’s bank participate in the transaction as intermediaries. The buyer’s bank promises to pay the supplier’s bank on behalf of the buyer as long as the goods are delivered from the supplier, and the supplier’s bank guarantees to pay the supplier whether the buyer’s bank actually pays or not. From the view of the supplier’s bank, this essentially switches the non-payment risk from the buyer to the buyer’s bank, and thus can replace an inferior screening test for foreign firms by the supplier’s bank with a superior screening test for domestic firms by the buyer’s bank. This is the gain from using a letter of credit system for international transactions. At the same time, however, since the supplier’s bank has only limited, imperfect information on the credit risk of the buyer’s bank, it incurs additional inter-bank informational friction. As long as the gains from a letter of credit outweigh the costs, a letter of credit would be chosen as the optimal payment system for the transaction. Clearly, this will not be true for domestic transactions because it only incurs additional costs without any gains

4. Conclusion:

International trade allows us to expand our markets for both goods and services that otherwise may not have been available to us. Specifically, the letter of credit ensures guaranteed payments and perform financial intermediation role. In the international trade, buyers and sellers are separated by thousands of miles or even tens of thousands of years, do not know each other. Importers, exporters can expect on time delivery, when payment is to check whether the goods in line with the contract, the best resale of the goods for payment later. In this period the bank hopes to get financial intermediation. Exporters want to get the goods shipped before the bank’s financial intermediation, post-shipment loans can be guaranteed. The letter of credit bank guarantee is the primary payment responsibility of the issuing bank, in which payment is conditional discharge to ensure that the purchase price of both import and export goods of the right of the document and representation will not be disappoint. But in domestic trade these kind of situation don’t arise. However, Letter of credit are used in domestic trade, although not as frequently, because shipping times are shorter and companies more frequently know each other or can get credit references, and they can use domestic courts if the deal goes bad.

So by considering all the aspect of Domestic and international trade it can be said that Letter of Credit is used in International Trade and to some extend in Domestic trade. But the disadvantage is there is no set format or rules that govern the domestic L/C unless they are subject to UCP.

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