Procedure and Usage of Letter of Credit Settlement and Risks of Letter of Credit

Procedures and Risks of Letter of Credit Settlement

As an international payment tool, the letter of credit is widely used in international trade. It is a written commitment issued by the bank, ensuring that the buyer will pay the seller after meeting specific conditions. This mechanism provides a relatively safe trading method for both parties, especially when they do not trust each other. However, the letter of credit is not without risks; its operational process is complex, requiring strict adherence to relevant rules by both buyers and sellers.

In the letter of credit settlement process, the first step is for the buyer to apply for the opening of the letter of credit. The buyer usually submits an application form to their account-opening bank, detailing transaction specifics such as product descriptions, amounts, delivery deadlines, etc. After reviewing, the bank issues the letter of credit according to the buyer's requirements and sends it to the seller. During this stage, it is crucial for the buyer to ensure that the provided information is accurate, as any error could lead to problems in subsequent stages.

Next is the review phase after the seller receives the letter of credit. The seller needs to carefully check whether the terms in the letter of credit match the contract, including price, quantity, transportation requirements, etc. If discrepancies are found, they should promptly notify the buyer or the bank for modifications. This process is vital to avoid disputes caused by inconsistent terms. For instance, a Chinese export company once faced delayed payments due to ambiguous terms in the letter of credit, which was eventually resolved through consultations with the importer to clarify specific terms.

Once the letter of credit terms are confirmed, the seller can begin fulfilling their contractual obligations, such as preparing goods and loading them onto ships. During this period, the seller should closely monitor the status of the goods and the validity of the letter of credit to avoid missing critical milestones. Additionally, the seller must prepare all necessary documents, typically including commercial invoices, bills of lading, insurance policies, etc. It is worth noting that the accuracy and completeness of these documents directly affect whether payment can be smoothly obtained. For example, an Indian company once faced rejection of payment due to minor errors in submitted documents, leading to cash flow difficulties.

When all preparations are complete, the seller can submit the documents to the designated bank for negotiation. The bank will rigorously review the documents to ensure they meet the requirements of the letter of credit. If everything is normal, the bank will pay the seller and transfer the documents to the issuing bank. At this point, the buyer needs to pay for the documents within the specified time to complete the entire transaction process. If the buyer fails to make timely payments, the seller has the right to take legal action to protect their own interests.

Despite the high level of security provided by letters of credit, there are still certain risks involved in their use. The primary issue is cost-related. Opening a letter of credit incurs certain handling fees, and as the scale of the transaction increases, so do the costs. Since letters of credit involve multiple parties, processing times are longer, increasing the capital occupation costs for enterprises. For example, a multinational company once faced tight cash flow during a large-scale procurement due to an excessively long letter of credit approval cycle, forcing them to seek short-term financing support.

Another common problem is fraud risk. Although letters of credit have certain anti-counterfeiting features, if both parties collude to forge documents, banks may face difficulties. There have been historical cases where unscrupulous merchants used false documents to defraud bank funds. To address this, banks often adopt stricter review measures, such as requiring additional guarantees or introducing third-party institutions to verify the authenticity of documents.

There is also a potential risk from exchange rate fluctuations. Since letter of credit transactions often span multiple countries and regions, exchange rate changes may adversely affect both parties. Especially under a floating exchange rate system, sharp fluctuations in currency values may result in actual returns falling short of expectations. When signing contracts, both parties should fully consider exchange rate factors and mitigate risks through forward foreign exchange transactions.

In conclusion, the letter of credit, as an important international trade settlement method, has a complicated and challenging process. Both buyers and sellers need to handle every link cautiously, ensuring accurate information and complete documents. At the same time, they should recognize various risks brought by letters of credit, plan financial arrangements reasonably, and seek help from professional service agencies when necessary. Only then can the advantages of letters of credit be maximized to promote healthy cross-border trade development.