banking and finance

Understanding Transferable Letters of Credit: Key Benefits, Parties Involved, and Practical Examples

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Definition: A Transferable Letter of Credit (LC) is a special type of LC that allows the initial beneficiary (often a middleman or trading company) to transfer part or all of the credit to one or more second beneficiaries (usually the actual suppliers). This is particularly useful in international trade, where intermediaries may not have the capital to buy the goods upfront but can facilitate the transaction as traders or intermediaries.

Why It Is Used in International Trade

In international trade, Transferable LCs are valuable because they provide a secure payment method for all parties involved. They help intermediaries or trading companies manage their cash flow and financing needs without requiring large amounts of upfront capital. This arrangement ensures that suppliers get paid, even if the intermediaries don’t have sufficient funds immediately.

Parties Involved

  1. Applicant: The buyer who initiates the request for the LC.
  2. Issuing Bank: The bank that issues the LC on behalf of the buyer.
  3. First Beneficiary: The intermediary or trading company receiving the original LC.
  4. Transferring Bank: The bank responsible for transferring the LC to the second beneficiary.
  5. Second Beneficiary: The supplier of the goods who receives the transferred LC.

Role of the Transferring Bank

The transferring bank’s role includes:

  • Confirming the LC is transferable.
  • Processing the request to transfer the credit to the second beneficiary.
  • Ensuring that the second beneficiary meets the terms and conditions of the LC.
  • Handling the substitution of documents if necessary.

Document Substitution

The first beneficiary can replace their own invoices and draft with those of the second beneficiary. This substitution keeps the profit margin of the first beneficiary confidential. Other documents, such as the bill of lading and insurance documents, are usually transferred as is.

Document Presentation

The second beneficiary submits their documents to the transferring bank. The transferring bank then checks these documents and forwards them to the first beneficiary. The first beneficiary may replace their invoices and draft before the documents are sent to the issuing bank.

Conditions That Can Be Curtailed in a Transferable LC

Certain conditions in the LC can be altered or curtailed when transferring the LC, such as:

  • The total amount of the credit.
  • The unit price of the goods.
  • The expiry date of the LC.
  • The latest shipping date.
  • The period allowed for presenting documents.

Calculation of Insurance Percentage

The insurance percentage typically covers the value of the goods plus an additional amount (often 10%) to protect against unforeseen events. Here’s how it works:

For the first beneficiary:

  • LC Value: $100,000
  • Insurance Coverage: 110% of $100,000 = $110,000

For the second beneficiary:

  • Transferred LC Value: $80,000
  • Insurance Coverage: 110% of $80,000 = $88,000

Relevant UCP 600 Article

The relevant article in the UCP 600 (Uniform Customs and Practice for Documentary Credits) that covers Transferable LCs is Article 38.

Example Scenario

Scenario: A retailer in the USA orders electronics from a supplier in China, but uses a trading company in Hong Kong as an intermediary.

  1. Applicant: Retailer in the USA.
  2. Issuing Bank: Bank in the USA.
  3. First Beneficiary: Trading company in Hong Kong.
  4. Transferring Bank: Bank in Hong Kong.
  5. Second Beneficiary: Supplier in China.

Here’s how the process unfolds:

  1. The retailer’s bank issues a transferable LC to the trading company.
  2. The trading company instructs the transferring bank to transfer part of the credit to the supplier in China.
  3. The supplier ships the goods and presents the documents to the transferring bank.
  4. The transferring bank forwards these documents to the trading company.
  5. The trading company substitutes their invoices and draft with those of the supplier and then sends the documents to the issuing bank.
  6. The issuing bank pays the trading company, who in turn pays the supplier, completing the transaction.

This arrangement ensures that the supplier gets paid promptly, the trading company can operate without large amounts of capital, and the retailer receives the goods as per the agreement.

You can also check out below explanation video in Youtube –

Understanding Confirmed Letters of Credit: Key Insights, Benefits, and UCP 600 Guidelines

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Confirmation of a letter of credit (LC) means that another bank, in addition to the issuing bank, promises to pay the beneficiary (exporter). This extra assurance is given by a bank usually located in the exporter’s country, known as the confirming bank.

How Documents Move Under a Confirmed Letter of Credit

When an LC is confirmed, the typical process involves:

  1. Issuance: The issuing bank in the importer’s country issues the LC and sends it to the confirming bank in the exporter’s country.
  2. Advising: The confirming bank advises the LC to the beneficiary adding confirmation.
  3. Shipment and Documentation: The beneficiary ships the goods and prepares the necessary documents as required by the LC.
  4. Presentation: The beneficiary presents the documents to the confirming bank.
  5. Examination and Payment: The confirming bank checks the documents. If they are compliant, the confirming bank pays the beneficiary (or agrees to pay at a later date).
  6. Forwarding Documents: The confirming bank forwards the documents to the issuing bank.
  7. Reimbursement: The issuing bank reimburses the confirming bank after verifying that the documents are in order.

Who is the Confirming Bank and What is Its Role?

The confirming bank is the bank that adds its confirmation to the LC at the request of the issuing bank. Its roles include:

  1. Guaranteeing Payment: Provides an additional guarantee of payment to the beneficiary.
  2. Document Examination: Reviews the documents presented under the LC for compliance.
  3. Payment: Pays the beneficiary if the documents are in order, regardless of whether the issuing bank has paid or not.
  4. Advising: Communicates the LC to the beneficiary.

How to Identify Confirmation in an MT700 SWIFT Message

In an MT700 SWIFT message, which is used for issuing LCs, confirmation details are found in:

  • Field 49 (Confirmation Instructions): Indicates whether the LC is available with the confirming bank and specifies the type of confirmation.
    • CONFIRM means the confirming bank is adding its confirmation.
    • MAY ADD means the bank may add its confirmation at its discretion.
    • WITHOUT means no confirmation is added.

Pros and Cons of Adding Confirmation to an LC

Benefits:

  1. Risk Reduction: Lowers the risk of non-payment for the beneficiary as they have assurance from both the issuing and confirming banks. Incase issuing bank does not pay, confirming bank is already liable to make payment.
  2. Trust: Increases the beneficiary’s confidence in the transaction, especially when the issuing bank is in a country with higher political or economic risks.
  3. Financing: Facilitates access to pre-shipment or post-shipment financing as banks view confirmed LCs as less risky.

Cons:

  1. Cost: Adds to the costs since the confirming bank charges a fee for its confirmation.
  2. Complexity: Adds an additional layer of complexity in terms of documentation and procedures.

Relevant UCP 600 Article on Confirmation

Article 8 of UCP 600 deals with confirmation:

  • Article 8 (a): Defines the obligations of the confirming bank, stating that it undertakes to honor or negotiate if the documents comply with the terms and conditions of the credit.
  • Article 8 (b): Obligates the confirming bank to pay the beneficiary, irrespective of reimbursement from the issuing bank.

Example of a Confirmed Letter of Credit

Imagine Company A in India wants to purchase goods from Company B in Germany. Company A’s bank (issuing bank) issues an LC for $100,000 and requests a German bank (confirming bank) to confirm the LC. The confirming bank agrees and advises the confirmed LC to Company B.

  1. Company B ships the goods and presents the documents to the confirming bank.
  2. The confirming bank examines the documents and finds them compliant.
  3. The confirming bank pays Company B.
  4. The confirming bank forwards the documents to the issuing bank.
  5. The issuing bank reimburses the confirming bank after its own document examination.

In the MT700 SWIFT message, Field 49 will show CONFIRM, indicating that the LC is confirmed.

This process ensures Company B receives payment even if there are issues with Company A or its bank, as the confirming bank has guaranteed the payment.

You may also refer below Youtube video for explanation –