Letters of Credit and Bills of Lading in
Commercial Transactions
Two
important documents are commonly required for a commercial transaction
involving the exchange and transport of a good between a buyer and a seller:
- Letter of credit. A document issued by a financial institution that
provides a promise of payment for a trade transaction, implying that it
can be redeemed if certain conditions are satisfied. They are mainly used
in international trade for transactions between actors, such as a buyer
and a seller, in different countries.
- Bill of lading. A document that establishes evidence and the terms of
a contract between a shipper, a transportation company and the agents
providing and receiving the cargo. It serves as a document of title, a
contract of carriage and a receipt for goods.
The
above figure provides the steps involved in a simple international transaction
between a seller and a buyer:
- A buyer and a seller agree upon
a transaction through a contract that specifies price, quantity, time and
place of delivery. Then the buyer will contact its bank to have a letter
of credit issued with the seller as beneficiary. This letter of credit can
either be funded by a loan and simply debited from the buyers account
balance if sufficient funding is available. If a loan is used, it is
subject to standard underwriting procedures involving a down payment, a
line of credit and interest rate based upon the buyer's credit worthiness.
Insurance is commonly required as a condition to issue a letter of credit
so that various risks, such as damage and delays, can be mitigated. The
bank commonly levy a fee ranging from 1 to 8% of the transaction,
depending on its value and complexity.
- With the letter of credit the
seller now has a line of credit available at its bank and final payment
will be made once the delivery conditions of the contract are satisfied.
The seller can then provide the consignment to a shipper in exchange of a
bill of lading promising that the consignment will be delivered at the
agreed destination. At this point the consignment is handled by the
transportation system and can involve the usage of port facilities,
warehouses, rail or trucks segments depending on the concerned transport
chain.
- The seller can then present to
bill of lading to its bank as an additional condition being meet to secure
final payment. It is important to underline that payment is not
necessarily provided to the seller immediately after the bill of lading is
provided, but after the buyer has taken ownership of the consignment and
confirmed that it meets the specification stated in the contract
(quantity, quality and condition). The bill of lading is then forwarded to
the buyer's bank in exchange of payment and afterwards to the buyer so
that the consignment can be claimed once delivered.
- The buyer is finally able to
provide the bill of lading to the shipper and claim the consignment. After
it has been confirmed, often by a neutral third party, that the
consignment meets the terms of the contract the seller can claim final
payment from its bank from the funds that were previously deposited.
It
is estimated that large commercial bank finance about 90% of all global trade
transactions. If for any reason the letter of credit cannot be cleared and
payment made the transaction cannot take place.
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