Is L/C a reliable payment tool?

Just 10 years ago, L/C - Letter of Credit was a very popular tool to cross-nation payment. Now L/C is still widely used. The reason that, traditionally, the buyer is hesitate to make prior payment to the seller overseas, while the seller does not like to ship the goods without receiving the payment. Therefore, the buyer and seller, both with desire to conduct the transaction, wish to have a mid-party to guarantee both payment from buyer and shipment from seller. There comes a trustable mid-party, bank. Then comes L/C.

 

Here is how the L/C works. Buyer, instead making payment directly to the seller, makes a deposit to his local bank. Buyer's local bank sends a statement to seller's bank stating if certain condition satisfied, the buyer's bank will make payment to seller's bank. The condition is normally the submission of certain documents, such as bill of lading, insurance policy, invoice and packing list, etc. Ocean bill of lading is particularly important, because it often represents the title of ownership of the goods. The statement is called documentary letter of credit, short for L/C. When the seller's bank receives the L/C, it will inform the seller the same statement. The seller, after making the shipment, present the required document including bill of lading to the seller's bank. By presenting the required documents, seller provides the evidence that the goods have been shipped out. So, the seller's bank sends the documents to the buyer's bank, and the buyer's bank makes the payment to the seller's bank. Finally the seller's bank makes the payment to the seller, and the buyer's bank transfer the documents to the buyer. With the documents, the buyer can claim the goods from the ocean carrier.

 

However, L/C is not totally reliable tool. The banks that offer the guarantee just verify the documents. They are not responsible for the move of the physical goods. There are still a lot of commercial risks related to the physical goods, in term of quality, quantity and specifications. In case the seller ignores the L/C, the buyer still need to keep the deposit in the bank until the L/C expires. And L/C is costly and not convenient to use.

 

Now with the globalization, ease of communication and availability of information, the buy and sell have much better understanding of each other. Mutual trust can be established much more easily. The role of L/C is becoming not so important now. Further more, many other parties can act as trustable mid-party, such as freight forwarders, export management companies and other service providers. On trend it that the buyer is more and more have the whole transportation process under control, in order to have better visibility of the supply chain. Trade term FOB or even EXW now become more and more popular than CIF, that means the buyer has strong control of the transportation, which greatly reduce the risk of the payment.

 

Composed by YuJie Tang, ChinaLINQ.com LLC