There are various payment instruments in international trade. From formal bank cheques to bank guarantees, parties in trade contracts can use several payment methods. A bill of exchange is essentially a payment instrument. A letter of credit can work as a payment instrument but is largely used as means of financial guarantee.
Both instruments are used in domestic and international trade contracts. A letter of credit is a widely used instrument in international contracts as it comes with greater authenticity and credibility.
Here is our comparison guide on both types of financial instruments.
Definition – A Bill of Exchange
A bill of exchange is a written instrument that obliges one party to make payment to a second party on a fixed date and agreed amount. A bill of exchange closely resembles a bank cheque. It is a type of promissory note. It can be transferred to a third-party with endorsement, and the first party will be bound to make the payment to the bill of exchange presenter.
A bill of exchange is a negotiable financial instrument that can be traded on the secondary market. It can be issued by individuals, companies, or financial institutes like banks.
Definition – A letter of Credit
A letter of credit is a form of bank guarantee that the beneficiary will receive the payment if the applicant fails to make the payment.
In the case of the buyer’s default, the bank covers the amount of the letter of credit. The bank can issue the facility as a loan facility to the applicant. A letter of credit is by default irrevocable, non-confirmed, and non-transferable.
Working Mechanism – Bill of Exchange and A Letter of Credit
A bill of exchange can be arranged by two parties directly or with the help of a bank. It usually involves three parties; a drawee, payee, and the drawer. Both parties agree on trade terms and conditions and decide to use a bill of exchange as a payment method. A bill of exchange issued by a bank, known as a bank draft, can be issued immediately with a later maturity date.
The beneficiary party (seller) can discount the bill of exchange to its bank and receive the funds immediately. A bill of exchange can be a sight draft that becomes payable as soon as the contract terms are fulfilled and the draft is presented. Usually, a time draft is used that becomes payable at a certain date. A bill of exchange can be forwarded to any third-party with endorsement on the back.
A letter of credit is issued by a bank on the request of the buyer. The bank requires cash or assets as a form of collateral to issue a letter of credit. It includes the terms and conditions of the payment mechanism aligned with the trade contract. However, a letter of credit is a separate legal document from a trade contract.
In case of buyer’s default, the bank obliges the payment with both instruments. However, a bill of exchange does not include any specific legal terms to be met before the payment can be released. A letter of credit is a more binding contract that reduces performance and financial non-compliance risks.
Important Types of a Bill of Exchange
A bill of exchange can be drafted by both parties in a trade contract directly. A bank often issues a bill of exchange that provides greater financial security to both parties.
A bill of exchange has the following important types:
Trade Draft: if the bill of exchange is issued by the buyer directly it is referred to as a trade draft.
Bank Draft: if a bill of exchange is issued through a bank, it is termed as a bank draft.
Sight Draft: in this type of bill of exchange, the payment becomes due immediately upon presentation of the order.
Time Draft: It includes a probatory period usually 60 or 90 days after an estimated time for the shipment of goods. It clearly indicates a future date of payment.
Important Types of a Letter of Credit
Both parties in trade contracts can agree on different features of a documentary credit. It can take several different forms as it is a highly customizable instrument.
Some important types of letters of credit are:
Commercial Letter of Credit: A standard form of documentary credit in which the bank acts as a neutral facilitator to proceed with the payment if all conditions are fulfilled.
Fully Funded Documentary Letter of Credit: It is a form of a standard letter of credit where the bank holds the applicant’s funds separately before issuing the LC. The applicant provides the funds upfront, hence it is called a fully funded LC.
A Standby Letter of Credit: it issued as an additional security net to the beneficiary to cover the default risk of the buyer. It is used as backup financial security that is used only if the primary payment method defaults.
Revolving Letter of Credit: This type of documentary letter of credit allows the applicant to use the facility multiple times with one approval from the bank. The applicant can issue several LCs up to the approved documentary credit limit.
Pros and Cons of Using a Bill of Exchange
A bill of exchange is means of payment in trade contracts for both international and domestic transactions. It offers several advantages and limitations as well.
Pros of using a Bill of Exchange are:
- It is a simple documented payment instrument. With no interest charges.
- The Beneficiary party can trade the bill of exchange on secondary markets.
- It mitigates the exchange rate risk for both parties in international trade without using complex instruments such as Futures.
- Both parties can save on bank costs, interest costs, and other fees if issued on mutual terms.
- Both parties have the option of involving their banks for further financial security.
Cons of using a Bill of Exchange are:
- It is an unsecured form of financial payment without the involvement of banks.
- It does not fully cover the default risk of the issuer.
- It lacks the financial guarantee or legal binding to both parties in international trade.
Pros and Cons of Using a Letter of Credit
A letter of credit is a widely used instrument in international trade. It offers greater financial security and reduces the risks for both parties.
Pros of using a letter of credit:
- It provides financial security to both parties in international trade.
- It comes with several features and it is a highly customizable instrument.
- It acts as facilitating instrument for payment, working capital, and financial security simultaneously.
- Enables businesses to plan better for large cash flow projects.
Cons of using a letter of credit:
- The bank cannot fully ensure the payment to the beneficiary, in case there is litigation or other factors in a trade dispute.
- It does not remove the financial currency risk for the beneficiary.
- It is a costly and sophisticated instrument that may not be accessible for small businesses easily.
A bill of exchange is a payment instrument while a letter of credit acts as a legal contract. A bill of exchange can be arranged without a bank. It is a transferable and negotiable instrument and can be traded on the secondary markets. A letter of credit provides greater financial security with several types as it is a highly customizable instrument.