Parties involved in a trade deal can choose a letter of credit as a payment option. Buyers can often choose to make the payment using a delayed LC. Payments to the sellers can be delayed for other reasons as well. Banks can help the sellers with early payments through a letter of credit discounting.
It is a facility from the bank to make early payments to a beneficiary of the LC It offers the flexibility of cash for the sellers without compromising the relations with the buyers. However, banks may charge certain charges against the facility as it can be a risky move for the banks.
What is Letter of Credit Discounting
A letter of credit discounting is a short-term financing facility for the beneficiary of the letter of credit. Seller’s bank can offer the early payment option with different scenarios and conditions. The crediting is approved after a thorough process and agreement with the seller (exporter).
The arrangement works between the seller and the advising bank. However, the advising bank may require a confirmation from the issuing bank on the creditworthiness of the buyer.
A discounting provides great benefits to the seller with early disbursement of funds. It helps the seller to manage cash flow and supplier relations. An alternative would be to seek financing from the bank or the counterparty in the trade deal that can be a costly option.
How Does It Work?
When two parties agree to use a letter of credit as a means of payment, the beneficiary has the option of using the discounting. The buyer may not want to release the payment until certain conditions are fulfilled and the shipment of the goods is confirmed.
Once the seller proceeds with the shipment of the goods, it can contact the advising bank for early disbursement of the payment. The bank can negotiate the terms and conditions of discounting with the seller.
It can be arranged in different ways. Some of the common options used by the banks are:
- Early disbursement of payment to the seller.
- Renegotiating the terms of the LC with the seller.
- Purchasing the documentary credit from the seller.
A letter of credit can be approved with different conditions. A bank may not offer the full payment as agreed through LC. The advising bank approves the discounting amount depending on the creditworthiness of the seller as well as the issuing bank’s confirmation.
The advising bank’s approval process can be similar to approving a new short-term financing facility. However, the bank does not require any collateral from the seller’s side for a letter of credit discounting. An LC works as collateral for the exporter to obtain advance payment.
Important Points to Note with a Letter of Credit Discounting
Discounting of the LC works through a formal arrangement between the advising bank and the seller. The bank can approve an early payment up to a certain limit. However, it offers further flexibility for the seller without compromising trade relations with the buyer side.
Here are some important points to note with a letter of credit discounting process:
- The discounting arrangement works between the advising bank and the seller side only.
- The seller needs to oblige the trade terms before applying for the discounting.
- Discounting can be offered with LC with a deferred, negotiation, or acceptance.
- Letter of credit at sight cannot be used for discounting as it provides immediate payment anyway.
- The bank may not approve the full amount of a letter of credit as early payment.
- The bank would charge special interest and processing fees for the arrangement.
- Discounting can be offered through renegotiation, purchasing the documentary credit, or an early disbursement of the funds.
- The advising bank of the seller approves the facility after appraising the creditworthiness of the seller as well as the issuing bank’s risk factor.
The most important factor in the discounting of a letter of credit is the issuing bank’s credibility. As the issuing bank will in turn appraise the credibility of the buyer. Other important factors can be the types and features of the LC. A confirmed letter of credit would further facilitate the seller for discounting.
Advantages of Letter of Credit Discounting
A letter of credit offers several benefits to both parties in the trade deal. Discounting of a letter of credit works between the advising bank and the seller. It offers several benefits to the seller in a trade deal.
- Discounting takes place at the discrete authorization of the advising bank in the letter of credit arrangement without involving the buyer.
- The seller can negotiate better pricing with delayed payment terms from the buyer.
- Letter of credit discounting helps the seller improve cash flow with early disbursement of letter of credit fund.
- It does not affect the trade relationship between the buyer and the seller.
- It reduces the credit risk for the seller.
- The seller can use the early payments for improving the trade relations with suppliers.
- The advising bank can also mitigate the default risk as discounting is offered with rights to discourse.
- Discounting is easier to obtain with confirmed letters of credit.
- The buyer receives the goods on-time and does not need to make payments earlier.
Disadvantages of letter of Credit Discounting
It offers several benefits to the beneficiary. However, it also has some disadvantages for all parties involved in a trade deal.
- Discounting comes with additional charges from the bank.
- An LC does not automatically provide the discounting facility even with confirmed letters of credit.
- It can delay and complicate the normal trade deal arrangements as the seller’s bank investigates the discounting prospects.
- The bank can face the default risk of the buyer or the issuing bank of the letter of credit.
Traditional arrangements with an LC provide financial security and benefits to both parties. Discounting of letter of credit provides further benefits to the seller. It comes at a cost of additional charges and interest. It does not affect the trade relations between both parties in the LC arrangement.