Personal Finance

What Is Letter Of Credit? A Complete Guide To Types And Applications

October 13, 2023

You must have probably come across the term “Letter of Credit” at some point in Singapore. But what is letter of credit? A letter of credit is a vital financial tool that guarantees sellers prompt and full payment, supported by a reliable bank.

This document holds immense significance in international trade, especially within Singapore’s dynamic and globally integrated economy. It serves as a robust mechanism, ensuring seamless transactions, and also sometimes minimises risks for all parties engaged in cross-border commerce.

Key Takeaways

  • International trade commonly involves the use of letters of credit.
  • These documents, issued by banks or financial institutions, ensure sellers receive timely and full payments from buyers.
  • Banks charge a fee for providing a letter of credit service.
  • There are various types of letters of credit, with one example being the revolving letter of credit.

How A Letter Of Credit Works In Singapore

Buyers may need a letter of credit for significant purchases in Singapore’s trade system. This letter assures the seller that payment will be made. A Singaporean bank issues this letter, promising the seller they will be paid.

Before the bank guarantees payment, the buyer must show they have enough money or a sufficient credit line. This proves they can pay for the purchase. Usually, banks ask for assets or cash as collateral to issue the letter of credit.

The letter of credit is like a promise that can be passed on. If it can be transferred, the beneficiary may give this right to someone else, like a third party or corporate parent.

Letters of credit used in international transactions are governed by the International Chamber of Commerce’s Uniform Customs and Practices for Documentary Credits.

Cost Of A Letter Of Credit In Singapore

The bank will ask for a fee to get a letter of credit in Singapore. This fee is a percentage of the total amount they are guaranteeing. How much you pay depends on which bank you use and how big the Letter of Credit is. For instance, the bank might charge 0.75% of the amount they are guaranteeing.

The type of letter matters too. If it’s an import-export situation, an unconfirmed letter of credit costs less. But if it’s confirmed, meaning the bank is more sure about the payment, it might cost more. 

Types Of Letters Of Credit In Singapore

There are four main types of letters of credit in Singapore. They include:

  • Commercial letter of credit
  • Revolving letter of credit
  • Traveller’s letter of credit
  • Confirmed letter of credit

Commercial Letter Of Credit

A commercial letter of credit is a payment method the issuing bank uses to make payments directly. The bank that issued it pays the person or company it’s meant for.

On the other hand, a standby letter of credit is like a secondary payment method. The bank only pays if the person or entity which got the letter can’t do it.

Revolving Letter Of Credit

A revolving letter of credit lets a customer use it multiple times within a set time frame. They can make several withdrawal requests as long as they stay within a certain limit. This is handy when you have lots of merchandise shipments happening regularly, so you don’t have to keep making new letters of credit each time.

Traveller’s Letter Of Credit

A traveller’s letter of credit assures that the banks in other countries will accept the drafts made by the issuing bank. This provides a reliable way for people travelling abroad to handle financial transactions.

Confirmed Letter Of Credit

A confirmed letter of credit works in a way in which there’s an extra bank other than the issuing bank involved. This second bank is the confirming bank, usually the seller’s.

The confirming bank, on behalf of the issuing bank, ensures the payment is made if the holder and the issuing bank would not do it. The bank issuing the letter in international deals usually asks for this setup. This makes sure everyone is protected.

Other Types Specific To Singapore’s Trade Needs

Irrevocable Letter Of Credit

The irrevocable letter of credit is widely used in Singapore’s trade transactions. It provides a high level of security for the seller, as it cannot be modified or cancelled without the agreement of all parties involved. This type is favoured for its reliability and assurance of payment.

Back-to-back Letter Of Credit

In Singapore, a back-to-back letter of credit is utilised when multiple parties are involved in a transaction, which a broker utilises. The seller receives a letter of credit from the buyer’s bank, which is then used as collateral to open another letter of credit in favour of the seller’s supplier. This allows for a smooth and secure flow of goods and payments.

Transferable Letter Of Credit

This type of letter of credit enables the original beneficiary (seller) to transfer all or part of the credit to another party, such as a subcontractor or supplier. This is particularly useful in industries where various entities contribute to the final product or service. It provides flexibility in managing financial arrangements within complex supply chains.

Red Clause Letter Of Credit

In Singapore, a Red Clause Letter of Credit allows for an advance payment to the seller before the goods are shipped. This is especially beneficial in situations where the seller requires funds to prepare or package the goods for shipment. 

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Example Of A Letter Of Credit In Singapore

One of the banks operating in Singapore, Citibank, provides letters of credit for buyers in regions like Asia, Africa, the Middle East, Eastern Europe, and Latin America. Most buyers in these regions face challenges in getting international credit independently.

Citibank’s letters of credit play a crucial role in reducing the credit risks associated with the importer’s country and the issuing bank’s commercial credit. Moreover, Citibank ensures that letters of credit are typically made available within just two business days.

This means that the confirming branch of Citibank guarantees payment. This quick turnaround is particularly advantageous for clients in potentially unstable economic conditions.

How To Apply For A Letter Of Credit In Singapore

To apply for a Letter of Credit in Singapore, one must first approach a bank. They will guide you through the application process, which typically involves providing necessary documentation such as invoices, contracts, and financial statements. The bank will then assess your eligibility and, if approved, proceed with issuing the letter of credit.

Import-export Example Within Singapore’s Trade Context

  • The exporter and their bank confirm the importer’s bank’s financial credibility since the importer’s bank credit must satisfy them first. They then finalise a sales agreement.
  • Following the sales agreement terms and conditions, the importer’s bank creates the letter of credit and sends it to the exporter’s bank. The exporter’s bank checks and forwards it to the exporters upon approval.
  • The exporter ships the goods according to the letter of credit. All necessary paperwork is submitted to their bank.
  • The exporter’s bank thoroughly checks the documents to ensure compliance with the letter of credit’s terms. The documents required are then forwarded to the importer’s bank if everything is in order.
  • The importer’s bank transfers the payment to the exporter’s bank. With the payment received, the importer can now claim the shipped goods.

Advantages And Disadvantages Of A Letter Of Credit In Singapore

Advantages

  • Tailored terms: Letters of credit in Singapore can be customised to fit the unique circumstances of each transaction, providing flexibility.
  • Clear transaction details: They help in clearly defining when and how transactions will take place, ensuring transparency among involved parties.
  • Efficient fund transfer: They facilitate smoother and more efficient money transfers, enhancing the overall transaction process.
  • Trust and security: Letters of credit are used to foster trust and provide security for buyers and sellers, creating a more reliable trading environment.

Disadvantages

  • Inflexibility to changes: The terms of a letter of credit may not adapt well to unforeseen political or economic shifts, potentially causing complications.
  • Time-consuming process: Establishing a letter of credit can be time-consuming for all parties involved, potentially leading to delays in the transaction.
  • Buyer’s financial responsibility: Buyers typically bear the costs of obtaining a letter of credit, which can be a financial burden.
  • Potential oversight: Letters of credit may not cover every single detail of a transaction, leaving room for potential errors or discrepancies.

Additional Information For Singapore

How A Letter Of Credit Works In Singapore’s International Trade

In Singapore’s international trade, a letter of credit is commonly employed to assure sellers that they’ll receive their payment punctually and completely, backed by a bank. When this letter is issued, the bank usually charges a fee, often a percentage of the letter’s value, and asks for collateral from the buyer. Different types of letters of credit used include revolving, commercial, and confirmed Letters of Credit.

In uncertain economic conditions, like an exporter facing instability, obtaining credit can be challenging. To address this, a bank can extend a letter of credit to a buyer. This arrangement ensures that the purchase is secure, and it can be arranged swiftly, typically within two business days, through the bank’s branch.

Additionally, since the bank already has a history with the exporter, they understand the buyer’s financial stability, assets, and creditworthiness well. This strengthens the level of trust between the parties involved.

Difference Between A Commercial Letter Of Credit And A Revolving Letter Of Credit

A commercial letter of credit involves the bank making direct payments to the beneficiary or seller. On the other hand, a revolving letter of credit allows for multiple payments within a specific time frame. These are often utilised by businesses with an ongoing relationship, usually extending up to a year.

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Conclusion

Understanding what is letter of credit and its various types is pivotal in navigating international trade, especially in Singapore’s bustling economy. This financial tool serves as a cornerstone, providing assurance and security for cross-border transactions. Embracing the intricacies of letters of credit is indispensable for successful global commerce.

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