Confirmed Letter Of Credit

A confirmed letter of credit is used in international trade as a financial instrument to support and provide double assurance to the importers and exporters. The documents cover the interests and favors of both parties involved in the trade business. This confirmed letter of credit is issued by the bank responsible for the payment.

In many trade relations and businesses, the document serves as a token of trust for the exporter in case the buyer is new or the exporter does not align with their creditworthiness. Depending on the type of business transaction, different types of letters of credit are issued to provide a guarantee and safeguard the buyer for confirmation delivery of the goods.

A confirmed letter of credit is a financial instrument used in international trade to cover the interests and protection of both parties involved in the transaction. Whenever a seller is doing business with a new client or doubts their creditworthiness, they can ask the buyer to bring a confirmed letter of credit, which means that a bank now backs the payment guarantee. But interestingly, in such arrangements, there are two banks involved in the transaction. The first one is the issuing bank, and the second one is the advisory bank, also known as the confirming bank.

Depending on the type of transaction, a bank may issue different types of letters of credit, such as transferable, irrevocable, standby, back-to-back, red clause, and deferred payment letters of credit. Similarly, each type of letter of credit has its purpose, and the bank charges a specific fee for it to be issued. Typically, banks charge 1% to 8% of the total transaction amount to issue it. The cost also depends on certain factors like location, type of transaction, agreement, and so on.

As banks get involved in the trade process, the risk of defaulting on payment is minimized, and people tend to have good faith and better trade relationships as they do not have to believe only in the other party but also in the bank itself. It is highly advised and utilized in trade transactions.

The process to receive a confirmed letter of credit is as follows -

• Issuance - After two parties form a trade contract, the importer applies for the L.C. in the exporter’s favor. The issuing bank sends the letter to the advising bank. The latter verifies the letter of credit and hands it to the exporter.
• Shipment - The exporter can verify their level of satisfaction and initiate the shipment process.
• Documentation - Once the shipment is processed, the exporter will submit the letter of credit to the confirming bank. The exporter can either do it by themselves or use freight forwarders. The exporter may need to submit other important documents like invoices, date and time of shipment, and trade receipts.
• Payment Settlement - The confirming bank sends it forward to the issuing bank. The bank initiates the payment, and the amount is paid. The bank then gives it to the importer, who uses the same document to receive the shipment.

Here are two examples to help one understand the concept better.

Example #1

Suppose Peter, an exporter in the U.K., and Pablo, an importer from the U.S., form a trade agreement. Since this is their first business transaction, they are unknown to each other and decide to have a confirmed letter of credit arrangement.

Pablo applies for a confirmed L.C. in a U.S. bank; it is the issuing bank. The bank forms the letter and processes it to the advising bank, Peter’s bank. The second bank then verifies the authenticity of the letter of credit and gives it to Peter.

It means that Peter has received the guarantee and confirmation from the advisory bank. Peter initiates the shipment. After this, Peter will submit the L.C. with other documents back to the advisory bank, which will then share it with the issuing bank (Pablo’s bank). The issuing bank will make the payment and give the letter of credit to Pablo, who will use it to take possession of the shipment. It is a simple hypothetical example.

Example #2

Suppose John, a luxury fabric retailer in the United States, decides to purchase $100,000 worth of high-quality textiles from Jane, a manufacturer in India. Since this is their first transaction and Jane is concerned about receiving payment, she requests a confirmed letter of credit. John applies for the letter of credit at First American Bank in the U.S., specifying that Global Trust Bank in India should confirm it. First American Bank issues the letter of credit and sends it to Global Trust Bank, which then adds its confirmation, guaranteeing payment to Jane even if First American Bank fails to pay. Jane is notified and, feeling secure, proceeds to manufacture and ship the textiles to John.

After shipping the goods, Jane submits the required shipping documents to Global Trust Bank, which verifies them and forwards them to First American Bank. Upon confirmation that the documents comply with the terms of the letter of credit, First American Bank transfers the payment to Global Trust Bank, which then pays Jane the $100,000. Finally, John receives the shipping documents from First American Bank and uses them to take possession of the textiles. This process ensures that Jane receives her payment securely and John receives his goods, demonstrating the effectiveness of a confirmed letter of credit in international trade.

The advantages of a confirmed letter of credit are -

• For a seller, the letter of credit directly confirms the payment initiation.
• For a buyer, it works like a protection and guarantee of their creditworthiness and desired delivery of products.
• Since the bank is issuing the letter, the risk of default becomes negligible or zero.
• It is treated as a financial instrument in international trade and a crucial document of business.

The disadvantages of a confirmed letter of credit are -

• The process of obtaining it is long and tiring.
• There are different fees involved in the process. It may get expensive.
• Since it involves two banks, it certainly increases the whole cost structure for the parties involved in the transaction.
• It can only be done by a buyer. Sometimes, they are getting into a transaction.

Both confirmed and unconfirmed letters of credit are commonly used in international trade and business operations. However, the main differences between confirmed and unconfirmed letters of credit are -

• With a confirmed letter of credit, the advisory bank guarantees the payment to the exporter. In comparison, an unconfirmed letter of credit has no such guarantee or advisory bank involved.
• It is expensive to obtain and may take time. In contrast, an unconfirmed letter of credit is less expensive.
• For a new importer, the seller may choose to have a confirmation letter of credit rather than operating on an unconfirmed letter of credit.