Many factories that are new to foreign trade have many misunderstandings about the operation of letters of credit. Either they are too superstitious and think that as long as foreign merchants open a letter of credit, everything will be fine. They are not sufficiently vigilant about “discrepancies” and panic when they are refused to pay; or they do not believe in letters of credit at all – especially after suffering losses from several discrepancies and refused to pay, they stick to the “payment before delivery” procedure, and as a result, they lose many trading opportunities. These two extreme concepts are caused by not understanding the operating characteristics of letters of credit. There are three basic criteria for a “reliable” letter of credit: opening by a well-known large bank, reasonable and feasible document requirements, and no “soft clauses”.
1. Opening by a well-known large bank
Opening by a well-known large bank is easier to understand: since the principle of a letter of credit is “the bank acts as an intermediate guarantor”, then first of all, the guarantor must be reliable. Unlike domestic banks, many foreign banks are privately owned, with large and small scales, and their credit ratings are naturally uneven. Because of their long history and reputation, well-known large banks can basically be fair and reasonable in letter of credit operations, and provide more thoughtful services to both buyers and sellers.
Generally speaking, banks in developed countries such as Europe and the United States have better reputations because they have a sound market economy system and relatively complete financial supervision. It is not difficult to find the names of the top 100 banks in the world on the Internet. You can directly search in Google with the bank name as a keyword to see if the client’s issuing bank is on the list.
In addition, there is a small trick to verify the reputation of a bank, such as checking the official website of the Chinese Embassy in the country where the issuing bank is located. The website occasionally introduces the main banks of the country.
The issuing bank of a letter of credit is so important that when negotiating with customers to use letter of credit settlement in foreign trade, it is usually stated in advance that “the letter of credit should be opened by a well-known bank.” However, merchants in Southeast Asia, Africa, South America and other regions sometimes cannot open letters of credit through well-known banks. In order to promote transactions, we can also accept letters of credit from small banks of unknown brands when it is really impossible, provided that they are “confirmed.”
Confirmation means: after an unknown small bank opens a letter of credit, another more reliable bank will provide a guarantee. This “re-guarantee” bank is called a confirming bank. If the small bank defaults on its debt and fails to fulfill its due responsibilities, the confirming bank must take the blame for it. The confirming bank is usually a well-known third-party bank or a notifying bank (that is, our bank) – in actual operations, the notifying bank is mostly the confirming bank.
Of course, banks charge fees for confirmation, which are usually borne by exporters. This increases transaction costs, but at least solves the contradiction that exporters do not trust the importer’s issuing bank. For those who require confirmation, just state to the customer in advance that “the letter of credit must be confirmed”, and there is no other special operation. A letter of credit with confirmation will have a corresponding “confirmed” clause. However, it should be noted that “confirmation” means that the confirming bank will bear the payment if the documents are flawless but the issuing bank fails to fulfill its responsibilities. Whether to confirm is entirely based on your own judgment.
2. Document requirements are reasonable and feasible
The so-called “document requirements are reasonable and feasible” refers to whether the documents required in the letter of credit, especially those issued by third-party institutions such as the Commodity Inspection Bureau and freight forwarders, can be obtained on time and in quantity. In addition, the letter of credit is often detailed to the statement of the document. If you encounter such documents with special and specific requirements for words and sentences, it is best to consult the document issuer in advance if you are not sure.
3. Identify “soft clauses”
“Soft clauses” is a jargon in foreign trade, which generally refers to “trap clauses”. There is no strict definition of “soft clauses”. It takes experience to identify and define “soft clauses”. Once a letter of credit is issued, it is the basis and guarantee for the seller to deliver the goods and the buyer to pay. Although there are many types of letters of credit, the most reliable and feasible one in actual operation is “irrevocable sight letter of credit”.
And “soft clauses” are clauses that undermine this foundation. Through “soft clauses”, the buyer can use tricks to make the letter of credit lose its “irrevocable” nature to some extent or force the seller to be unable to perform the letter of credit. The intention of the buyer to maliciously set “soft clauses” is mostly to transfer market risks. We know that foreign trade transactions have a long cycle and the market fluctuates greatly. If the market is not good at that time, the buyer will use soft clauses to destroy the already opened letter of credit, so as to achieve the purpose of breaching the contract or forcing the seller to reduce the price. Once you have seen through the soft clauses, you must argue with reason or take alternative measures to get the customer to cancel the clause.
Of course, some internationally renowned large buyers often have soft clauses in their letters of credit. The purpose is to restrain exporters and facilitate their own management. These soft clauses are often “tyrannical clauses” that cannot be changed or negotiated. The pros and cons of the terms depend on your own consideration. But as long as soft clauses appear, you must be extra cautious.
The above are the three major criteria for measuring the reliability of letters of credit. I hope it will be helpful to you.