Usance Letter of Credit: a Worked Example

Under a sight letter of credit, the issuing bank pays when complying documents are presented, and debits its customer, the importer, at the same time. The importer must fund the goods before it has sold them, often with a trade loan from the same bank. A usance credit builds that funding period into the credit itself. The bank still examines the documents at once and commits once they comply, but the payment date is set some way off.

For the exporter, the commitment is what matters: from that point it is owed money by a bank, not a buyer, and short of fraud a dispute about the goods does not stop payment at maturity. The waiting is a separate problem, solved by money. The importer, meanwhile, has its supplier's credit for the usance period, backed by its own bank's promise. For the importer's bank, it is a commitment that runs from issue until payment.

Under the ICC's UCP 600, which governs most documentary credits because their text says so, a credit must state whether it is available by sight payment, deferred payment, acceptance or negotiation. Usance comes mainly in two forms. In a deferred payment credit, the bank incurs an undertaking to pay at maturity, without a draft. In an acceptance credit, the exporter draws a draft on the bank, which accepts it and pays it at maturity; the accepted draft is a banker's acceptance, a negotiable instrument. A negotiation credit can also call for a usance draft on the issuing bank, but a credit may not be made available by a draft drawn on the importer.

The maturity is fixed by the credit's wording, commonly a number of days after the bill of lading date or after sight of the documents, and under the rules 'after' excludes the date named. The transport documents must be presented within 21 calendar days of shipment unless the credit says otherwise, and each bank has up to five banking days to examine them. A nominated bank that has incurred a deferred payment undertaking or accepted a draft is authorised by its nomination to prepay or purchase it, and the issuing bank's reimbursement falls due at maturity, whether or not the nominated bank paid early. The price of paying early is:

The rate reflects the funding cost for the period and the risk of the bank that will pay at maturity. Dollar discounts are commonly calculated on a 360-day year; other currencies may use 365.

A sawn-timber exporter, constructed for this page like every figure in it, ships US$1.44m of lumber to a building-products importer abroad. The importer's bank issues a credit subject to UCP 600, available with the exporter's bank by deferred payment at 120 days after the bill of lading date. The bill of lading is dated 10 March. The exporter presents the documents on 17 March; its bank finds them complying on 24 March, incurs its undertaking and offers to prepay it the next day at 6.0% a year. The rate is the example's.

The exporter has its money fifteen days after shipping, at a cost of 1.75% of the invoice. Whether that cost falls on the exporter or was built into the price is a matter of the sale contract, settled before the credit was opened. What the exporter did not buy, unless the discount was agreed without recourse, is freedom from the issuing bank: if that bank fails to pay on 8 July, the terms of the prepayment decide whether the exporter must repay.

Seen from the importer's bank, the difference is the length of time its promise is outstanding. Suppose the importer opens one such credit every month, each about 30 days before shipment. A sight credit is outstanding from issue until it is paid soon after presentation, about 45 days in this example. The usance credit is outstanding until maturity, about 150 days.

The trade is the same and the limit the bank must approve is more than three times larger. For most of those 150 days the bank's risk is no longer documentary: once the documents comply it releases them to the importer, who takes the goods, and what the bank holds is the importer's promise to put it in funds at maturity. That is about four months of credit risk on the importer, read like any other lending. Some importers ask instead for a usance payable at sight credit, in which the exporter is paid at sight and the importer's bank, or another, funds the deferral and charges the importer interest. That moves the financing cost, not the bank's exposure.

A usance credit also differs from documents against acceptance under a documentary collection. There the importer accepts the draft itself and the banks only pass documents; in its basic form, no bank promises to pay.

DEFINED IN ONE PARAGRAPH → · CONFIRMED CREDITS → · BANK GUARANTEE VS LETTER OF CREDIT →

On the exporter's side, a usance credit is two different receivables either side of the bank's commitment. Before the documents are found complying, the exporter is exposed to its own paperwork and to the buyer's willingness to waive a discrepancy. Afterwards, it holds a claim on a bank, and its lender can discount it or count it in a borrowing base on terms it would not offer against the buyer. Where the issuing bank or its country is weak, confirmation is often what makes the claim worth discounting.

On the importer's side, the usance period should match the business. If the importer sells the timber and collects within 120 days, the credit has funded the whole cycle. If its stock turns slowly or its customers pay late, maturity arrives before the cash does, and the bank pays the exporter and then waits for its customer, the outcome the credit limit was approved to absorb.

PRODUCT FILE: LC DISCOUNTING → · HOW BANKS READ EXPORTERS →