Discounting of Letter of Credit (LC) is a short-term credit facility provided by the bank. In the Letter of Credit discounting process, the bank purchases the documents or bills of the exporter and in return make him the payment for a security or a fee. LC discounting is actually a term used for ease in place of ‘LC Bill Discounting’, which means discounting of a bill backed by LC. Read further to know the meaning of LC bill discounting, the process of LC discounting, its advantages and disadvantages.
Introduction of Letter of Credit Discounting
We live in an era where trade is not restricted to national boundaries, we trade internationally. Global trading though sounds good but brings a lot of difficulties like overseas distances, trust between the parties, unstable economic environment, nature of transactions, different trade laws of each country, etc. So to eliminate such difficulties and to assure the seller about the recovery of his money, Letter of Credit Discounting came into existence. It acts as a financial security in international trade.
Letter of Credit Discounting Definition
To understand the meaning of Letter of Credit Discounting, we need to understand the meaning of Letter of Credit in short. Letter of Credit is a guarantee given by the bank to pay to the seller for the buyer’s obligation, in case buyer fails to make the payment. In simple words, bank promises to pay for the goods which buyer has purchased from the seller.
Coming back to Discounting of Letter of Credit; it often happens that a seller is willing to get quick payment. Whereas the buyer does not want to pay immediately. So to resolve this difficulty, the bank offers the seller to get immediate payment or say advance payment, even if the buyer wants a longer credit period for payment. LC discounting is helpful to all the parties in the trade.
- the seller gets immediate payment for his sale;
- the buyer receives the goods along with the credit period to pay
- the bank receives a premium from the buyer when he makes the payment to the bank.
Basic Documents Required for LC Discounting (or LC Bill Discounting)
- Bills, drawn under irrevocable LC. (Generally, bills backed by revocable LCs are not discounted)
- Bills drawn should strictly conform to the terms mentioned in Letter of Credit.
- The bills of exchange need to be related to bonafide trade transactions.
How Does Letter of Credit Discounting Work?
Discounting of Letter of Credit is a short-term credit facility provided by the bank to the beneficiary. Bank purchases the documents or bills of the exporter (beneficiary) after he fulfills certain compliances. On meeting these compliances, the bank makes him the payment. The exporter shall be required to pay a fee or discounting charges to the bank, which is termed as Letter of credit discounting charges. These charges vary from bank to bank. Letter of Credit discounting rate is generally between 6 percent and 15 percent of total invoice value. It may be higher or lower depending upon the quantum, limit, size of the company that seeks the facility and the bank’s comfort with its financial discipline.
Letter of Credit Discounting Process
Letter of credit discounting process initiates when the buyer, on the request of the seller, obtains an LC from a financial institution before the goods are shipped to him. LC acts as a guarantee to the seller. So in the case of default by the buyer, the bank will clear the dues of the seller. Now the exporter submits the export documents to the bank. Bank forwards these documents to the issuing bank or confirming bank. The LC issuing bank or confirming bank checks the authenticity of the document submitted by verifying all documents with the originals. Once the documents are verified, they communicate back their acceptance of bill under LC to the bank. Now if the seller wants immediate payment and buyer is willing to have a longer credit period, the bank pays the seller the entire amount of bill after deducting the discount.
LC Discounting Limit / Credit Facility Approval
Globalization has given a boost to imports and exports. A lot of people who are into import and export need discounting of the letter of credit on a day-to-day basis, for which they approach the banks. Banks fix a threshold limit for discounting the LC bill for a given period.
Below mentioned is the process that a company has to follow for applying to the bank for LC Bill discounting limit:
- Firstly, the beneficiary has to apply for the required facilities with a justification for the requirement along with submitting financial documents.
- The bank officials then conduct a personal interview of the exporter.
- Bank’s Field Investigation team visits the place of the applicant for verification.
- The bank checks the credit score of the applicant.
- The bank further analyzes various parameters of the company like the background, nature of business, experience in the business, financial viability, etc.
- Then the file of the applicant is placed for obtaining sanction from the appropriate authorities.
Advantages and Disadvantages of LC Discounting
The following are the advantages of LC Discounting for the beneficiary/exporter:
- It speeds up the cash flow movement in the organization as the beneficiary receives an advance payment which helps in the smooth movement of working capital in the organization.
- The beneficiary receives immediate payment before the maturity date of the bill. The beneficiary can use this amount for his business during the production process to pay his suppliers and for funding the operations.
- LC Discounting eliminates the credit risk, as the bank gives assurance to the beneficiary for the buyer’s obligation.
- LC Discounting is a safe and secure mode of getting funds, as the bank discounts LC only after verifying the authenticity of both of the parties.
- Prevailing discount rates are applicable on the letter of credit. Hence, it eliminates the chances of manipulating the discount rate.
- It offers the beneficiary an opportunity to give longer payment terms to his trading partner. This not only puts the beneficiary in a better position to negotiate for the deal but also helps to build a strong relationship with their trading partner.
The following are the disadvantages of LC Discounting for the beneficiary/exporter:
- Bank charges a fee or margin for discounting LC. This results in beneficiary paying up extra fees for the amount due to him.
- Focus is only on documentation and not on the physical verification of goods like the quality of goods, its quantity, etc.
- Since the discounting rates vary from bank to bank, the applicant may be troubled in selecting which bank to visit for LC discounting.
- A lot of documentation is required which results in consumption of huge resources of the applicant.
- It is a time-consuming process, as various rules need to be complied by the beneficiary and verified by the bank.
- Forex risk is associated with LC discounting. The exchange rate keeps on changing which may result in a loss to the beneficiary.
- Rules governing discounting of LC are complex.
Thought letter of credit discounting has some disadvantages, it is a very useful financial service offered by banks which facilitate smooth operations in international trade.