A sight letter of credit is a special type of letter of credit in which a payment term “sight” is used in a letter of credit. It basically means “payment at sight”. It is also known as letter of credit at sight.
In a sight letter of credit, the payment for the transactions is released immediately after the seller presents the required documents to the advising bank. The documents required as per the terms of a letter of credit is usually the proof of shipment. This includes invoice, packing list, bill of lading, insurance, etc.
- Why use Sight Letter of Credit?
- How does a Sight Letter of Credit Work?
- Advantages of Sight Letter of Credit
- Disadvantage of Sight Letter of Credit
A regular letter of credit is a document that guarantees payment to the seller if the conditions of the letter of credit are confirmed by both the buyer and the seller. However, the time by which buyer releases payment to the seller depends on the type of the letter of credit. For example, a red clause or a green clause letter of credit gives an option of advance payment before the shipment of goods, whereas the usance letter of credit gives an option of differed payment. In case of sight letter of credit, the payment is released immediately after the required documents are presented to the advising bank.
Here when we say payment is released immediately it usually means in five to ten business days. This is because the advising bank needs time to review the documents submitted by the seller. In most cases, the advising bank sends the documents to the bank that has issued the sight letter of credit. Thereafter, once the documents get confirmation from the issuing bank, it will release the payment.
Why use Sight Letter of Credit?
The letter of credit by itself is used as a payment tool to ensure the safety of both the parties involved in the international trade. However, the sight letter of credit is very specific in its usage.
A sight letter of credit helps manage the seller’s working capital cycle. It is a boon especially for small companies who are working on tight bootstrapping principles. Such companies may insist on sight letter of credit from their buyers.
Furthermore, a sight letter of credit may prove to be a very useful tool when the seller is doubtful of receiving payment. This can be due to numerous reasons such as the buyer may be located in a volatile region where there is political or economic tension or buyer himself may be in some financial turmoil. In this case, the seller prefers that he gets paid as quickly as possible, so he asks for sight letter of credit.
How does a Sight Letter of Credit Work?
Let’s understand the working of sight letter of credit with an example –
Example – Mr. Rick (importer/ buyer) residing in Spain decides to buy goods worth USD 10,000.00 from Miss Erika from Japan. Miss Erika (exporter/ seller) insists to use sight letter of credit for the transaction. Mr. Rick agrees and applies for sight letter of credit of USD 10,000.00 in the name of Miss Erika from Citibank in Spain. Miss Erika nominates Bank of Japan her advising bank.
Following is the sequence of the transaction –
- Based on the application of Mr. Rick, Citibank Spain issues a sight letter of credit of USD 10,000.00 in the name of Miss Erika and sends it to Bank of Japan.
- Bank of Japan forwards the sight letter of credit to Miss Erika. Miss Erika checks the terms and accepts it.
- Miss Erika manufactures and ships the ordered goods (amounting to USD 10,000.00) to Mr. Rick and receives a bill of lading from the shipping line. She also intimates Mr. Rick of the shipment and sends him a digital copy of shipping documents.
- Mr. Rick makes the payment of USD 10,000.00 to Citibank Spain as per amount in invoice and sight letter of credit
- Citibank Spain hold this money in an escrow account
- Miss Erika submits the original shipping documents (invoice, packing list, bill of lading, etc.) along with the original letter of credit to Bank of Japan.
- Bank of Japan reviews the documents in 2 days and forwards it to Citibank Spain
- Citibank Spain takes another 3 days to review the documents and passes it on to Mr. Rick who accepts the documents. Also, on the same day, Citibank Spain releases payment of USD 10,000.000 and forwards it to Bank of Japan
- Next day Bank of Japan deducts its advising charges from USD 10,000.00 and deposits the remaining payment in the account of Miss Erika.
- Note that here the entire documentary transaction took about 7 days. Miss Erika received the payment on the 8th day after she shipped the goods. Also, we must note that the average sea transit time from Japan to Spain is 45 to 55 days. So Mr. Rick had not received the goods when he made the payment.
Now let’s discuss the advantages and disadvantages of this letter of credit:
Advantages of Sight Letter of Credit
Seller can Manage his Working Capital Efficiently
One of the most definitive advantages of a sight letter of credit is that the seller receives the payment quickly after shipping the goods. Consequently, he will not face a cash crunch and can manage his working capital efficiently.
Interest Benefit for Seller
Usually, any business uses an overdraft facility or working capital loan to manage its working capital. This becomes especially true when the seller provides a credit period for the buyer. The credit period can be anywhere from 15 days to 3 months. For that time the seller has to forgo his interest on the amount receivable from the buyer. The sight letter of credit eliminated this, as a result, the seller gets the interest benefit.
Competitive Advantage to the Buyer
As the buyer is not taking any credit period from the seller, he can negotiate better prices and other terms with the seller. This gives the buyer a competitive edge in the market.
The sight letter of credit is low in cost, therefore, an efficient payment tool to use in international trade.
Disadvantage of Sight Letter of Credit
Risk of receiving Wrong Goods for the Buyer
In a sight letter of credit the buyer pays before receiving the goods, thereby he is exposed to the risk of receiving the wrong goods. There are many possibilities such as the seller may send the wrong goods, or the quality is not as per the requirement. In extreme cases, the seller may be a fraud and ship a box of rocks to the buyer and disappears with the money.
Less Credit Period for the Buyer
In a sight letter of credit the buyer is not taking any credit period to pay the buyer, as a result, he also forgoes the interest rate. This is a cost disadvantage to the seller. He also has to take extra effort to manage his working capital cycle.
Seller maybe at Disadvantage During Negotiation
As discussed in the previous point, when using the sight letter of credit, the buyer is in an advantageous position during negotiation. This automatically means that the seller is in a disadvantageous position.