Guide To Letter Of Credit Discounting

Let’s imagine you are an exporter running a business selling hardware parts and receive a huge order from an importer overseas. It will be a great opportunity for your business but as per the importer’s payment terms, you will receive payment after 90 days post-shipment. Will you be able to trust that unknown buyer? How will your business survive during this credit period? To resolve this difficulty, the concept of a Letter of Credit & Bill Discounting comes into the picture. What is LC & Bill Discounting? How does it work? And why are we discussing them here? Keep reading to know.

Introduction to LC Discounting

Letter of Discounting is a short-term credit facility provided by the bank where the LC issuing bank purchases the documents or bills of the exporter backed by the LC after the shipment is done and makes him advance or immediate payment for a security or a fee after deducting the discount charges. “LC Discounting” is a term used in place of “LC Bill Discounting” that means discounting of a bill backed by the LC.

To understand the meaning of what an LC Discounting is, we first need to be aware of what an LC is.

A letter of credit, also known as a payment guarantee letter or a documentary credit letter is a legal guarantee issued by the bank or a financial institution to the exporter that the importer is capable of paying & performing the terms & conditions of the LC contract. But in the event, if the importer defaults or fails to make the payment, the issuing bank will recover the full or remaining amount.

In simple words, the bank promises the exporters that they can ship the ordered goods within the knowledge of being paid on time. An LC is financial security for both the importers & exporters in international trade. Importers are assured that the order is shipped before the payment is made and exporters are assured that they will get their money on time.

Now in this process, what if the importer is not willing to make the immediate payment and the exporters don’t want to wait for their payment after the shipment is done & needs to be paid immediately? To address this difficulty, the bank offers exporters to get the advance payment by discounting their documents backed by an LC even when the importer wants a longer credit period to arrange funds.

How Does the Letter of Credit Discounting Work?

As we have mentioned above, an LC discounting is a process where a bank provides a short-term credit facility to the exporters by making them an advance or immediate payment after they fulfill certain compliances. But when & how does it take place?

1. The process of LC discounting occurs when the buyer requests for an LC to be issued in the favor of the exporters from a bank or a FI before the goods are shipped to him.
2. Now the exporter submits the necessary documents to his bank.
3. The exporter’s bank forwards these documents to the LC issuing bank or confirming bank to check their authenticity & reliability with the originals.
4. Once the issuing bank is satisfied that the documents are correct, it provides its acceptance to the exporter’s bank and assures that the payment will be made on time.
5. Now if the exporter wants an immediate or advance payment due to a lack of working capital to survive after the shipment is done, he can get these documents discounted from the issuing bank.
6. The bank pays the exporters with the net amount after deducting the discount charges.

The exporters are required to pay a certain fee or discounting charges to the bank which are known as Letter of credit discounting charges. These charges vary from bank to bank depending on the credit period, amount, creditworthiness of the buyer, and other factors. The rate of LC discounting is generally between 6% & 15% of the total invoice value.

This way:
1. The exporter gets an advance payment for delivered goods & services
2. The importer receives the goods along with a credit period to arrange funds
3. The bank receives a premium from the buyer when he pays the bank.

Advantages of LC Discounting:

Following are the major advantages of Letter of Credit Discounting. Let’s have a look:

1. Since the beneficiary i.e. exporter receives an advance/immediate payment once the bills are accepted & discounted by the issuing bank, it speeds up cash flow in the organization that further helps with the smooth working capital flow.
2. As the exporter receives an advance payment before the maturity date of the bill, they can utilize this amount to accelerate the production process or for funding the operations.
3. It eliminates the credit risk as the issuing bank assures the exporters of the importer’s obligations.
4. LC discounting is one of the safest & secure modes of getting an advance payment as the bank discounts the bills only after verifying the authenticity of both parties.
5. The bills or other documents backed by an LC often bear the prevailing discounting rates, thus eliminating the risk of manipulating the rates.
6. It enables the beneficiary to allow longer payment terms to his trading partner. It not only brightens up their chances of negotiation but also helps establish a strong relationship with them.

Disadvantages of LC Discounting:

Following are the major disadvantages of Letter of Credit Discounting. Let’s have a look:

1. Since the exporters can only get their advance payment after paying a certain discounting fee to the bank, it can cause them to pay extra costs.
2. During the process, the issuing bank is only responsible for verifying the documentation and not the physical verification of goods like quality or quantity, etc.
3. As the rates for LC discounting vary from bank to bank, it may be hard for the exporters to choose the best bank.
4. An LC discounting calls for a lot of documentation requirements.
5. It is a time-consuming process as several rules are required to be compiled by the exporters and verified by the bank.

Though the letter of credit discounting has its own disadvantages, it is one of the most useful & safe trade finance instruments being provided by the banks or FIs.

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