The financial option to discount a letter of credit is a strategy that businesses will sometime use as a means of generating cash today for a letter of credit that is slated to be honored at some point in the future. Essentially, this approach is similar to factoring an invoice, in that the seller who is awaiting payment for goods that have been shipped and received by the buyer can approach his or her bank to receive an advance of funds that is near the total worth of that letter of credit (LC). This allows the seller to enjoy the proceeds from the purchase now rather than later, using the money for whatever purpose is needed.
In order to discount a letter of credit, the seller’s bank will contact the bank issuing the letter of credit provided by the buyer. Upon confirming the terms surrounding that LC with the issuing bank, the financial institution can then present the seller with a percentage of the total value of that anticipated payment. Typically, the amount extended will be reduced by whatever fees the institution charges for offering this type of service, with the fees ranging anywhere from 3% all the way to 20%, depending on the policies of the lender. When the letter of credit is due, the lender receives that sum directly and the transaction is considered settled in full.
As a means of protecting the interests of the financial institution, the process used to discount a letter of credit will typically include a provision known as an irrevocable payment undertaking. This simply means that the seller cannot revoke the rights of the bank to claim the letter of credit in full once it is presented for payment. Typically, the arrangements will also include provisions that hold the seller liable in the event that any set of circumstances should occur that render the letter of credit null and void, effectively protecting the lender from losing money on the deal.
While the action to discount a letter of credit can be used in a number of business scenarios, the setting will normally involve an exporter who is selling goods to a buyer or importer located in another country. When this is the case, the trade laws relevant to both countries involved will dictate how the discount of a letter of credit is written, and what provisions are included to protect the rights and responsibilities of all parties involved. As with any type of business transaction, it is important to read and understand all the terms found in the contract governing the discount of a letter of credit, making sure there is no opportunity for miscommunication that could lead to problems later on.