Business transactions of buying and selling from any part of the world are common. The trust factor lies in the payment methods opted by the buyer as well as the seller.
There are different methods to collect the payment from the customer and deliver the item. There are different payment methods available across the globe when international business is happening.
Letter of credit and Bills of exchange are few of the offline payment methods most used in international trade that helps the buyer as well as the seller.
Letter of Credit vs Bills of Exchange
The main difference between the letter of credit and bills of exchange is that Letter of credit focus on the payment mechanism and bills of exchange is nothing other than a payment instrument.
Comparison Table Between Letter of Credit and Bills of Exchange (in Tabular Form)
| Parameter of Comparison | Letter of credit | Bills of Exchange |
|---|---|---|
| Risk Factor | There is less risk of the importer’s bank having payment as default as once the letter of credit is issued, it cannot be withdrawn. | There is a risk because it depends on the importer on making the payment or backing out of the process |
| Holding authority | Greater control is in the hands of the importer | Greater control is in the hands of the exporter |
| Mode | Bank usually pays the money | It is always the individual who pays the money |
| Discount factor | There is no discount factor here | Seller can avail the discount facility |
| Payment factor | It will set the rules of the payment and it doesn’t support the actual payment process | Actual payment is received here by the seller |
What is Letter of Credit?
Letter of credit is also known as Documentary credit and it is a part of Trade finance. There are usually two parties involved in this, one is the Buyer and the other one will be Seller. Buyer opts in for a purchase of the product and looks at the possible available resources.
The seller gets a query regarding the buyer’s requirement and then proceeds by letting the buyer knowing the product and the process. The buyer gets in touch with the seller and ask for the process of payment for the purpose and doesn’t want to make the payment directly since they are meeting for the first time/transacting for the first instance.
Seller doesn’t agree for the same and insists buyer make the payment and get the goods delivered. A buyer approaches a bank which is called Opening bank/ issuing bank for issuing the Letter of credit to purchase the product. The issuing bank verifies it and sends the information to advising bank.
Advising bank verifies the details and issues a mutually agreed letter to the seller, once the seller receives it then the goods will be packed and ready for transit so that it reaches the seller.
Before the transit is made, the seller documents the Transport, Insurance, and other overhead details to the Advising bank then later the same goes to the issuing bank and then it reaches the buyer at last. Meanwhile, the goods have arrived at the buyer’s place and payment is made to the seller parallel with extra service charges. The buyer sells the goods and gets the payment on time and the same goes with the seller receiving the goods on time.
What is Bills of Exchange?
Bill of exchange usually happens between three parties, Drawer, Drawee and the Payee.
In the first instance, Buyer buys a product and usually prefers payment through cash. In the second instance, Buyer buys a product but prefers 45 days credit to make the payment. In the last instance, Buyer buys a product and prefers for 45 days credit but here Seller hands over the Buyer a draft called a bill of exchange.
The draft issues are called a bill of exchange and it is an acknowledgment signed by the Buyer and the same is given back to the Seller. Usually, if we look at the risk factor in the mentioned instances, the first instance will not have any risk since it is directly related to the payment through cash. The second instance will have a certain level of risk since it is about credit.
The third instance involves a certain amount of benefit too in the form of Bill of Exchange because cash is not blocked until the credit period. Bill of exchange benefits a seller in three different ways i.e the Drawer/Seller can wait till the date of maturity and receives the cash after 45 days. He can also get cash at any point by discounting the bill at a reasonable rate of interest. Bill can also be further endorsed (easily transfer the bill to someone he has to pay)
Main Differences Between Letter of Credit and Bills of Exchange
- The main difference between Letter of credit is a financial document is, LOC is issued by a bank or a financial institution upon the request of the buyer to the seller but the bill of exchange is an acknowledgement that revolves around the buyer, seller and payee.
- Letter of credit doesn’t have a specific time period as credit, but bill of exchange has this credit policy concerning the days that have been asked for.
- Letter of credit is rigid whereas the bill of exchange is flexible in the entire process.
- Letter of Credit does not offer any discount on purchase but Bills of exchange can offer a discount even after it is issued.
- Letter of credit can be used only once but the same rule doesn’t apply for a bill of exchange
Conclusion
Letter of credit and bill of exchange are beneficial for both buyers and sellers that facilitates smooth transaction process. Both of them assures the payment is made without any hassles. Letter of credit focus more on the payments after the delivery and bill of exchange also focus on the same with some leniency given to the buyer in terms of delivery.
It is more like trust factor that lies as a bridge between buyer and seller and it becomes stronger by these two factors and the usage of these methods are beneficiary for both Buyer and the Seller as the payment process flow is very easier and credible.
References
- https://papers.ssrn.com/sol3/papers.cfm?abstract_id=151849
- https://cbr.cba.org/index.php/cbr/article/download/2486/2486/
- https://digitalcommons.nyls.edu/cgi/viewcontent.cgi?article=1059&context=journal_of_international_and_comparative_law