Difference Between Bill of Exchange and Letter of Credit

Introduction

A Bill of Exchange and a Letter of Credit are two essential financial instruments used in international trade and commerce.

While they both facilitate transactions between buyers and sellers, they serve different purposes and have distinct characteristics.

What Is a Bill of Exchange?

A bill of exchange is a written promise used in global trade where one person agrees to pay a certain amount of money to another person either immediately or on a specified date. It's similar to a check or a note that can be used by individuals or banks and can be transferred to others by endorsement.

Key Takeaways

• A bill of exchange is a written agreement where one person promises to pay a specific amount of money to another person either when asked or at a later date.
• A bill of exchange typically involves three main parties: the drawee, who is responsible for paying the money; the payee, who receives the money; and the drawer, who instructs the drawee to pay the payee.
• A bill of exchange is a tool used in international trade to assist importers and exporters in completing their transactions.
• Although a bill of exchange isn't a contract on its own, the parties involved can use it to outline the terms of a deal, like setting credit terms and deciding on the interest rate.

Understanding Bills of Exchange

In a bill of exchange transaction, there can be up to three main parties. The drawee pays the specified amount mentioned in the bill. The payee is the person or entity who receives this payment. The drawer is the party that instructs or obliges the drawee to make the payment to the payee. Usually, the drawer and the payee are the same unless the drawer transfers the bill to a different payee.

A bill of exchange is a written document that shows how much one person owes another. It's commonly used in global trade to pay for goods or services. Even though it's not a contract by itself, it helps the parties involved follow the contract's terms. This document can state that payment is immediate or on a specific future date. The time between billing and payment is known as the usance period, which can be extended with credit terms like 90 days. Also, for a bill of exchange to be valid, the drawee must agree to it.

Bills of exchange typically don't include interest, making them like post-dated checks. If they aren't paid by a certain date, they might start accruing interest, but this must be stated on the document. On the other hand, they can be sold at a discount before the payment date. A bill of exchange must clearly state the amount, the date, and the parties involved, such as the drawer and drawee.

If a bill of exchange comes from a bank, it's called a bank draft, and the bank guarantees payment. When individuals issue bills, they're called trade drafts. A bill payable right away is a sight draft, where the exporter keeps ownership of goods until the importer pays on delivery. If payment is due later, it's a time draft, giving the importer some time after receiving goods to pay.

What is a Letter of Credit?

A Letter of Credit (LC) is a document issued by a bank that assures a seller they'll receive the buyer's payment on time and in the correct amount and currency. If the buyer can't pay, the bank covers the cost. LCs are common in international trade, reducing risks for importers, exporters, and banks. They help ensure smooth payments and reduce the chance of not getting paid for goods delivered.

Key Takeaways.

1. A Letter of Credit is a paper from a bank promising to ensure that a buyer pays on time in the right amount and currency.
2. If the buyer doesn't pay, the bank is responsible for the remaining amount that's still owed.
3. Basically, the bank becomes the payment source, charging a fee for the service and sometimes asking for collateral as well.
4. Letters of credit are crucial in international trade finance because they create a secure way to handle payments for imports and exports without using up cash reserves.
5. Letters of credit come in various forms, including basic types like confirmed or unconfirmed and special types like Red Clause LC.
6. Payment for the shipped goods can be sent to either the seller's bank or a well-known, trustworthy bank.
7. Payment to the seller is only made when all the terms, conditions, and necessary documents of the letter of credit are fully met.

What is the Typical LC Process?

When the seller is unsure about the buyer's creditworthiness or wants to ensure timely payment, they can demand payment through an irrevocable letter of credit. If the bank issuing the LC is unfamiliar to the seller or if there are doubts about a foreign bank's ability to fulfill its obligation, the seller can ask their bank or a reputable international bank to confirm the letter of credit, with approval from the issuing bank. Banks usually ask for securities or cash as collateral when issuing a letter of credit, along with a fee, typically a percentage of the LC amount. The International Chamber of Commerce's Uniform Customs and Practice for Documentary Credits regulates letters of credit in global transactions.

Basic Types of Letters of Credit

1. Commercial Letter of Credit
   A commercial letter of credit is a straightforward payment method where the issuing bank directly pays the beneficiary. It's the simplest type among different kinds of letters of credit.
2. Revolving Letter of Credit
   A revolving letter of credit is a single credit letter that handles numerous transactions across an extended period. It's employed for recurring transactions involving the same goods between a consistent buyer and seller.
3. Confirmed vs. Unconfirmed Letter of Credit
   A confirmed letter of credit involves an extra assurance added to the original letter of credit obtained by a borrower from a second bank. This second letter ensures that if the first bank fails to make the payment, the seller will still receive payment from the second bank. The issuing bank commonly requests this arrangement in international transactions.
4. Irrevocable vs. Revocable Letter of Credit
   An irrevocable letter of credit essentially means that it cannot be canceled or changed without the agreement of the beneficiary. This type of credit is considered standard in letters of credit. The idea of a Revocable Credit was discontinued in 2007.

Difference Between Bill of Exchange and Letter of Credit

Conclusion

A Bill of Exchange is like an IOU note where one party promises to pay another at a later date. On the other hand, a Letter of Credit is more like a guarantee from a bank, ensuring that a payment will be made on time and in the right amount. In short, a Bill of Exchange is a promise to pay, while a Letter of Credit is a bank-backed assurance of payment.