Investment and Financial Markets

What Is a Usance LC and How Does It Work?

Explore the Usance Letter of Credit, a vital instrument for managing deferred payments and ensuring security in international trade.

A Letter of Credit (LC) is a financial instrument used in international trade to guarantee payment. It commits a bank to ensure a buyer’s payment to a seller is made on time and for the specified amount, even if the buyer faces financial difficulties. A Usance LC is a specific type of Letter of Credit that incorporates a deferred payment period, distinguishing it from a Sight LC which requires immediate payment. This feature offers flexibility in trade transactions.

Understanding Usance

Usance refers to a specified period during which payment is deferred. This period, also known as the tenor, means payment is not made immediately upon presentation of compliant documents but after a predetermined number of days. Common usance periods range from 30, 60, or 90 days, sometimes up to 180 days, typically calculated from the date of shipment or document presentation to the issuing bank.

A Usance LC differs from a Sight LC, which mandates immediate payment once required documents are submitted and verified. With a Usance LC, the issuing bank, after verifying compliant documents, accepts a draft (a bill of exchange) and commits to making payment at the agreed-upon future maturity date. This deferred payment mechanism provides the buyer with credit, allowing them to receive goods and potentially generate revenue before payment is due.

Key Participants

  • Applicant: Also known as the importer or buyer, this party requests their bank to issue the Letter of Credit. They are responsible for initiating the transaction and ensuring the LC terms align with the purchase agreement.
  • Beneficiary: Typically the exporter or seller, this party is entitled to receive payment under the LC’s terms. They are responsible for shipping goods and presenting all required documents in strict compliance with the LC’s conditions.
  • Issuing Bank: This bank issues the Usance LC on behalf of the applicant and undertakes the primary payment obligation. It is legally bound to pay the beneficiary at maturity, provided all presented documents are compliant.
  • Advising Bank: Usually located in the beneficiary’s country, this bank receives the LC from the issuing bank and authenticates it before formally notifying the beneficiary. While it typically does not assume a payment obligation, it plays an important role in verifying the LC’s authenticity.
  • Confirming Bank: This bank may be involved, often at the beneficiary’s request, to add its own payment undertaking. This provides additional security for the beneficiary, particularly when there are concerns about the issuing bank’s creditworthiness or the stability of its country. It essentially guarantees payment to the beneficiary, even if the issuing bank defaults.

Transaction Lifecycle

The Usance LC transaction begins when a buyer and seller agree on trade terms, including the use of a Usance Letter of Credit for payment. The buyer, as the applicant, then instructs their bank, the issuing bank, to formally issue the Usance LC according to the agreed-upon terms and conditions. This instruction specifies details such as the goods, quantity, value, required documents, and the deferred payment period.

Once issued, the issuing bank transmits the Usance LC to an advising bank, typically located in the seller’s country. The advising bank verifies the LC’s authenticity and then informs the seller, the beneficiary, about the terms and conditions of the credit. The seller reviews these terms carefully to ensure they can meet all requirements for shipment and documentation.

Upon confirming the LC’s terms, the seller ships the goods as per the trade agreement. After shipment, the seller prepares all the necessary documents, such as commercial invoices, packing lists, and bills of lading, ensuring they precisely match the specifications outlined in the Usance LC. These documents are then presented to their bank, which might be the advising bank or a nominated bank, for examination.

The seller’s bank reviews the presented documents for strict compliance with the LC’s terms. If compliant, these documents are then forwarded to the issuing bank for verification. Upon the issuing bank’s successful examination and confirmation that all documents are in order, the bank “accepts” the bill of exchange or draft. This acceptance signifies the issuing bank’s irrevocable commitment to make the payment to the beneficiary at the specified future maturity date, making the bank’s undertaking to pay binding.

Payment and Discounting

Following the issuing bank’s acceptance of the draft, the usance period officially commences. Payment from the issuing bank, or the confirming bank if one is involved, occurs only upon the exact maturity date of this usance period. This means the beneficiary must wait for the predetermined number of days, such as 30, 60, or 90 days, before receiving the funds.

However, a beneficiary with an accepted Usance LC has the option to receive funds earlier through a process known as “discounting” or “negotiation.” In this arrangement, the beneficiary sells their accepted draft to a bank or another financial institution before its maturity date. The bank purchases the draft at a discounted value, providing the beneficiary with immediate liquidity.

The discounting bank then holds the accepted draft until its maturity date. On the maturity date, this bank presents the draft to the issuing bank (or confirming bank) and receives the full face value of the LC. This mechanism allows the exporter to manage their cash flow more effectively by converting a future receivable into immediate funds, while the discounting bank earns a fee from the discount.

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