The commercial letter of credit is somewhat similar in principle to the traveler's letter, but it is used to pay for merchandise purchased from exporters in foreign countries. In effect it authorizes an exporter to draw against the correspondents of the issuing bank for the amount named in the letter on account of specific shipments. As a rule it is issued in pounds sterling, as this form of credit is the most readily negotiable throughout the world. By means of a commercial letter of credit an importer can purchase merchandise in any foreign country on a cash basis, although he will not have to pay for it until the maturity of the drafts drawn by the exporter, from one to six months after date of acceptance. At the same time the exporter in a foreign land receives his payment on a cash basis as soon as he presents to the local representative of the issuing bank evidence that he has shipped the goods according to contract.
The financing of commercial credit may take various forms, but the principles upon which the whole business is based may be shown by a, concrete case.1 A silk manufacturer in Paterson, New Jersey, purchases by cable ten bales of raw silk in Canton. China. He goes to his banker in New York and gets a commercial letter of credit covering the terms of his purchase. Such a letter would be addressed to some bank in London requesting it to "accept" the drafts of the Canton merchant up to a specified amount and under certain conditions relating to bills of lading, insurance papers, etc. The New York banker sends the letter of credit to the silk exporter in Canton, who ships the goods to New York after having them insured and receiving the marine bill of lading and the insurance certificate. The Canton merchant then draws a four months' draft on the London correspondent of the New York bank, attaching to it the invoice, bill of lading, and other shipping papers. He takes the draft to his local bank and sells it at the prevailing rate for four months' exchange on London. He has received his payment for the goods and is out of the transaction.
Long before the silk gets to New York the draft will reach London and be presented to the London correspondent of the New York bank. If the London banker is l Escher, pp. 143-160.
satisfied that the draft and the documents conform to the terms of the credit, he accepts the draft, marking it payable four months from the date of presentation. He then dispatches the documents which were attached to the draft to the New York banker by mail steamer. After a time the silk also arrives and arrangements must now be made by which the Paterson manufacturer may get possession of it. He has not paid anything on the importation, yet he wants the goods. On the other hand, when the banker,, surrenders the bill of lading he parts with the only security he has for the payment of the draft for which he is responsible through his London correspondent. Sometimes the goods are stored and turned over to the merchant only when he shows that he has sold them and needs them to make delivery. In the case of this raw silk it may be warehoused and parcelled out to the manufacturer in small lots as needed. More generally the importer gets possession of the goods by signing a "trust receipt."1 This receipt states that the manufacturer has received the goods and that he will sell them and apply the money received to the payment of the four months' draft before or at maturity. The particular form of receipt will depend upon the standing of the firm signing it. Most trust receipts stipulate that the proceeds from the sale of the goods will be kept separate from other assets of the firm and deposited with the banker as the goods are sold. At the end of the four months the draft drawn by the Canton firm and accepted by the London bank falls due and the New York banker must remit funds to meet it. If before the draft matures the Paterson concern has not met its obligation to the New York banker by prepayments as the silk is manufactured or sold, the banker will send it a memorandum of the amount due, which will be the face of a demand draft at the ruling rate of sight sterling plus the banker's commission. The Paterson firm sends a check for the amount. The New York banker then buys demand exchange on London and remits it in time to cover the maturing draft in London, thus closing the entire transaction.
Commercial Letter of Credit - Front.
Commercial Letter of Credit - Back.
1 For form of trust receipt, see Escher, p. 150.
We have already noted the advantage to both the importer and the exporter in the use of the commercial letter of credit. The banker's interest in the transaction is one of commission. The New York banker gets a commission from the silk importer, and the London banker on whom the credit is issued gets a commission for accepting the drafts. Yet neither banker has had to put up any actual money, the whole operation being based upon the banker's credit.