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The process described below and the diagram that follows provide an example of a trade transaction creating a commercial letter of credit and a banker’s acceptance. The numbers in parentheses refer to the steps in the diagram. In addition, a more detailed explanation of the different roles that a bank may take in a commercial letter of credit transaction is provided at the end of this section.

Process

NE Trading is interested in purchasing 20 personal computers from Tokyo Tech (1). Because the two companies have never done business with each other, Tokyo Tech requires that NE Trading obtain a commercial letter of credit. The letter of credit places the bank in the intermediary role to facilitate the transaction’s completion.

NE Trading takes the computer purchase contract to its bank, FNB, and completes an application for a commercial letter of credit (2). FNB opens the letter of credit and sends the original and a copy to Tokyo Tech’s bank, Suki Bank (3). Tokyo Tech is not familiar with FNB, so it pays a fee to have Suki Bank confirm the letter of credit, which makes Suki Bank liable should NE Trading and FNB fail to perform under the letter of credit. Suki Bank staff members verify the letter of credit and notify Tokyo Tech of its validity (4).

Tokyo Tech ships the goods to NE Trading (5) and presents the shipping documents to Suki Bank (6) to have them negotiated. Along with the documents is a draft, drawn on FNB, for the selling price of the goods. This example uses a time (90 days) draft. The terms of the draft were negotiated when the terms of the letter of credit were determined. Suki Bank examines the documents and, if they meet the terms and conditions of the letter of credit, sends the draft and the shipping documents to FNB (7). Had it been a sight draft, Suki bank would have made payment of the invoice amount to Tokyo Tech and mailed the draft and documents to FNB, requesting that its account be credited for the amount paid.

FNB compares the documents with the letter of credit to ensure that they meet the letter’s terms and conditions. If all is in order, FNB gives NE Trading the documents (8) and an advice of amount paid, and notifies Suki Bank that it “accepts” the draft (9). The term “accepted” is stamped on the face of the draft, thus creating a banker’s acceptance. If NE Trading were a large corporation with a market name, it could accept the draft itself without requiring FNB to accept, creating a trade acceptance.

By accepting the draft, FNB has accepted Tokyo Tech’s demand for payment and has committed to paying Tokyo Tech in 90 days. The accepted draft is then sent to Tokyo Tech, through Suki Bank (10). As part of the letter of credit agreement, NE Trading is required to pay FNB within 90 days (11). FNB then uses those funds to pay Tokyo Tech, through Suki Bank (12, 13).

Appendixes > Appendix C

Tokyo Tech may hold the acceptance until maturity and present it to FNB for payment, or it may obtain immediate cash by selling the acceptance to an investor, perhaps to FNB or Suki Bank. In the latter case, Suki Bank would then present the acceptance at maturity to FNB for repayment.

When FNB accepted the draft in the example, it acquired an unconditional obligation to pay at maturity a specified amount, either to Tokyo Tech or to the holder of the instrument if Tokyo Tech discounted the acceptance. If discounted, Tokyo Tech would remain secondarily liable to the holder (purchaser or discounter) of the acceptance in the event of default by FNB.

If FNB purchases (discounts) its own acceptance, it may elect to hold the acceptance in its own portfolio. In this event, the acceptance is recorded as a loan to NE Trading and must be funded like any other loan. More commonly, however, the bank will choose to replenish its funds by selling (rediscounting) the acceptance in the secondary market, either directly or through a dealer. If the banker’s acceptance is not held in portfolio, the bank records its obligation as “acceptances executed.”

When an acceptance is sold, ownership is transferred by endorsement to another party termed “holder in due course.” The holder in due course has recourse to all previous endorsers if the bank creating the acceptance does not pay. The secondary obligor (payee on draft) has an unconditional obligation to pay if the accepting bank and endorsers do not, hence the term “two-name paper.”

Appendixes > Appendix C

Sample Trade Transaction

Participants in a Commercial Letter of Credit Transaction

The key roles that a bank may play in a commercial letter of credit transaction are described below. A bank may play more than one role in the transaction.

• Issuing or opening bank: The bank that issues a documentary credit on the instructions of the importer (account party). The bank is usually, but not necessarily, the importer’s own bank. It is obligated to pay if the documents presented are in accordance with the terms of the letters of credit. The issuing bank is usually located in the importer’s country.

• Advising or notifying bank: The bank that notifies the exporter (beneficiary) that a letter of credit has been opened by the issuing bank and informs the exporter of the terms and conditions of the letter of credit. The advising bank is usually located in the same place as the exporter and can be a branch office of the issuing bank or a correspondent bank. The issuing bank most often sends the letter of credit through its branch office or

Appendixes > Appendix C

correspondent bank to avoid fraud. The exporter, however, can request the importer to specify the exporter’s bank as the advising bank. The exporter’s bank might not be the issuing bank’s correspondent bank. The advising bank is not responsible for the payment of the letter of credit that it advises unless it adds its own confirmation to pay.

• Confirming bank: The bank that has added its commitment to that of the issuing bank to pay the letter of credit, providing all the documents are in order. This commitment holds even if the issuing bank or the importer fails to make payment. Some beneficiaries (exporters), particularly those not familiar with the issuing bank, ask the buyer to have the letter of credit issued in the importer’s country and “confirmed” by a bank in the exporter’s country.

• Negotiating bank: The bank that negotiates or accepts the documents for examination and, if these documents are in order, remits payments to the beneficiary. The term “negotiation” arises when a letter of credit calls for sight draft but reimbursement is on a remittance basis or it takes time to be paid by a reimbursement bank. The negotiating bank normally is authorized by the issuing bank to negotiate documents and is specifically named in the letter of credit. If the letter of credit indicates that it is

“available with any bank by negotiation,” the issuing bank authorizes the beneficiary to present documents to the bank of his or her choice for examination and collection of payment. The negotiating bank is usually the paying bank.

• Paying bank: The bank that effects payment of documents negotiated under a letter of credit. It is usually also the negotiating bank, unless the letter of credit allows another bank to negotiate or the paying bank is unable to negotiate.

• Reimbursing bank: The bank with which the issuing bank maintains an account. This bank is authorized by the issuing bank to charge that account to pay claims received from the negotiating or paying bank for documents that have been presented.

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