Letter of credit
An LC is a financial document which is provided by a third party i.e. a bank or a financial institution that guarantees the payment for goods and services to the exporter once the exporter submits the required documents. A letter of credit has three important elements – the beneficiary i.e. seller who is the recipient of the LC, the applicant i.e. buyer who buys the goods and services and the issuing bank that issues the LC on the buyer’s request.
It is the most versatile and secure instruments for international traders. LC can also be termed as letter of guarantee. The required documents are responsible to protect the interests of both the buyer and seller as they can get paid immediately or at a later predefined date. If the required payment is done immediately to the seller than we call it on sight, but there are chances that the importer might do the payment once the shipment has reached the destination. It can be classified into two categories i.e. revocable and irrevocable. Irrevocable cannot be changed until both parties agree over it whereas, revocable can be changed as per one. Thus revocable is inadvisable to avoid risks.
Types of Letter of Credit:
There exist various types of letter of credit (LC) to support trade transactions. LC classification by their purposes:
- Commercial LC : A standard LC which is also known as documentary credit
- Export / Import : Depends upon who uses it. If used by an exporter then termed as an exporter letter of credit and vice versa.
- Transferable and Non-Transferable LC : A transferable LC allows a beneficiary to further transfer all or a part of the payment to another supplier in the chain or any other beneficiary. This happens in the case of intermediary. Whereas non- transferable LC doesn’t allow to transfer of money to third parties.
- Revocable and Irrevocable LC : Revocable LC allows the issuing bank or the buyer to alter the terms at any time without any notification to the seller or beneficiary. Whereas the irrevocable LC doesn’t allow the issuing bank to make any changes without the approval of all the parties.
- Stand-by LC : Standby letter of credit ensures the payment to the seller if anything wrong happens i.e. if the buyer does not pay.
- Confirmed and Unconfirmed LC : In confirmed LC along with the issuing bank the advisory bank also guarantees the payment to the beneficiary. Whereas in unconfirmed LC assurance is given only by the issuing bank.
- Revolving LC : If there exists more than one transactions then in spite of getting multiple LC’s revolving LC is chosen to cover multiple transactions. It is further classified as Time Based (Could be Cumulative or Non-Cumulative) and Value Based.
- Back to Back LC : In this type of LC there is involvement of an intermediary and two LC’s are issued. One LC is issued by the buyer’s bank to the intermediary and another by intermediary’s bank to the actual seller.
- Red Clause LC : As per this partial payment is made before the shipment of goods. The advance is paid against a written confirmation from the seller and the recipient.
- Green Clause LC : Partial payment as an advance but not only on the basis of written confirmation but the proof of warehousing of goods is also considered.
- Sight LC : As per this payment is made after the submission of required documents. Documents are reviewed by the bank and beneficiary is paid if the documents meet the conditions specified within the letter of credit.
- Deferred Payment LC : It ensures payment after a certain period of time.
- Direct Pay LC : In this the beneficiary does not interact with the buyer. Issuing bank directly pays the beneficiary and then asks the buyer to repay the amount.
Letter of credit process
Letter of credit can be availed by the following process:
- Buyer and seller finalize to conduct business. Then the seller demands letter of credit for guaranteeing the payment.
- Post to business confirmation buyer applies for a letter of credit from his bank in favour of the seller.
- After going through various requirements buyer's bank approves the credit risk made by the buyer, issues and forwards the credit to its correspondent bank (advising or confirming).
- Advising bank further authenticates the credit and forwards the original credit to the beneficiary.
- Seller performs the shipment of goods, then verifies and develops the required documentation to support the letter of credit. Documentary requirements vary as per the risk involved in dealing with a particular company.
- Then the seller have to present the required documents to the advising or confirming bank for the further processing of payment.
- Bank examines the documents for compliance with the terms and conditions of the letter of credit.
- If the documents are found accurate as per the conditions, then the confirming bank claims the funds by:
- Debiting the account of the issuing bank.
- Waiting until the issuing bank remits, after receiving the documents.
- Reimburse on another bank as required in the credit.
- Reimburse on another bank as required in the credit.
- Issuing bank then examines the received documents for compliance. If they are in order, the issuing bank will debit the buyer's account.
- Then the documents are forwarded to the buyer by the issuing bank
It is suggested that both the parties should inspect the documentation to avoid delays, further costs or deferred payment. Even though the guidelines and form of Letters of Credit are majorly the same around but the content may differ. Inspections of documentation include a check for errors and mistakes because minor negligence can cost a fortune in this case. Hence it is advisable to check the documentation several times and stay double sure.
How to prepare LC documents
A set of documents are required depending upon the needs and type of company. Bust most common documents that must be included within the LC drafts are:
- Commercial Invoice
A commercial invoice for export is also known as seller’s bill for commodities sold by him. It contains details in terms of name and address of the seller, description of goods, the price per unit, quantity, total value etc. It is termed as the most basic and important export document. Sometimes these invoices are also used by governments to determine the true value of goods when assessing customs duties.
- Bill of Lading
Bill of lading can be considered as a contract between the owner of the goods and the carrier. It is the document to provide proof or evidence of shipment. Serves as a shipment receipt and contains details such as type, quality and destination of goods. It can be further categorized as a straight bill of lading (non-negotiable) and a negotiable or shippers order bill of lading.
- Warranty of Title
It can be termed as a warranty which is given to the buyer by the seller. It states that the goods are good and the transfer is right. This certifies clear product transfer. It is issued to the purchaser and issuing bank expressing an agreement to indemnify.
- Letter of Indemnity
It indemnifies the purchaser against some certain stated circumstances. Indemnification is generally used to guarantee that relevant shipping documents will be provided as soon as they become available.
Usage of Letter of Credit
Letter of Credit is usually produced and formatted under the supervision and based on the guidelines of Uniform Customs and Practice for Documentary Credits, issued by the International Chamber of Commerce.
Once the order is received and then the importer will approach the bank or the financial institutions to convince them to serve as an intermediary. The role of the intermediary is to console the seller/exporter that once the goods are ships and reach the destination the payment will be done in full by the seller as per the agreement. Normally to ensure the paperwork and terms and conditions, all the involved parties are requested to follow up the terms and then sign the contract. Letter of Credit is a legally binding documents, LC is accepted by 175 countries around the globe. The main focus of the Letter of Credit is to lower the number of risks involved in global trading by ensuring the payment terms and conditions. As mentioned before, overseas markets are harder to trust since there is a geographical gap, although LC fills the gap and mainstreams the entire process.
Advantages of Letter of Credit
LC works in the favour of both i.e. buyer and supplier. It reduces the risks taken by both the parties.
Advantages of LC to seller:
- Reduce the production risk, if the buyer cancels his order
- Get financing in the period between the shipment of the products and receipt of payment
- The seller has the obligation of buyer's bank to pay for the shipped goods
- The seller can calculate the payment date for the shipped goods
- Due to a complaint about the goods the buyer will not be able to refuse to pay
Advantages of LC to buyer:
- The buyer can decide the time period within which the goods must be shipped
- The buyers solvency can be demonstrated by a letter of credit
- In the case of issuing a LC providing for delayed payment, the credit is granted to the buyer by seller
- It allows the buyer to avoid or reduce pre-payment
Parties involved in letter of credit
Following parties are involved within the LC process:
- Applicant of LC
- LC issuing bank
- Beneficiary party
- Advising bank
- Confirming bank
- Negotiating bank
- Reimbursing bank
- Second beneficiary
Who uses Letter of Credit?
Many businesses that trade in large quantity, it could be domestically or overseas both. Since there were cases of default non-payment issued from the customer end. Hence to ensure the cash flow of the company and lowering the risk associated with trading LC are useful to any sort of business. In addition to that, an LC can also benefit companies that structure their business around e-Commerce or services.
The following points should be considered to decide whether to request LC or not:
- The cost integrated and the risks involved with non-payment. The parties will incur the cost.
- Expertise and Legal requirements
- Documentation needed
- The supplier / Customer creditworthiness
Difficulties and problems with Letters of Credit
- It is difficult to get technical check assistance in letter of credits and it becomes questionable when it comes to small Letters of Credit if they are profitable or not for traders;
- It is doubtful if they are 100% self liquidating;
- More risks are attached with specific countries that banks are now prevented from dealing with whereas LC’s are not;
- LCs are more seen as a mode of payment and as a guarantee of payment;
LC’s are seen as a revocable instrument. This can be due to the poor drafting and governing law and clauses added with it. The following points are not covered in letter of credit;
- The LC does not reflect the commercial reality of today’s market.
- Difficult terms are involved that may lead to delay and can increase resultant costs through the requirement.
- Information along with the terms and conditions is needed to be efficiently shared amongst all the parties involved in the process.
- It may be difficult to deal with a bank for availing LCs and along with this inexperienced document checkers can raise issues
A letter of credit is widely used in international trade. In both the markets i.e. global market and a local one, as a buyer you always need to pay for your purchase, which is facilitated by letter of credit. Due to its effectiveness it is considered as the safest mode of payment in international trade. It is a very helpful tool which ensures smooth trade transactions. However, it is in the interest of the parties to be fully aware about the technicalities, advantages and disadvantages of the letter of credit. It reduces the credit risk involved for buyer as well as seller.