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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.

Importance of Letter of credit

International trade includes many factors such as distance, different laws in each country and the lack of personal contact and for these factors letters of credit act as a reliable payment mechanism. 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.

Thorough Documentation

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.

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 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 get the required documentations 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.
  • After this the confirming bank forwards the documents to the issuing bank
  • 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

Who uses Letter of Credit?

  • 1) Overseas business: International trade and wholesale producers are the primary users of LC.
  • 2) Online businesses: Many online or e-commerce and service businesses often consider Letter of Credit for overseas transactions.
  • 3) Small and medium enterprises:

Key features of Letter of Credit:

  • Avoids potential disputes overseas
  • Some form of guarantee to a seller/supplier that they will get paid
  • Flexibility and variability across different types of LCs
  • Secure payment method endorsed by most major markets
  • Risk of non-payment is taken by the banks rather than the buyer
  • Often required by national border/exchange control agencies

Parties involved in letter of credit

  • Applicant of LC
  • LC issuing bank
  • Beneficiary party
  • Advising bank
  • Confirming bank
  • Negotiating bank
  • Reimbursing bank
  • Second beneficiary

Benefits of LC to seller

  • check_circle_outlineHelps to reduce production risk, if the buyer cancels order
  • check_circle_outlineGet financing in pre shipment and post shipment form
  • check_circle_outlineImThe seller has the obligation of buyer's bank to pay for the shipped goodsprove
  • check_circle_outlineThe payment date for the shipped goods can be calculated by the seller
  • check_circle_outlineDue to a complaint about the goods the buyer will not be able to refuse to pay

Benefits of LC to buyer:

  • check_circle_outlineLet the buyer to decide the time period within which the goods must be shipped
  • check_circle_outlineThe buyers solvency can be demonstrated by a letter of credit
  • check_circle_outlineIn the case of issuing a LC providing for delayed payment, the credit is granted to the buyer by seller
  • check_circle_outlineIt allows the buyer to avoid or reduce prepayment

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