A letter of credit serves as a guarantee that the buyer will pay the seller. It is given out by a bank and guarantees that the purchaser will pay all fees and interest due. The bank pays the whole amount or the remaining amount on the buyer’s behalf if the buyer is unable to make such a payment.
A letter of credit reduces risk. It is given out in exchange for money or a security deposit. Typically, banks charge a fee, which is a portion of the Letter of Credit’s value. If you want to know more about a letter of credit, this article will guide you to all details you need to know.
What is a Letter of Credit?
A letter of credit, sometimes known as an LC, is a written document provided by the opening bank for the importer. The exporter is guaranteed by its issuance that the issuing bank would pay the exporter for the foreign commerce carried out between the two parties.
The exporter is the LC’s beneficiary, and the importer is its applicant. An LC contains a commitment from the issuing bank to pay the given amount by the provided timetable and documentation.
An LC’s guiding idea is that the issuing bank won’t be needed to physically guarantee the shipment of the goods; instead, they will issue the payment based simply on the documentation provided. The bank has no justification to refuse the payment if the submitted papers are in line with the LC’s terms and conditions.
Why are letters of credit essential ?
A letter of credit is advantageous for both parties because it allows the buyer to prove his trustworthiness and negotiate longer payment terms by having a bank back the trade transaction. It also assures the seller the assurance that he will receive his funds upon fulfillment of the terms of the trade agreement.
What are the Characteristics of a letter of credit?
Negotiability
A letter of credit is a transactional agreement, and the conditions are subject to modification or alteration with the consent of the parties. A letter of credit must include a guarantee of payment upon demand or at a certain time to be negotiable.
Revocability
Revocable or irreversible letters of credit are also possible. The obligation to pay may be cancelled at any time since the canceled letter of credit cannot be guaranteed. All parties have equal authority and cannot alter or amend an irrevocable letter of credit without their mutual permission.
Assigning & Transferring
A letter of credit may be assigned or transferred, and the recipient may do so as well. No matter how many times the beneficiary assigns or transfers the LC, it will always remain in force.
Time & Sight Drafts
After the beneficiary submits all receipts and required documentation, the issuing bank will only pay the beneficiary when the letter of credit matures.
The required Documents for a Letter of Credit
• Commercial Invoice
• Insurance Certificate
• Packing List
• Certificate of Origin
• Bill of Lading
• Airway Bill
• Certificate of Inspection
How does a letter of Credit work?
An LC is a contract that allows the issuing bank to operate independently or at the request and direction of the applicant (importer). The issuing bank may make a payment to the beneficiary (or on their behalf) under an LC agreement (that is, the exporter). As an alternative, the exporter’s bills of exchange or draft may be accepted by the issuing bank. Bills of exchange may also be paid or accepted by advised or nominated banks with permission from the issuing bank.
Fees and expenses associated with an LC
When it comes to LC, there are several costs and refunds involved. Most of the time, all parties handle the payment under the letter of credit. Banks may charge the following fees:
- Opening fees, which include the commitment costs paid up front and the usance fee paid over the LC’s predetermined duration.
- Reimbursement Fee: The cost incurred by the reimbursement bank to reconcile the credit amount between the issuing bank and the confirming bank or the designated bank.
- Opening fees, which include the commitment costs paid up front and the usance fee paid over the LC’s predetermined duration.
- Reimbursement Fee: The cost incurred by the reimbursement bank to reconcile the credit amount between the issuing bank and the confirming bank or the designated bank.
Who is involved in LC Process?
The major parties involved are the following;
Applicant:
A person who asks his bank to provide a letter of credit is known as an applicant (buyer).
Beneficiary:
The seller who receives his payment through the method is essentially a beneficiary.
Issuing bank:
Also known as an opening bank, which is in charge of releasing the letter of credit upon the buyer’s request.
Advising bank:
The advising bank, which is often placed in the exporter’s nation, is in charge of transferring documents to the issuing bank on the exporter’s behalf.
Confirming bank:
When the exporter is unsatisfied with the issuing bank’s Guarantees. The confirming bank plays a vital role in providing more guarantees for the issuing bank.
Negotiating bank:
Negotiates the LC-related documentation that the exporter has provided. According to the validity of the documents, it makes payments to the exporter and requests repayment under the credit.
(Note:- It can either be a separate bank or an advising bank)
Letter of Credit Types
The following list includes the most popular or well-known letter of credit Types:
- Revocable Letter of Credit
- Irrevocable Letter of Credit
- Confirmed Letter of Credit
- Unconfirmed Letter of Credit
- LC at Sight
- Usance LC or Deferred Payment LC
- Back to Back LC
- Transferable Letter of Credit
- Un-transferable Letter of Credit
- Standby Letter of Credit
- Freely Negotiable Letter of Credit
- Revolving Letter of Credit
- Red Clause LC
- Green Clause LC
Conclusion
A letter of credit often helps the beneficiary or seller by ensuring that the buyer or issuing bank pays the seller the agreed-upon sum. Since International transactions are protected and guaranteed by letters of credit.
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