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Guide to Letter Of Credit: Definition, Types, and Procedure

Being a global businessman, you have probably heard or aware of the term "Letter of Credit". Today, the letter of credit has become a crucial and important part of international trade that soothes the smooth international transactions made by any businessman. What is it exactly? Find out.

Guide to Letter Of Credit

Well, a letter of credit is a document issued by one bank to another with a guarantee to pay a specified sum of money to the seller on behalf of the buyer. In simple words, if the particular buyer is not in a condition to pay the seller on time, the payment will be made by the bank. It is an important document in the case of international dealings and is one of the major financial services that are required by global businessmen. One of the most important & crucial functions of a letter of credit is that buyers and sellers both can reduce their risk and ensure on-time payment with the delivery of goods and services.

1. Seller Protection - With the letter of credit, the sellers are fully-protected as in the case, if the buyer is unable to pay the money to sellers, it will be made by the bank that has issued a letter of credit only if the seller meets all mentioned requirements in the letter. This is very useful if both the parties i.e. buyers and sellers are in different countries.

2. Buyer Protection - Letter of credit also protects buyers. If you are paying someone to get products or services and if they fail to deliver, you are able to get paid by using a standby letter of credit.

Key Points to Keep In Mind about Letter Of Credit:

There are some important & essential things you should know about the letter of credit. Here they are as follows:

1. A letter of credit provides security to both i.e. buyers and sellers.

2. Letter of Credit issued by a bank only after when a Business asks for it instead of an individual and possesses some assets or credit to get the approval.

3. They are complicated and easy enough to make any expensive mistake.

Types of Letter Of Credit

A letter of credit is an important international trade finance instrument that guarantees the sellers that they will be paid for the large transaction under international trade. There are various types of letters of credits in the international trade transactions you can avail according to your preference and suitability. Some of them are here as follows:

Sight Letter of Credit 

Under a sight letter of credit, payment is made to the seller immediately after the required documents have been submitted to the authorized bank, provided the conditions in the letter of credit have been met. Banks are, however, allowed a reasonable period of time for checking purposes (not more than five working days after they receive the documents).

Deferred Payment

In the case of a letter of credit with deferred payment, the payment to the seller is not made when the documents are submitted, but instead at a later time defined in the letter of credit. In the Asia, this kind of documentary credit is also known as a "usance L/C."

Acceptance

In the case of an acceptance credit, the payment to the seller is not made when the documents are submitted, but instead at a later time defined in the LC. The seller can request a discount from the bank that accepted the bill of exchange, or from another bank, and thus draw the amount of the bill minus the discount at any time after the documents have been submitted.

Negotiable Credit

Negotiable Credit Under UCP 600 (Uniform Customs and Practice for Documentary Credits, 2007 revision, article 2) negotiation means the purchase by the nominated bank of drafts (drawn on a bank other than the nominated bank) and/or documents under a complying presentation, by advancing or agreeing to advance funds to the beneficiary on or before the banking day on which reimbursement is due to the nominated bank. Unfortunately, the term "negotiable credit" is understood and applied in different ways in different parts of the world.

Transferable Letter of Credit (LC)

Transferable letters of credit are particularly well adapted to the requirements of international trade. They allow an intermediary to transfer a LC to a supplier, thus enabling the intermediary to reduce the extent to which it uses its own funds to process business transactions

Revolving LC

If the buyer requests partial deliveries of the ordered goods at specific intervals (contract for delivery by installments), payment can be made under the terms of a revolving global letter of credit that covers the value of each consecutive installment. The bank is normally liable for the total value of all agreed partial deliveries. However, the second partial payment is not effective until the first installment has been paid, and so forth.

Red Clause LC

In the case of a red clause credit (letter of credit with advance payment), the seller can request an advance for an agreed amount (defined in the terms and conditions of the letter of credit) from the correspondent bank. This advance is basically intended to finance the manufacture or purchase of the goods to be delivered under the letter of credit. The advance is normally paid against receipt and a written undertaking from the seller to subsequently deliver the transportation documents before the credit expires.

Green Clause LC

Unlike the red clause LC, in the case of a green clause letter of credit, the advance is normally paid not only against receipt and a written undertaking from the seller to subsequently deliver the transportation documents before the credit expires, but also against receipt of an additional document providing proof that the goods to be shipped have been warehoused.

Unconfirmed 

In the case of an unconfirmed letter of credit, the correspondent bank merely notifies the seller that a letter of credit has been opened. In this case, it makes no promise to pay and is therefore not required to honor documents presented by the seller. As a result, the seller may rely exclusively on the issuing bank (letter of credit service provider bank) and therefore bears the collection risk of the issuing bank and the country risk – according to their domicile – as well as the transfer risk.

Confirmed

If the correspondent bank confirms the letter credit (on behalf of the issuing bank), then it is committing itself towards the seller to honor documents that are in compliance with the documentary credit terms and presented on time. In this case, the seller receives not only an obligation by the issuing bank but also a legally equivalent and independent promise of payment on the part of the correspondent bank. The seller then bears the collection risk of the confirming bank and, if this bank is not domiciled in his country, the corresponding country risk – according to its domicile – as well as the transfer risk.

Revocable

All letters of credit subject to the current "Uniform Customs and Practice for Documentary Credits" (UCP 600), which is effectively the norm nowadays, are regarded as irrevocable. It is possible in theory to open a revocable LC, but this is no longer done in practice for various reasons (difficult wording/insufficient security [revocation]).

Irrevocable

An irrevocable LC is a firm commitment by the issuing bank to make payment if the documentary credit conditions are fulfilled. It may not be amended or canceled without the consent of the seller and all obligated banks. If the seller wishes to amend or cancel individual conditions of the letter of credit, then he must ask the buyer to issue an instruction to the issuing bank in this respect.

Procedure for a Letter of Credit

Now you know what a letter of credit is and its types and advantages. But now you must start wondering, "How to open a letter of credit?" or "What is the procedure to get the letter of credit?" In this blog post, we are explaining a brief guide to get the letter of credit. Let’s  give it a look:

Who Opens The Letter Of Credit?

A letter of credits is opened by the importer's bank in favor of the exporters in accordance with the instructions provided by the importers. In other words, importers are the ones who provide the terms and conditions of the letter of credit.

Step-By-Step Guide to Letter of Credit

Signature Of Sales Contract - At the very first step, the importer needs to sign a sales contract with terms & conditions of the sale including delivery period, good descriptions, prices, and delivery date and many more.

Contact Your Bank - First, you need to approach your bank to open a letter of credit. After discussing the terms of sales, the banking officer will draw up the letter and help you in filling the necessary information like the completion and evaluation of the application form.

Submit LC To The Buyer - After creating the letter of credit, the issuing bank sends it to the buyer i.e. importer for getting the approval. The seller or buyer may ask for making some changes. The bank makes changes and once all three parties get agreed, we can conduct business with the seller.

You must ensure that a documentary letter of credit is released and the standby letter of credit is renewed.

How Does The Payment Make?

With the letter of credit, a beneficiary i.e. holder of the letter of credit only gets paid after executing some required actions and fulfilling the requirements mentioned in the letter of credit.

1. For International Trade - The exporter is required to deliver the merchandise to the shipyard to fulfill the requirements of the letter of credit. After the delivery, the exporter gets the documentation proving that he has made the delivery. Then it is forwarded to the bank. In some cases, the letter of credit is required to be paid at the time of delivery only. The letter of credit helps to keep international trade finance transactions secure & safe.

2. Required Documents - To initiate the payment on the letter of credit, the bank first analyzes the document to get the assurance that the exporter has executed required actions irrespective of the quality of goods or other items.

3. For Performance Transaction - If the buyer wants to receive the payment on the basis of a standby letter of credit, he has to prove that he did not get the delivery as asked and the seller has failed to do his actions. In such situations, the bank is responsible to pay the one who has suffered.

In today's time, the letter of credit is an essential document for global businessmen to carry smooth international transactions. So make sure to open a letter of credit with a reliable and authentic financial institution.