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

Oct 28, 2020 - 06:13 AM Author - Alex Pardin


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.

Different Types of Letter Of Credit

A letter of credit is an important international trade 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:

Commercial letter of credit - They are the standard letter of credit also known as import/export or documentary letters of credit commonly used in international trade. This is issued by a bank with a guarantee to pay & act as a neutral third party after fulfilling all the conditions mentioned in the agreement.

Standby Letter of Credit- This type of letter of credit is something different from other types of letters of credit. Instead of facilitating a transaction, the standby letter of credit offers payment or compensation if something goes wrong or fails. They are very similar to a commercial letter of credit but they are only payable when the beneficiary or payee proves that they did not get what was promised.

Confirmed Letter Of Credit - In this type of letter of credit, the bank confirms the letter of credit and guarantees that the payment will be done to exporters. This happens in the case when the exporters do not trust the respective bank that has issued a letter of credit on behalf of the buyers as they are not familiar with it. So they require the bank to confirm the letter of credit in their home country that they will have to pay the exporters.

Unconfirmed letter of credit - In this type of letter of credit, the correspondent bank hardly notices the letter of credit and hence there are no promises made. In this case, the seller may rely on the issuing bank and bear the risk.

Revocable letter of credit - This is the letter of credit that can be changed or altered by the issuing bank or buyer anytime without any prior notification to the seller. Usually, these types of letters are not used as sellers do not get any protection.

Irrevocable letter of credit - It is a letter of credit that does not allow buyers and issuing banks to make any changes without the approval of concerning parties. It cannot be changed without authorization from involved parties.

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.