Travellers from the late 20th century and early 21st frequently used a paper form issued by a financial institution that functioned as a credit file. Later on, traveller’s checks, credit cards, and ATMs took the place of the credit file.
A letter of credit is an important payment method in international trade because it’s an excellent option when used in various market conditions. It’s advantageous when the parties involved are geographically distant from each other, have different laws, and prefer different trading customs.
A vendor can sell his goods to the purchaser without fear of not getting paid after the shipment of goods. Letter of credit ensures the seller that the bank will pay the seller if the purchaser fails to make the payment. It is a primary risk management technique utilized in worldwide commerce.
The seller has the right to demand payment from the bank if the buyer cannot fulfil the purchase. The financial institution will examine the demand and meet the terms of the letter of credit.
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What is a Letter of Credit?
Large companies must have a system to protect themselves from financial risk in today’s global economy. One strategy involves issuing a letter of credit. These pieces of paperwork guarantee that the company will receive payment for goods and services they ship. But before goods or services are imported, the company must make sure their supplier has the funds to cover the costs.
Letter of Credit (L/C) is a commercial instrument that importers and exporters can utilize to ensure the completion of their trade transactions.
A bank offers a letter of credit. It provides evidence of funds transfer from the applicant to the beneficiary. An L/C is also known as the documentary LC, which assures the completion of trade transactions while transferring funds to the supplier.
It is used for international trade. The letter of credit process includes identifying the beneficiary, the issuing bank, and both confirming parties.
Parties Involved in the Letter of Credit and their Role
The bank opens the Letter of Credit draws an order on behalf of the usually a buyer of goods. The buyer on whose behalf the LC is opened is called ‘applicant’ or ‘opener’.
#2. Issuing Bank
The bank that initiates an LC and undertakes to make payment to the beneficiary on receipt of required documentation depending on the type of the LC is called the LC issuing bank.
The beneficiary is the exporter or seller receiving the payment after selling goods or services through LC in international trade.
#4. Advising Bank
The bank informing the beneficiary about the Lending Agreement is the Advising bank. Usually, the location of the advising bank is the same as that of the beneficiary.
#5. Nominated Bank(Bank Making the payment to the beneficiary)
Nominated Bank is an international bank in the exporter’s country authorized to receive or negotiate the documents and pay the amount to the exporter.
Importance of Letter of Credit
A letter of credit carries lots of importance in international trade; some of the important features follows below:
- The buyer doesn’t have to make any advance payments; the purchaser shall make payment only once.
- The letter of credit acts as a passport for your venture to conduct more business with clients outside the country.
- A letter of credit is a commitment to the seller if the buyer is somehow not able to make the payment.
- Alongside intercontinental trade, a letter of credit can help companies and organizations obtain sufficient funding for their big ventures. Use this letter to verify the credit history of a corporation or individual. If the customer can’t pay for their purchases, the financial institution will pay them.
Benefits of Using a Letter of Credit
Understanding the importance of letters of credit as an international trade document is crucial; below are the essential advantages of LC:
- Your business will be able to develop valuable resources in new regions. Letters of credit encourage your company to broaden its existing connections and forge new working relationships.
- Letter of credit also has options to include several different terms, stipulations, and prerequisites when issuing the letter of credit. In addition, the letter can be tailored to the needs of just one transaction or multiple transactions with the designated parties.
- LC makes issuing banks independent of any counterparties’ obligations and any potential liabilities that may arise from the partners’ dealings.
- LC transfers the creditworthiness from the exporter or buyer to the issuing bank. The importer can carry out multiple transactions simultaneously as long as he has access to a conventional bank.
- A letter of credit is top security for exporters because it guarantees the importer’s ability to pay.
- An LC is simple to administer. A supplier has to demonstrate that the material he has supplied complies with the initial stipulations, and he’s saying that the goods have been shipped. The issuing bank will examine the documents and advise the seller accordingly.
- The exporter could benefit from pre-shipment financing against an LC. This advantage will maximize the possibility to relieve any funding gaps.
Disadvantages of Using a Letter of Credit
An LC also carries some disadvantages, and it is vital to know the drawbacks before moving further:
- In business, a letter of credit adds extra cost by using banks’ services to execute transactions.
- An LC belongs to complex contractual obligations, and one has risks it can be exploited.
- An LC involves a possible material fraud risk; The bank will pay the exporter once its representatives thoroughly review shipping documents and verify the terms of their deal. However, disputes and conflicts may arise if the goods received by the buyer are not of the quality that the seller assured.
- A letter of credit has an expiration date and must be used before the same.
- Details in LC need to be adjusted when the terms or amount change.
- Letters of credit are notoriously challenging to get rid of or terminate.
Types of Letter of Credit
As an LC plays a pivotal role for the entities involved in international trade, It also has various versions which are being used as per the requirement or nature of the agreement. Below are the types of letters of credit which are often used in businesses.
#1. Revocable Letter of Credit
The bank can cancel this letter of credit or modify it at the applicant’s instructions without notifying the beneficiary (Seller). The bank will, at its discretion, have no losses to bear after the revocation of this LC.
#2. Irrevocable Letter of Credit
The LC cannot be reconsidered or undone without the beneficiary’s (seller) consent. This fact represents the absolute liability of the bank (issuer) to the beneficiary.
#3. Standby Letter of Credit
This Letter of Credit is like a bank guarantee that gives a buyer and seller more flexibility in the agreement. The bank honours this Letter of Credit when the importer fails to fulfil financial obligations to the exporter.
#4. Revolving Letter of Credit
A revolving letter of credit is a particular letter of credit that buyers and sellers can use for ongoing operations. A revolving letter of credit is detailed in how it is used on the same commodity between the same buyer and the seller to replenish stock.
For example, suppose a Textile mill in India imports raw materials from Belgium regularly using a Letter of Credit. In that case, they can use the same LC for the required period until there are changes in rate and quantity. Also, other factors need to be looked after, like the fabric market and import-export policy of the govt of both the parties involved.
#5. Unconfirmed Letter of Credit
In this type of LC, the bank issuing the letter of credit shall only be responsible for paying the exporter or beneficiary.
#6. Transferable Letter of Credit
This LC allows the seller to authorize a second party(ies) to oversee a part of the Letter of Credit. This inclusion of double or more parties in the LC can occur when the seller is not the exclusive manufacturer of the goods. And the seller is purchasing different parts from different manufacturers to produce the product.
#7. Payment at Sight Letter of Credit
Bank will make the payment as soon as it receives all the necessary documents related to the agreement and transactions between the buyer and the seller. Payment at sight LC orders the bank to pay to the exporter immediately.
#8. Deferred Payment Letter of Credit
The bank is not liable to pay immediately to the exporter after receiving the necessary documents. Instead, the bank shall clear the outstanding later, as mentioned on the deferred payment letter of credit.
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The Process of Letter of Credit
The process of an LC is an easy and secure way to conduct business. Let us look at the life cycle of an LC stepwise:
Process 1: The client or the applicant approaches the issuing bank to apply for a letter of credit. This bank is known as a permitting or opening bank.
Process 2: Typically, advising banks are in the same country as the beneficiary. They will receive a Letter of Credit issued by the buyer’s issuing bank. Additionally, the advising bank will verify the authenticity of the letter of credit by checking the name, product description, etc.
Process 3: Advising bank assures the seller regarding the payment through LC And guides the seller to proceed with the agreement. The banks are now the intermediaries who will facilitate the transmission of this letter of credit.
Process 4: The seller will ship the goods as agreed by the buyer after making payment guarantees on the product. The seller will then receive the bill of lading.
Process 5: The Nominated or the Accepting bank will now compose the Bill of Lading for the buyer. After the shipping documents are checked in the bank, it will then make the payment to the seller or exporter.
Process 6: Now, the nominated bank will send the shipping documents to the issuing bank and demand payment.
Process 7: Issuing Bank will notify the buyer by sending documents for approval, ensuring that they are correctly filled and all the products have been shipped.
Process 8: The buyer then pays the issuing bank. Further, the issuing bank sends the payment to the nominated or negotiating bank. And hence the process cycle of letter of credit gets completed.
Documents Required to Apply for Letter of Credit
- Correctly filled application form with passport size photograph.
- KYC of the applicants
- Financial documents of the buyer
- Related commercial documents, Proforma invoice with details of the goods and price
- Required copies of the seller
- Advising bank details (from the side of the beneficiary)
In this article, we have tried to explain how a letter of credit is an arrangement that guarantees a buyer will receive goods from a seller. It is used as a way for buyers to purchase from sellers from another country with whom they don’t have a prior relationship and who may not accept their form of payment. The letter of credit also allows the bank to provide funds up-front to the seller, which alleviates some of the risk associated with international trade.