A letter of credit provides an irrevocable guarantee to the seller that provided the goods and/or services are delivered to the buyer according to contractual terms and with the required documents, it will be paid by the bank that issued letter of credit. It also provides assurances to the buyer that the goods and/or services ordered will be received, in line with the required documentation and under any contractual terms set out in the purchase agreement.
Participants under letter of credit
The beneficiary is entitled for payment if he can provide the documentary evidence required by the letter of credit. Performance of the underlying contract between the seller and the buyer is not liable by issuing bank. The issuing bank's obligation to the buyer is to examine all documents to insure that they meet all the terms and conditions of the credit. If the beneficiary (seller) conforms as per the letter of credit, the seller has to be paid by the bank.
2. Issuing Bank
The issuing bank is liable to pay and get reimbursed from its customer becomes absolute after the completion of the terms and conditions of the letter of credit. The issuing banks' role is to provide a guarantee to the exporter that if compliant documents are presented, the bank will pay the exporter the amount due and to examine the documents, and pay if the documents comply with the terms and conditions set out in the letter of credit.
3. Advising Bank
An advising bank, usually a foreign bank of the issuing bank will advise the beneficiary. Normally, the beneficiary wants to use a local bank to ensure that the letter of credit is valid. In addition, the advising bank would be responsible to send the documents to the issuing bank. If the issuing bank doesn’t pay the beneficiary, the advising bank is not obligated to pay.
4. Confirming Bank
The correspondent bank might confirm the letter of credit for the beneficiary. At the request of the issuing bank, the correspondent obligates itself to ensure payment under the letter of credit. The confirming bank is usually the advising bank.
Letter of Credit Characteristics
Letters of credit are usually negotiable. The issuing bank is not only obligated to pay the beneficiary, but also any bank nominated by the beneficiary. The letter of credit has to include an unconditional promise to pay, on demand or at a definite time for negotiable.
Letters of credit is either revocable or irrevocable. A revocable letter of credit can be revoked or modified for any reason, at any time by the issuing bank without notification. Once the documents presented and met the terms and conditions in the letter of credit, and if the draft is honored, then letter of credit cannot be revoked. The revocable letter of credit is not used commonly.
The irrevocable letter of credit cannot be revoked without the agreement of the issuing bank, the confirming bank, and the beneficiary. An irrevocable letter of credit from the issuing bank insures the beneficiary that if the required documents are presented and the terms and conditions are met with, payment will be made.
3. Transfer and Assignment
The beneficiary can transfer the rights or assign the right to draw, under a credit only when the credit states that it is transferable or assignable. However, even if the credit specifies that it is nontransferable or non-assignable, the beneficiary can transfer the rights prior to performance of conditions of the credit.
4. Sight and Time Drafts
All letters of credit need the beneficiary to present a draft and specified documents so as to receive payment. Drafts are of two types – time and sight.
A time draft is not payable until a particular time period over as stated on the draft. The bank needs to accept the draft as soon as the documents comply with terms. The issuing bank has a reasonable time to verify those documents. The issuing bank has an obligation to accept drafts and pay them on maturity.
A sight draft is payable immediately once it is presented for payment. The bank is allowed a reasonable time to check the documents before making payment.
Step 1:- The buyer makes agreement to purchase goods from the seller. This agreement can be a purchase order, an accepted pro-forma invoice, a formal contract, or an informal exchange of messages. Agreement is made as to goods being purchased, how and when they are to be shipped and insured, and how and when payment is to be made. In this case, the agreement is to use a letter of credit as the payment mechanism.
Step 2:- The buyer gives application to his bank for a letter of credit, by signing the bank's letter of credit agreement form.
Step 3:- After approval of the application, the issuing bank issues the actual letter of credit instrument and sends it to the seller (beneficiary).
Step 4:- After receiving the issuing bank's assurance of payment, the seller makes shipment of the goods to the buyer.
Step 5:- The seller prepares the required documents in the letter of credit and presents them to the issuing bank.
Step 6:- The issuing bank verifies the documents. If it finds that the documents comply with the letter of credit, the issuing bank makes payment to the seller.
Steps 7 & 8:- The issuing bank gets payment from the buyer in accordance with the terms of the applicant’s letter of credit agreement and forwards the documents to the applicant.
Step 9:- The buyer uses those documents to pick up the merchandise from the shipment carrier, completes the letter of credit cycle.
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