Definition of Letter of Credit:
A letter of credit or LC in simple words refers to a written guarantee or commitment to pay, by a buyer’s (importer’s) bank, which is also known as the issuing bank to the exporter’s or seller’s bank, which is referred to as the negotiating or accepting bank. A letter of credit is also named as a documentary credit or a banker’s commercial credit. LC guarantees payment on the terms that the exporter submits the required documents within a specific time frame. The documents include (clean bill of lading, commercial invoice, certificate of origin, etc.). The person to whom the letter of credit is issued (the exporter) is known as the beneficiary. The importer may make the payment to its bank (the amount that is to be paid to the exporter) or it may negotiate to get credit.
There are various types of letter of credit that are used in international trade which are:
An irrevocable LC is the type of Letter Of Credit that can be cancelled or changed only with the consent of the beneficiary. Thus, the bank becomes dependent on the exporter and its bank. A revocable LC is an LC that can be cancelled and changed by the applicant (importer) without the approval of the beneficiary. The bank will have no liabilities to the beneficiary after revocation.
A standby LC is somewhere close to a bank guarantee since the bank makes payment only when the buyer (importer) fails to fulfil payment liabilities of the exporter or seller.
In case of a confirmed LC, the exporter’s bank adds a condition that the payment will be made irrespective of the importer making payment to its bank. In case of an unconfirmed LC, the issuing bank will be liable only for payment of this LC (only when the importer makes the payment)
When a particular LC can be transferred by the main beneficiary to another secondary beneficiary, the LC is said to be transferable. However, the second beneficiary cannot further transfer the LC.
In case of a back to back LC, a new LC is issued by the main beneficiary to the second beneficiary taking the original LC as security or guarantee. It is usually used for exporters or suppliers of goods.
A payment at sight LC also known as sight LC, is characterized by immediate payment (within 7 days) after the required documents have been submitted.
The seller may request and get an agreed amount as advance before the submission of documents and shipment of goods. This portion is printed in red in the document and thus is termed as red clause.
Under a restricted LC only a specific bank is designated to pay for, accept and negotiate the LC. In case of an unrestricted LC there is no such designated bank
Usance LC is a LC wherein credit is paid for by the importer after an indicated period accepted by both buyer and seller. Thus, payment isn’t made immediately after the presentation of documents.
How banks fund Letter Of Credit?
A question hovers in the mind, that, how a bank funds the LC to the buyer?Basically, this is done in the below manner:-
Documents required for Letter Of Credit
Various risks are involved in the international market. To being on a safer side, the bank from the seller’s side asks for various documents. Below lists is the document required:
Risks associated with Letter Of Credit
When you are dealing in an international market, it means, you are in an unknown sea, unknowingly of its risks associated to it; the tides and waves may hurt your boat (business) very badly, and may sink (derail) you.
Risks that can come into your way are as below:-
Any of the party may fail to fulfill the contract, for example, the buyer may not have enough finance available to him, to make a purchase after he has given an order to the seller.
Letter of Credits are used for:-
Protection to buyer:
If a seller is unable to fulfill the contract, then, the buyer can go ahead and claim for the refund of the money. The bank on the seller’s side will pay the money, if the seller is not unable to pay the amount, at the time of non-delivery of the said service. This will concrete the buyer’s confidence in the international market.
Protection to seller:
If the buyer is unable to pay the buyer, then, the seller can exercise the right of Letter Of Credit. The seller can ask for the payment from the bank, which has issued the Letter Of Credit to the buyer.
The conclusion is that the Letter Of Credits are widely accepted into the international financial market. Despite being an negotiable instrument, it has widely gained popularity. Every large bank is now dealing in Letter Of Credits, as it opens the new market: for banks, buyers and sellers.
The buyers and sellers can now openly go for international trade, as they have surety of “Letter Of Credit” in their mind, that their money will not go elsewhere.
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