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:
Irrevocable and Revocable LC: 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.
Standby LC: 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.
Confirmed and Unconfirmed LC: 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)
Transferable LC: 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.
Back to Back 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.
Payment at sight LC: 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.
Red Clause: 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.
Restricted and Unrestricted LC: 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: 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.
BENEFITS OF LC
- The letter of credit is considered beneficial for both the buyer as well as the supplier in international trade.
- The various advantages of a letter of credit for a buyer i.e. importer:
- The buyer is assured delivery of goods within the specified time period given in the letter of credit. The buyer has to make payment after receiving the documents and receiving the shipment of goods.
- Since the importer’s bank makes the payment on its behalf it gives creditworthiness and makes it easier for the importer to carry out trade. At the same time, it gives extra time to the importer to arrange money for making the payment since they know the payment schedule and hence they can plan accordingly
- A letter of credit reduces the chance of non-performance by the exporter.
The advantages of a letter of credit for an exporter i.e. seller:
- A letter of credit works as a guarantee to the exporter that assures timely payment irrespective of the importer’s financial status.
- There is a possibility that the exporter might receive payment after submission of documents and before the delivery of goods. In such a case payment takes place before goods are delivered to the importer.
- A LC makes it easier for the exporter to secure pre order financing and it also mitigates the risk of dealing with an unknown importer in a foreign nation
- Payment cannot be refused by the importer on account complaint about the goods.