Letter of Credit is a financial document used in international trade. It is a payment guarantee given by the bank to the supplier of the goods. A “Credit Letter” issued by the bank will be a sort of promise to the goods seller if the buyer fails to make the payments. Letter of Credit is also termed as “Lifeblood of International Commerce’’. Letter of credit is the most secure, safe and legal financial instrument used in global trade businesses to ensure on-time payments.
Major advantage of letter of credit to a supplier is minimizing of credit risk. Buyer cannot deny payment by raising dispute on quality of goods, as letter of credit terms & conditions are based on documentation.
Components of Letter of Credit
- Issuing Bank- The banks that offer credit.
- Applicant- arranges for payment.
- Beneficiary- receives payment from issuing bank.
- Specified time limit- payment has to be in a specified time.
- Agreement- parties agree on Terms and Conditions listed in the letter of credit
The Letter of Credit Process
There are typically seven steps
- The importer arranges for the issuing bank to open an LC in favor of the exporter.
- The issuing bank transmits the LC to the nominated bank, which forwards it to the exporter.
- The exporter forwards the goods and documents to a freight forwarder.
- The freight forwarder dispatches the goods and either the dispatcher or the exporter submits documents to the nominated bank.
- The nominated bank checks documents for compliance with the LC and collects payments from the issuing bank for the exporter.
- The importer’s account at the issuing bank is debited.
- The issuing bank releases documents to the importer to claim the goods from the carrier and to clear them at customs.
Different types of Letter of Credit
1. REVOCABLE LC– In revocable documentary credit, the bank can, at any time, amend or cancel the documentary credit on its own initiative or at the request of the buyer and shall not involve any liability by the bank towards the beneficiary.
2. IRREVOCABLE LC – A letter of credit that does not allow the issuing bank to make any changes without the approval of all the parties. Irrevocable documentary credit is therefore more advantageous to the seller as it gives more security in terms of payment.
3. CONFIRMED LC – A confirmed letter of credit is a letter of credit in which the seller or exporter has payment guarantee from a second bank or a confirming bank. It is generally issued where supplier needs confirmation from another bank, once issuer has low rating.
4. UNCONFIRMED LC – Typically, this type of letters of credit does not need other bank’s confirmation.
5. TRANSFERABLE LC – This type of letters of credit issued, when the party is not the end supplier. This means the LC beneficiary is just a middle party in the actual deal. But they have a right to request their bank to transfer, in favor of the principal supplier. Also, once the LC is transferred to the second beneficiary, it cannot transfer again to any other 3rd party. This LC is especially beneficial in those cases when the Seller is not a sole manufacturer of the goods and purchases some parts from other parties, as it eliminates the necessity of opening several LC’s for other parties.
6. STANDBY LC – This LC is closer to the bank guarantee and gives more flexible collaboration opportunity to Seller and Buyer. The Bank will honour the LC when the Buyer fails to fulfill payment liabilities to Seller.
7. BACK-TO-BACK LC – Back-to-Back Letter of Credit is a negotiable instrument in which the seller gets a Letter of Credit from the buyer and the seller further transfers the Letter of Credit to its supplier. Usually, this letter of credit is used in a transaction that comprises an intermediary between the seller and buyer.
8. RED CLAUSE LC – A letter of credit that partially pays the beneficiary before the goods are shipped or the services are performed. The seller or beneficiary can then use the money to buy, manufacture, or ship goods to the buyer. This letter of credit gives the opportunity to an exporter to obtain pre-shipment finance.
9. GREEN CLAUSE LC – Green Clause Letter Of Credit is the extended form of Red Clause Letter Of Credit. A letter of credit that pays advance to the seller just not against the written undertaking and a receipt, but also a proof of warehousing the goods. This type of letter of credit is usually used in transactions related to commodity market such as wheat, rice, gold, etc.
10. SIGHT LC – In a sight letter of credit, the payment for the transactions is released immediately after the seller presents the required documents to the advising bank. This includes invoice, packing list, bill of lading, insurance, etc. It is also known as letter of credit at sight.
11. DEFERRED PAYMENT LC – A letter of credit that ensures payment after a certain period of time. A type of Letter of Credit in which a conditional undertaking is taken by the bank to pay the seller on behalf of the buyer on a specified future date after completion of the transaction. A deferred payment letter of credit is naturally a better deal for buyers than for sellers. These are also known as term or usance letters of credit.
12. REVOLVING LC – A single revolving letter of credit can cover several transactions between the same buyer and seller.