Letter of Credit

A letter of credit is a form of payment commonly used in global trade in which a bank gives a monetary promise to businesses that import and export commodities. Both exports and imports are possible with a letter of credit. Businesses doing business globally must engage with unfamiliar suppliers and must have a guarantee of payment before proceeding with any transaction. 

Types Of Letter of Credit

Letter of Credit for Commercial transaction

This is a frequent type of letter of credit used in global trade. A “documentary credit” or a “import/export letter of credit” are other terms for it.  When all of the terms of the deal have been met, a bank acts as a neutral party to release funds.

Letter of Credit on Standby

This form of letter of credit is unique in that it guarantees payment if something goes wrong.

A standby letter of credit, rather than facilitating a transaction, compensates when something goes wrong. Standby letters of credit are similar to commercial letters of credit in that they are only payable if the payee (or “beneficiary”) can demonstrate that they did not get what was promised in a contract.

LC for export/import

Based on who uses it, the identical LC becomes an exporter or importer LC. It will be addressed to as an export letter of credit by the exporter, and an import letter of credit by the importer. 

LC that can be transferred

A LOC permits a beneficiary to transfer all or part of a payment to another beneficiary chain. This is most common whenever the beneficiary is merely a middleman for the true supplier. This type of LC should allow the beneficiary to furnish its own documentation while still transferring the funds.

LC that isn’t transferable

This sort of letter of credit restricts funds from just being transferred to a third party. The funds are only sent to the intended recipient, and also the credit would be used to compensate anybody else.

LC that is revocable

The bond issuer or the buyer can alter an LC at any time without telling the vendor or beneficiary. These letters are not widely used since the recipient is not protected.

Irrevocable LC

This is the type of LC in which the issuing bank is prohibited from making any changes without the consent of all parties.

How Does It Work?

The issuing bank might act on the instruction and guidance of the client under their own behalf under a letter of credit. The bank can transfer the money to (or on behalf of) the beneficiary under an LC agreement. Alternatively, the exporter’s cash transactions or draughts can be accepted by the issuing bank. 

Characteristics of a Letter of Credit

• A letter of credit is granted in exchange for collateral/security, which could include the buyer’s fixed deposits and bank deposits, among other things.
• Depending on the form of a Letter of Credit, the bank may incur costs.
• The International Chambers of Commerce (ICC) publishes guidelines for any type of Letter of Credit.
• Banks will refuse payment if they discover even the tiniest error in the buyer’s name, product name, shipping date, or other details.

Process of letter of credit

The Letter of credit process actually happens between three people. They are buyer, seller and buyer’s bank.

The following steps clearly explains the process

Step 1: The person who wants to buy goods will make an agreement with the person who is selling the goods. The agreement may be any type. It might be a formal contract etc .Also in agreement might include any type of information.

Step 2: The buyer applies for a letter of credit with his bank by signing the letter of credit application provided by the bank.

Step 3: After the application was approved, the bank which is issuing money will send the letter of credit to the person who is selling goods.

Step 4: The seller will send goods to the buyer, only after the bank make sure of payment details

Step 5: The seller now prepares the documentation details that are mentioned in the letter of credit and gives them to the bank.

Step 6: The bank now examines all the documents of the seller. If all the documents are correct, then the bank starts paying money to the seller.

Step 7: The buyer or the applicant will transact money according to the terms of the letter of credit.

Step 8: after all the process has been done, the buyer uses documents and takes the goods.

Conclusion

A Letter of Credit is a contractual agreement between the foreign buyer’s bank and the exporter’s bank to pay after the exporter ships the products and shows the relevant papers as proof.

Letters of Credit are a trade financing mechanism that protects both seller and buyer. They can assist you in gaining new business in overseas markets. This means that the exporter receives a payment guarantee while the importer receives fair payment terms. If the buyer is unable to pay the whole sum due, the bank that issued the LOC will be required to pay the selling.