LETTER OF CREDIT
A letter of credit (LC), is a payment mechanism used in international trade to provide an economic guarantee from a creditworthy bank to an exporter/suppler of goods. In the recent period LCs are also used in National/Local trading also. It is also known as a documentary credit or bankers commercial credit, or letter of undertaking (LoU).
It is a letter or undertaking from buyer’s bank guaranteeing that the buyer’s payment to a seller will be received on time and for the correct amount. In the event that the buyer is failed to make a payment on the purchase, the bank will be required to cover the full or remaining amount of the purchase.
LC is an important aspect in international trade because of factors such as distance, lack of personal relationship between each party, different trade laws on each country etc. Normally LC will be sent from buyers bank or financial institution directly to the seller or seller’s bank. Buyers bank will collect a fee from buyer for issuing a letter of credit to his supplier.
It protects supplier payment by giving guarantee that if the buyer fails to pay, the bank who issued LC must pay the seller as long as the seller meets all the requirements mentioned in the letter of credit.
LC not only protects suppliers but buyers also. The supplier also needs to fulfill the conditions or requirements mentioned in the LC to get the payment against this document.
DIFFERENT TYPES OF LETTER OF CREDIT
Commercial letter of credit
Commercial letters of credit provide for direct payment by the bank to the beneficiary/supplier upon presentation of required documentation. Commercial letters of credit are mainly used as a primary payment method in export and import of the tangible goods in international trade. It is also referred as documentary credit
Import/Export Letter of Credit
Import letter of credit is using in Internal Business. It is issued by the importer’s bank on behalf of the importer to the exporter being the beneficiary. It is a guarantee by the importer’s bank that the payment will be given to the exporter or seller. The credit capacity of the importer is replace with the credit capacity of the issuing bank. This improves credibility and reduces the risk of fraud. There are terms and conditions regarding the type, quantity, place of delivery and time of delivery mentioned in the import LC. It also mentions the documents to be submitted as proof of shipment like Bill of Lading(BL). The exporter has to submit required documents satisfying these conditions before the payment can be released to him
Revocable & Irrevocable Letter of Credit
Revocable letter of credit can be modified/changed or cancelled by the buyer bank who is issuing LC, after its issuance at any moment without getting the beneficiary/Supplier’s approval. But if the beneficiary/Supplier fulfill their obligations/requirements as per the LC before they receive the amendment/cancellation notice from the issuing bank, then the issuing bank require to pay the amount. A revocable letter of credit can provide as a limited security payment method to the beneficiary/Supplier, because they are subject to amendment or cancellation without their prior knowledge. As a result revocable letters of credit are not used frequently in international trade.
Irrevocable Letter of Credit is a letter of credit type which cannot be cancelled or amended by the issuing bank without the consent of beneficiary/Supplier. In other words, every amendment requires beneficiary’s acceptance in order to be effective. Irrevocable letters of credit give much more payment security to the beneficiaries than revocable letters of credit. As a result, irrevocable letters of credit are the types of LCs that dominantly seen on the market place.
Revolving Letter of Credit
A revolving letter of credit is useful for multiple payments.5 If a buyer and seller expect to do business repeatedly, they may prefer not to get a new letter of credit for every transaction (or for every step in a series of transactions). This type of LC allows businesses to use a single letter of credit for numerous transactions until the letter expires, and letters might be valid for three years or less.
Back to Back Letter of Credit
Back to back Letter of Credit are normally comes when there is an intermediately company between buyer and seller like distributor/ broker/commission agent.
In this case, two distinct LCs will be prepared. One issued by the buyer’s bank to the distributor/broker/commission agent and the other issued by the intermediary’s bank to the seller. When the broker gets original LC from buyer, he goes to his own bank and will prepare a second LC with the seller as the beneficiary. The seller is thus ensured of payment upon fulfilling the terms of the contract and presenting the appropriate documentation to the intermediary’s bank. In some cases, the seller may not even know who the ultimate buyer of the goods is.
Documentary Letter of Credit
Documentary Letter of Credit is called At Sight Letter of Credit (Sight LC). This LC Stats that, the seller/exporters receives their payment from the buyer/importer, once the terms and conditions specified in the LC are completely fulfilled. The Issuing bank gives a guarantee that they will pay the amount, if the buyer fails to do so even if the requirement as per LC, is completely fulfilled by the supplier. When the seller/exporter makes a compliant presentation regarding the non-payment of buyer,, the issuing bank or financial institution will make the payment to the seller/exporter. This type of LCs are mostly used in international business transactions, where the buyer/exporter and seller/importer have yet to build a close business relationship and/or are located in different countries.
Standby Letter of Credit
This type of LC is different: It provides payment if something fails to happen. Instead of enabling a transaction, a standby LC provides compensation when something goes wrong. Standby LCs are generally similar to commercial LC, but they are only payable when the payee (or “beneficiary”) can prove that they didn’t get what was promised in an agreement. Standby LCs are a form of insurance that ensures you’ll get paid, and they can also guarantee that services will be performed satisfactorily.
Letters of credit can also protect buyers. If you pay somebody to provide a product or service and they fail to deliver, you might be able to get paid using a standby letter of credit. That payment can be a penalty to the company that was unable to perform, and it’s similar to a refund. With the money you receive, you can pay somebody else to provide the product or service needed.
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