Being a global trader, you may have come across the term “Letter of credit”. You often wonder what is letter of credit, how letter of credit works, and why global traders need it. This Letter of credit guide can help you get your answers.
What Is A Letter Of Credit?
Do you want to know what is LC?
Also known as “Payment Guarantee Letter”, “Credit Letter”, or “Documentary Credit Letter”, an international Letter of Credit is issued by a bank or financial institution as a legal document guaranteeing an on-time buyer’s payment to the seller in a global trade deal. In the event, if the buyer defaults ie. is unable to pay or perform the T&C of the contract, the issuing bank will reimburse the full or the remaining amount on behalf of the buyer.
What Is The Need For Applying For A Payment Guarantee Letter?
International trade deals are often influenced by various overseas factors such as distance, countries differing in-laws, and lack of familiarity of parties to the contract, etc., making them a little bit risky for global importers & exporters. The importers are not willing to pay the exporters until the goods are shipped from foreign ports to their destination while the exporters demand payment as the shipment takes place to further avoid their risk of non-performance.
This LC guide will help you know how a letter of credit in international trade works as an appropriate, suitable & reliable payment mechanism for global traders. The issuing bank, on behalf of its customer ie. the buyer/importer, assures sellers/exporters that they will get the payment for their rendered services in international trade.
This is one of the features of letter of credit that the buyers are assured that the sellers will be paid after presenting shipment documents while the sellers have peace of mind of getting payment, regardless of the buyer’s capability to pay or perform, as the trade deal is backed by the issuance of a LOC. Now you know that under an LC, both importers & exporters are sure about LC payment.
Also known as “Payment Credit Letter”, an LC can be used for both import & export business with the main purpose of facilitating legally backed assurance to both the buyer & seller of the fulfillment of contractual obligations in global trade transactions. First, the seller’s obligation to deliver the ordered goods as mentioned in the LC agreement, and secondly, the buyer’s obligation to pay for the delivered goods within the predetermined period.
Features of Letters of Credit:
Take a look at some of the characteristics of letter of credit to have a clear understanding:
1. One of the most prominent features of a payment guarantee letter is that the issuing bank is entitled to make the payment solely based on the document presented. They are not responsible for authenticating the shipping of the goods physically.
2. Letters of credit are also known as documentary credit, and the bank charges a certain fee depending on the type of bank credit letter.
3. The issuing bank can deny the payment of bank credit letters if they observe any type of mistake in the buyer’s name, product name, shipping date, etc.
4. Documentary LC is issued against collateral that may include the buyer’s fixed deposit or bank deposit etc.
Importance of Letter of Credit
Letter of Credit plays a vital role in global trade transactions. It ensures beneficiaries that they will be paid on time for their rendered services regardless of the buyer’s capacity. A documentary letter of credit allows sellers to mitigate the risk of payment failure for delivered goods as the risk is shifted to the issuing bank.
Seller Protection – Under letter of credit services, if a buyer defaults or shows his inability to pay a seller on time due to any circumstances, the seller can approach the issuing bank. As the bank verifies the seller’s fulfillment of all the requirements mentioned in the agreement, it releases the payment.
Buyer Protection – Documentary LC also protects buyers. If the buyer has paid a seller to provide a particular product or service and the seller fails to deliver, the buyer is authorized to get the payment using a Standby LC.
Parties Involved In The Issuance of LC:
Following parties are involved in the issuance of a payment guarantee letter(LOC):
1. Applicant/Importer – Who requests a bank to issue LC.
2. Beneficiary / Exporter – Who gets the payment from the bank in case of the buyer’s default
3. Issuing Bank – Who issues the LC in import finance on behalf of its applicant
4. Advising Bank – An international bank that transfers the documents to the issuing bank on behalf of the exporters. It is usually located in the exporter’s country.
5. Confirming Bank – The bank that provides an additional guarantee to the undertakings of the issuing bank in case the exporter is not satisfied with the issuing bank’s assurance.
Types of Letter of credit
There are several types of LCs that can be used by global traders in international transactions in accordance with the features of LC. However, here we have explained some of the major types of LCs.
1. Commercial LOC
2. Standby LC
3. Revocable LC
4. Irrevocable Bank Credit
5. Confirmed Letter of Credit
6. Unconfirmed LC
7. Back-to-Back Bank Credit Letter (LC)
8. Red Clause Payment guarantee letter
9. Transferable Letter of Credit
10. Non-transferable Payment guarantee letter
11. Revolving letter of credit
We have also published a separate guide on Different Types of Letters of Credit that will help you understand their use in detail.