A Letter of Credit (LC) is a document that guarantees the buyer’s payment to the sellers. It is issued by a bank and ensures timely and full payment to the seller. If the buyer is unable to make such a payment, the bank covers the full or the remaining amount on behalf of the buyer.
A letter of credit is issued against a pledge of securities or cash. Banks typically collect a fee, i.e., a percentage of the size/amount of the letter of credit.
Parties to the Letter of Credit
- Applicant: The party who requests the letter of credit. This is the person or organization that will pay the beneficiary. The applicant is often an importer or buyer who uses the letter of credit to make a purchase.
- Beneficiary: The party who receives payment. This is usually a seller or exporter who has requested that the applicant use a letter of credit.
- Issuing bank: The bank that creates or issues the letter of credit at the applicant’s request. It is typically a bank where the applicant already does business
- Negotiating bank: The bank that works with the beneficiary. This bank is often located in the beneficiary’s home country, and it may be a bank where the beneficiary is already a customer. The beneficiary submits documents to the negotiating bank, and the negotiating bank acts as a liaison between the beneficiary and the other banks involved.
- Confirming bank: A bank that “guarantees” payment to the beneficiary as long as the requirements in the letter of credit are satisfied. The issuing bank already guarantees payment, but the beneficiary may prefer a guarantee from a bank in their home country. This may be the same bank as the negotiating bank.
- Advising bank: The bank that receives the letter of credit from the issuing bank and notifies the beneficiary that the letter is available. This bank is also known as the notifying bank and may be the same bank as the negotiating bank and the confirming bank.
- Intermediary: A company that connects buyers and sellers, and which sometimes uses letters of credit to facilitate transactions. Intermediaries often use back-to-back letters of credit.
- Freight forwarder: A company that assists with international shipping. Freight forwarders often provide the documents exporters need to provide in order to get paid.
- Shipper: The company that transports goods from place to place.
- Legal counsel: A firm that advises applicants and beneficiaries on how to use letters of credit. It’s essential to get help from an expert who is familiar with these transactions.
Types of Letter of credit
- Irrevocable LC :-
This LC cannot be cancelled or modified without consent of the beneficiary .This LC reflects absolute liability of the Bank to the other party.
- Revocable LC
This LC type can be cancelled or modified by the Bank (issuer) at the customer’s instructions without prior agreement of the beneficiary (Seller). The Bank will not have any liabilities to the beneficiary after revocation of the LC.
- Stand-by 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.
- Confirmed LC.
In addition to the Bank guarantee of the LC issuer, this LC type is confirmed by the Seller’s bank or any other bank. Irrespective to the payment by the Bank issuing the LC (issuer), the Bank confirming the LC is liable for performance of obligations.
- Unconfirmed LC.
Only the Bank issuing the LC will be liable for payment of this LC.
- Transferable LC
This LC enables the Seller to assign part of the letter of credit to other 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.
- Back-to-Back LC
This LC type considers issuing the second LC on the basis of the first letter of credit. LC is opened in favor of intermediary as per the Buyer’s instructions and on the basis of this LC and instructions of the intermediary a new LC is opened in favor of Seller of the goods.
- Payment at Sight LC
According to this LC, payment is made to the seller immediately after the required documents have been submitted.
- Deferred Payment LC
According to this LC the payment to the seller is not made when the documents are submitted, but instead at a later period defined in the letter of credit. In most cases the payment in favor of Seller under this LC is made upon receipt of goods by the Buyer.
- Red Clause LC.
The seller can request an advance for an agreed amount of the LC before shipment of goods and submittal of required documents. This red clause is so termed because it is usually printed in red on the document to draw attention to “advance payment” term of the credit.
Provides security for sellers in deals, so if a customer isn’t able to pay for a transaction, the sellers can get paid without issue.
Costs a fee for the buyer to obtain, and is sometimes not an option if buyers want to deal with particular sellers
Builds trust and security in transactions, especially international trade deals, and often when parties haven’t worked together before
Doesn’t cover all aspects of transactions, such as the speed at which goods arrive, the quality with which they arrive, etc.
Can provide detailed, written guidelines for when a buyer needs to provide money during a transaction
Doesn’t account for mitigating circumstances in transactions, such as inflation affecting foreign exchange rates, political unrest, supply chain issues, changing international trade laws, etc.
With third-parties involved, the exchange of money can often happen more efficiently than going direct from buyer to seller, especially in international trade deals where laws may be difficult to navigate
Generally can be a time-consuming process for both parties involved
Highly customizable, and can be written to satisfy the terms of individual deals