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 Letter of Credit (LC)
Basic of Letter of Credit (LC)
PART - I

A presentation by- Puneet Harjani

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 > Introduction

• Principles and Theory :

– it is most important segment of non fund based business for banks.

– it is also known as documentary credit.

– a need for a streamlined system involving banks as an intermediate was felt by the

trading world because of the inherent drawbacks of the documentary collection system

prevailing earlier, which poses risk both for importer and exporter , which led to the

evolution of Letter of Credit or Documentary Credit system.

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 > Introduction

• Definition:
– A Letter of Credit, simply defined, is a written instrument issued by a bank at the
request of its customer, the Importer (Buyer), whereby the bank promises to pay the
Exporter (Beneficiary) for goods or services, provided that the Exporter presents all
documents called for, exactly as stipulated in the Letter of Credit, and meet all other
terms and conditions set out in the Letter of Credit.

• If the Letter of Credit is issued in course of international trade

– the Letter of Credit should comply with FEMA regulations,

– and are also subject to provisions of Uniform Customs and Practices for
Documentary Credit (UCPDC) framed by International Chamber of Commerce (ICC)

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 > Introduction

• Synopsis :
Letter of Credit therefore:

– Are an arrangement by banks for settling international commercial transactions.

– Provide a form of security for the parties involved.

– Ensure payment, provided that the terms and conditions of the Letter of Credit

have been fulfilled.

– Mean that payment by such means is based on documents only, and not on

merchandise or services involved.

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 > Parties in LC Transaction

A transaction in a Letter of Credit may involved several parties from the

issue of the LC till making payment of the bills to the Seller:

• Applicant
– The buyer who finalizes the terms and conditions of purchase transaction
and submits a request to his bank for issuing a LC in favor of the seller.

• Beneficiary
– The beneficiary of the letter of credit is generally the seller of the goods and
services or the person in whose favor the credit has been issued.

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 > Parties in LC Transaction
• Issuing Bank / Opening Bank
– An issuing bank is the one which on receipt of request from its
customer, the applicant’s (purchaser’s) bank examines the proposal and
open a LC in favor of the beneficiary with the stipulated terms and
condition.

• Advising Bank/ Correspondent Bank

– In case seller (beneficiary) resides in a different lace or in a foreign
country, the issuing bank may contact some other bank in the beneficiary’s
country may agree to advise the credit to the beneficiary and thus play the
role of an advising bank.

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 > Parties in LC Transaction
• Confirming Bank :
– The Confirming bank adds its guarantee to the credit opened by another
bank, thereby undertaking the responsibility of payment/negotiation
acceptance under the credit, in additional to that of the issuing bank.
Confirming bank play an important role where the exporter is not satisfied
with the undertaking of only the issuing bank.

• Reimbursing Bank
– Reimbursing Bank is the bank authorized to honor the reimbursement claim
in settlement of negotiation/acceptance/payment lodged with it by the
negotiating bank. It is normally the bank with which issuing bank has an
account from which payment has to be made.

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 > Parties in LC Transaction
• Nominated/ Negotiating Bank :
– The Negotiating Bank is the bank who negotiates the documents submitted
to them by the beneficiary under the credit either advised through them or
restricted to them for negotiation. On negotiation of the documents they
will claim the reimbursement under the credit and makes the payment to
the beneficiary provided the documents submitted are in accordance with
the terms and conditions of the letters of credit.

• Second Beneficiary:

– Second Beneficiary is the person who represent the first or original

Beneficiary of credit in his absence. In this case, the credits belonging to the
original beneficiary is transferable. The rights of the transferee are subject
to terms of transfer.

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 > Parties in LC Transaction

Terms Definition Activity

Applicant Importer Buy
Beneficiary Exporter Sell
Issuing/Opening Importer’s Bank Issues L/C
Bank
Advising Bank Exporter’s Bank Advises L/C
Confirming Bank Advising Bank or 3rd Confirms L/C
Party Bank
Paying Bank Any bank as Pays the Draft
specified in L/C

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 > Mechanism of LC

Contract
1
Buyer Seller
Goods
9 4

2 8 Debit Payment
5
Letter of Credit 7
6

Application Letter of Credit

Documents Documents
Buyer’s Bank 3

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 > Mechanism of LC
1st Principle of Letters of Credit: Letters of Credit are documentary.

Step 1.
• The seller and the buyer enters into a sales contract where buyer agrees to purchase goods from
the seller. This agreement may be a purchase order, an accepted pro-forma invoice, a formal
contract, as to how and when goods are to be shipped and insured, and how and when payment is
to be effected. In this case they agree that letter of credit will be used as the mechanism of
payment.
Step 2.
• The buyer applies to his bank for a letter of credit in favor of the seller (beneficiary), signing the
bank’s letter of credit application/agreement form specifying the terms and condition under which
the Letter of Credit shall be issued.
Step 3.
• After approving the application, the issuing bank issues the actual letter of credit instrument and
sends it to the beneficiary (the seller), thus undertaking the definite obligation of effecting payment
to the beneficiary upon presentation of documents, strictly complying with the terms and condition
of the credit .

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 > Mechanism of LC
2nd Principle of Letters of Credit: Letters of Credit are independent
of any other contract or obligation.

Note: There are 3 separate contracts in a letter of credit transaction:

a) The contract of sale
b) The L/C application/agreement
c) The L/C itself.
Step 4.
• As soon as the seller receives Letter of Credit (issuing bank’s assurance of payment), the seller ships
the goods to the buyer provided the terms of credit meets the terms of underlying sales contract.
Step 5 & 6.
• The seller prepares the documents called for in the letter of credit and presents them to the Issuing
bank. The issuing bank examines the documents whether they strictly comply with the terms of
letter of credit. If the documents meet the requirement the issuing bank pays the beneficiary
(seller) in the manner stipulated under the credit.

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 > Mechanism of LC

Step 7 & 8.
• The issuing bank sends the documents to the buyer (applicant) and obtains payment in accordance
with the terms of the applicant’s letter of credit agreement ( usually by debit to the applicant’s
account)

Step 9
• On receiving the documents from bank, the applicant (buyer) is in a position to pick up the
merchandise from the carrier, completing the letter of credit cycle.

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 > Mechanism of LC

Confirmed Letters of Credit

Contract
1
Applicant Beneficiary
Goods
12 5

L/C L/C 6
10 Debit Pay-
Applica
ment
tion Docum Docum
11
ents 4
2 ents 7

L/C 3
Applicant’s 8
Documents Confirming
Bank Payment Bank
9

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 > Mechanism of LC

• In case of Confirmed Letter of Credit the issuing bank invite another bank into the
transaction, having presence in the country of the seller. This second bank is called the
confirming bank, it will confirm the letter of credit issued by the issuing bank , and thus
undertakes the primary obligation to effect payment to the beneficiary (seller) [But if it merely
informs the seller of the LC without any obligation on its part they will just act as an advising
bank]. They become a third party to the letter of credit “contract” and have the right to refuse
amendments.

For Conforming Bank

• When a bank adds their confirmation to a letter of credit, they are engaging to treat the letter of
credit as if they issued it themselves. If and when the beneficiary presents compliant documents
to the confirming bank, the confirming bank must pay. The confirming bank takes the risks of
being able to then collect payment from the issuing bank. [It may also act as a nominating
bank, if the LC calls for negotiation]

The major effect is to shift country risks to the confirming bank.

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 > Mechanism of LC

Freight
11
Goods Forwarder Transport
Documents
5 6
Foreign Contract Goods
1 Seller Document
Buyer L/C
6
Preparation
L/C 4 Company
L/C 10b
Debit 6
Appli- Advising
cation Docu- L/C &
10a
Bank Documents
2 ments
Payment
3a
9a
Buyer’s L/C Seller’s
Bank Documents Bank
9b

Reimbursement Claim
3b Reimbursing
Reimbursement 7
Bank 8
Authorization
Reimbursement

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 < How LC works in Reality

Step 1.
• The buyer agrees to purchase goods from the seller using a letter of credit as the mechanism of
payment.

Step 2.
• The buyer applies to his bank for a letter of credit, signing the bank’s letter of credit
application/agreement form.

Step 3 a
• After approving the application, the issuing bank issues the actual letter of credit instrument and
forwards it to their chosen advising bank.

Step 3 a
• At the time the L/C is sent, the issuing bank also sends a reimbursement authorization to their
chosen reimbursing bank. This bank is the clearing bank the issuing bank uses when making
payments in the currency of the L/C and will play a role when the time comes to pay the L/C.

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 < How LC works in Reality

Step 4.
• The advising bank authenticates the letter of credit and delivers it to the beneficiary (the seller).
If the issuing bank has requested them to do so, the advising bank may add their confirmation to
the L/C (and thereby become the confirming bank).

Step 5.
• Having received the issuing bank’s assurance of payment (and that of the confirming bank if the
L/C has been confirmed), the seller delivers goods to a freight forwarder, who ships the
merchandise to the buyer.

Step 6.
• The seller, the freight forwarder, and/or a document preparation company prepares the
documents called for in the letter of credit and presents them to the “nominated bank.” The
letter of credit may nominate a specific bank where documents are to be presented or it may say
it is “available with any bank,” giving the seller the freedom to choose where to present
documents. If the L/C has been confirmed, documents must be presented to the
advising/confirming bank.

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 < How LC works in Reality

Step 7.
• The nominated bank examines the documents and, if they comply, obtains funds for payment to
the beneficiary in accordance with the terms of the letter of credit, generally by sending a
reimbursement claim to the reimbursing bank.
Step 8.
• The reimbursing bank matches the negotiating bank’s claim against the reimbursement
authorizations they are holding, charges the issuing bank’s account, and transfers funds to the
nominated bank.
Step 9 a & b.
• The nominated bank transfers payment to the beneficiary (seller) and forwards the documents to
the issuing bank.

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 < How LC works in Reality

Step 10 a & b

• The issuing bank examines the documents. If it agrees with the nominated bank that the
documents comply with the letter of credit, the issuing bank obtains payment from the
applicant (buyer) in accordance with the terms of the applicant’s letter of credit agreement and
forwards the documents to the applicant.

Step 11.

• The applicant (buyer) uses the documents to pick up the merchandise from the
carrier, completing the letter of credit cycle.

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 Types of Letter of Credit

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 > Types of Letter of Credit
• Revocable & Irrevocable Letter of Credit

– Irrevocable LC : A letter of credit is deemed to be an irrevocable credit,

which can neither be amended nor cancelled without an express
agreement of all the parties concerned. i.e. the applicant, issuing bank,
beneficiary and confirming bank (if any).

– *Revocable LC : The concept of “ Revocable Credit “ which was in effect

till UCPDC 500 (till 30th June, 2007) has been withdrawn under the latest
revision. Thus an LC can only be irrevocable in nature.

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 > Types of Letter of Credit
• Sight Credit & Acceptance (Usance) Credit

– Sight Credit : is the LC prescribes the condition of ‘ payment at sight ‘, in

this the beneficiary gets the benefit of immediate payment upon
presentation of the proper documents laid down as per the terms of LC at
the paying bank.

– Usance Credit: If the beneficiary decides to grant a period of credit to

importer after sight such a LC is called Acceptance Credit. The period of
credit is called Usance, in this type of LC the beneficiary draws a usance
draft on the buyer or issuing bank or confirming bank depending on the
terms. This draft is presented along with documents and the beneficiary is
advised that the amount in the draft will be paid to him on prefixed future
date .

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 > Types of Letter of Credit
• Standby Letter of Credit

– standby letter of credit is the one which is opened for non-performance of

some activity it is very much similar in nature to a bank guarantee. The
main objective of issuing such a credit is to secure bank loans.

– Unlike a traditional letter of credit where the beneficiary obtains payment

against documents evidencing performance, the standby letter of credit
allow a beneficiary to obtains payment from a bank even when the
applicant for the credit has failed to perform as per the terms.

– Standby LC is payable only in case where an event had occurred but

performance for the event has not happened.

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 > Types of Letter of Credit

– An example of this could be a construction of a bridge. An agreement

would be in place between the applicant and the beneficiary that in case
after construction of the bridge, if the payment is not made for the
services rendered, a claim would be made under the Standby LC.

• A standby letter of credit is subject to "Uniform Customs and Practice for

Documentary Credit" (UCP), International Chamber of Commerce
Publication No 500, 1993 Revision, or "International Standby Practices"
(ISP), International Chamber of Commerce Publication No 590, 1998.

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 > How Standby Letter of Credit Works

9 Contract 4
Applicant 1 Beneficiary

8
2
Payment 5
Debit

Letter of Credit 7 6 Letter of Credit

Application
Documents
Documents
Applicant’s Bank
3

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 > How Standby Letter of Credit Works
Step 1.
• Two parties enter into a contract that calls for one party to arrange a letter of credit in favor of the
other. With a standby letter of credit, the agreement is that the L/C will not be drawn unless the
applicant defaults on the contract. Standby letters of credit can be used as bid
bonds, performance bonds, advance payment guarantees, and for many other purposes.

Step 2.
• The first party applies to his bank for a letter of credit, signing the bank’s letter of credit
application/agreement form, and indicating what documents the beneficiary will be required to
present in order to be paid.

Step 3.
• After approving the application, the issuing bank issues the actual letter of credit instrument and
sends it to the beneficiary (the seller), thus undertaking the definite obligation of effecting
payment to the beneficiary upon presentation of documents, strictly complying with the terms
and condition of the credit .

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 > How Standby Letter of Credit Works

Note: There are 3 separate contracts in a letter of credit transaction:

a) The contract of sale
b) The L/C application/agreement
c) The L/C itself.
Step 4.
• Having received the issuing bank’s assurance that the applicant will perform (or the L/C can be
drawn), the beneficiary performs his end of the contract.

Step 5
• In the event the beneficiary feels the applicant has defaulted, he prepares the documents called for
in the letter of credit and presents them to the issuing bank.

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 > How Standby Letter of Credit Works

Step 6
• The issuing bank examines the documents. If it determines that the documents comply with the
letter of credit, the issuing bank pays the beneficiary. Note that there is no inquiry into the truth of
the documents and permission to pay is not sought from the applicant, who is likely to not want
the bank to pay and to insist he is not in default on the contract

Step 7 & 8
• The issuing bank obtains reimbursement for the payment from the applicant and forwards the
documents to the applicant

Step 9
• If the applicant feels the drawing was not justified, he can seek to get the funds returned under the
terms of the contract.

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 > Types of Letter of Credit
• Revolving Letter of Credit:
– Single L/C that covers multiple-shipments over a long period. Instead of
arranging a new L/C for each separate shipment,

– the buyer establishes a L/C that revolves either in value (a fixed amount is
available which is replenished when exhausted) or in time (an amount is
available in fixed installments over a period such as week, month, or

– This type of LC is used when the buyer needs shipments of the same
commodity at specified intervals e.g. monthly. It may revolve automatically
or subject to certain conditions.

– Example 1: Supply of coal to the iron industry is an ongoing material and

therefore as and when the goods are delivered, documents are submitted
and payment is made.

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 > Types of Letter of Credit
For the next supply of coal, there is no new LC that is issued, rather the existing
one is "Reinstated" (bring back into use again) to the original amount.

– Assume that the supplier and the buyer agrees that 200MT of coal would be
delivered on a monthly basis for 12 months. The value of the LC for 200MT
of coal is Rs 12 lakhs . Every month 200MT of coal will be shipped and
documents for Rs 12 lakhs would be submitted for payment. Once it get's
paid in the first month, the LC amount is automatically reinstated to Rs 12
lakhs for the next month's payment.

• Revolving L/Cs can be either cumulative or non-cumulative

 Under a cumulative resolving L/C, the exporter is allowed to carry over any
amounts not drawn in previous periods. For example, if a revolving L/C is
issued for US$100,000 monthly, cumulative, and the exporter draws only
USD80,000 in one

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 > Types of Letter of Credit
month, the unutilized amount (i.e. USD20,000) may be carried over to next month.
That means the sum of US $120,000 becomes available the next month.

 Whereas under a non-cumulative revolving L/C, any amount not drawn during
a given period may not be available for drawing in next period. As in the above
example, the unutilized amount of USD20,000 can not be carried over and
added to the amount of next shipments, that means the exporter can draw
only US$100,000 in each succeeding month.

As per the Exchange Control Manual, revolving LCs should not be established for
import of goods into India without prior approval of RBI.

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 Risk Assessment

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 < Risk Assessment

+
Positive
Letters of Credit
•Standby
•Commercial (Acceptances)
-
Negative

Cash in •Confirmed
Advance
•Insurance •Transferable
Vendor •Ex-Im Bank •Back-to-Back
Financing •CEFO •Assignment of Proceeds

Foreign Exchange
Foreign
Receivables
Exporter Neutral Importer
(Seller) (Buyer)
Zone
(Beneficiary) (Applicant)

-
Negative
Open Account
Documentary
Collection
+
Positive
 < Risk Assessment

On the part of opening bank risk associated with Import LCs can be classified into :

• The financial standing of the Importer:

– he should be in a position to arrange for funds required at the time of retirement of bills
under LC. This involves an appraisal of the creditworthiness of the importer as a
borrower.

• Acceptability and saleability of the goods:

– This is a generic risk associated with all modes of international trade, and may affect the
importer’s ability to pay for his consignment.

• The status of the Exporter ( or beneficiary of the LC)

– This is the risk inherent in a situation that an errant exporter may ship substandard goods.

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 < Risk Assessment

• Country Risk:

– This includes risk elements like the political and economical stability of a country and
exchange controls etc. Country Risk is however more pertinent for exporters rather than
importer..

• Foreign exchange Risk:

– A depreciation in the local currency vis-a-vis the transaction currency may lead importer
to pay more for the consignment than originally envisaged.

The disadvantage attached with the LC is that it assures correct documents but not
necessarily correct goods.

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 > Communication through SWIFT

– The communication in respect of documentary credit among the banks

take place through SWIFT (Society for Worldwide Inter-Bank Financial
Telecommunication) network.

– SWIFT provides secure network to banks and financial institution to

transfer financial transactions worldwide through a 'financial message'.

– SWIFT messages consist of five blocks of data including three

headers, message content, and a trailer.

– SWIFT messages are present and categorized in specific MT (Message

Type) numbers. MT are crucial to identifying content.

– Example: MT304

– The first digit (3) represents the category.

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 > Communication through SWIFT

A category denotes messages that relate to particular financial

instruments or services such as Precious Metals (6), Treasury (3), or
Travelers Cheques (8). The category denoted by 3 is Treasury Markets.

– The second digit (0) represents a group of related parts in a transaction life
cycle. The group indicated by 0 is a Financial Institution Transfer.

– The third digit (4) is the type that denotes the specific message. There are
several hundred message types across the categories. The type
represented by 4 is a notification.

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 Thank You
A-301, Titanium Square, Thaltej
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S.G. Highway, Ahmedabad – 380054

W : www.edgewise.in

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