Letter of Credit

A Letter of Credit is a payment term generally used for international sales transactions. It is basically a mechanism, which allows importers/buyers to offer secure terms of payment to exporters/sellers in which a bank (or more than one bank) gets involved. The technical term for Letter of credit is 'Documentary Credit'. At the very outset one must understand is that Letters of credit deal in documents, not goods. The idea in an international trade transaction is to shift the risk from the actual buyer to a bank. Thus a LC (as it is commonly referred to) is a payment undertaking given by a bank to the seller and is issued on behalf of the applicant i.e. the buyer. The Buyer is the Applicant and the Seller is the Beneficiary. The Bank that issues the LC is referred to as the Issuing Bank which is generally in the country of the Buyer. The Bank that Advises the LC to the Seller is called the Advising Bank which is generally in the country of the Seller. The specified bank makes the payment upon the successful presentation of the required documents by the seller within the specified time frame. Note that the Bank scrutinizes the 'documents' and not the 'goods' for making payment. Thus the process works both in favor of both the buyer and the seller. The Seller gets assured that if documents are presented on time and in the way that they have been requested on the LC the payment will be made and Buyer on the other hand is assured that the bank will thoroughly examine these presented documents and ensure that they meet the terms and conditions stipulated in the LC. Typically the documents requested in a Letter of Credit are the following:
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Commercial invoice Transport document such as a Bill of lading or Airway bill, Insurance document; Inspection Certificate Certificate of Origin But there could be others too.

The Documentary credit Cycle

Irrevocable unconfirmed letter of credit

Letters of credit (LC) deal in documents, not goods. Should letter of credit be chosen as the payment method? An importer should only be thinking of opening a letter of credit if his country's exchange control regulations require it or if the exporter insists upon it. Otherwise, the procedure ought to be avoided because it can quite often cause problems for both parties. Exporters will need to be certain that it is necessary to use a letter of credit. Typical considerations include:
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Is it a legal requirement in the importing country? What is the country risk of the importing country o Would a confirmed letter of credit be more suitable? What is the usual practice in trading with that country and in that particular commodity? What is the value of the order? o Will the bank charges be out of proportion to the value?

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What is the importer's credit rating? Are they a new customer or has a trading relationship already been established? What is the standing of the Issuing bank? o Would a confirmed letter of credit be more suitable? Recommendation by banks who may advise that the best method of payment is a "confirmed irrevocable letter of credit" irrespective of the country, strength of issuing bank and without much regard to the value of the consignment. "Always traded this way" o The reasons for requesting this method of payment should be periodically reassessed

Proper letters of credit have the following basic components: Applicant: The party applying for the letter of credit, usually the importer in a grain transaction. The Issuing Bank: The bank that issues the letter of credit and assumes the obligation to make payment to the beneficiary, usually the exporter. Beneficiary: The party in whose favor the letter of credit is issued, usually the exporter in a grain transaction. Amount: The sum of money, usually expressed as a maximum amount, of the credit defined in a specific currency. Terms: The requirements, including documents that must be met for the collection of the credit. Expiry: The final date for the beneficiary to present against the credit. These are the necessary components of any letter of credit for the credit to become a valid, operable instrument. The importer/applicant will give the issuing bank instructions that cover such items as:
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The full, correct name, address and contact information of the beneficiary, usually the exporter.

A brief description of the grain involved, including the quantity, quality and unit price.

The method, place and form of shipment, the location of the final destination and other shipping issues including transshipment, partial shipment and the latest shipping date.

The full, correct description of the documents required, including the period of time after the documents are issued within which they must be presented for payment. In addition, the credit should specify if payment is to be immediate (at sight) or with some degree of deferment (i.e., four days after acceptance).

Details of the letter of credit itself, including the amount (usually expressed as a maximum), the expiry date, how the credit will be made available and the transferability of the credit.

The type of credit. The revocable credit, the irrevocable credit or the confirmed irrevocable letter of credit.

Revocable letter of credit: Revocable credits may be modified or even canceled by the buyer
without notice to the seller. Therefore, they are generally unacceptable to the seller.

Irrevocable letter of credit: This is the most common form of credit used in international
trade. Irrevocable credits may not be modified or canceled by the buyer. The buyer's issuing bank must follow through with payment to the seller so long as the seller complies with the conditions listed in the letter of credit. Changes in the credit must be approved by both the buyer and the seller. If the documentary letter of credit does not mention whether it is revocable or irrevocable, it automatically defaults to irrevocable.

There are two types of irrevocable letter of credit

Unconfirmed credit (the irrevocable credit not confirmed by the advising bank) In an unconfirmed credit, the buyer's bank issuing the credit is the only party responsible for payment to the seller. The seller's advising bank pays only after receiving payment from the issuing bank. The seller's advising bank merely acts on behalf of the issuing bank and, therefore, incurs no risk.

Confirmed

credit

(the

irrevocable

confirmed

credit)

In a confirmed credit, the advising bank adds its guarantee to pay the seller to that of the buyer's issuing bank. Once the advising bank reviews and confirms that all documentary requirements are met, it will pay the seller. The advising bank will then look to the issuing bank for payment. Confirmed Irrevocable letters of credit are used when trading in a high-risk area where war or social, political, or financial instability are real threats. Also common when the seller is unfamiliar with the bank issuing the letter of credit or when the seller needs to use the confirmed letter of credit to obtain financing its bank to fill the order. A confirmed credit is more expensive because the bank has added liability

Standby Letter of Credit In the event that the bank's customer defaults on a payment to the beneficiary, and the beneficiary documents proof of its loss consistent with any terms set forth in the letter, a standby letter of credit may be used by the beneficiary to secure payment from the issuing bank.

(A guarantee of payment issued by a bank on behalf of a client that is used as "payment of last resort" should the client fail to fulfill a contractual commitment with a third party. Standby letters of credit are created as a sign of good faith in business transactions, and are proof of a buyer's credit quality and repayment abilities. The bank issuing the SLOC will perform brief underwriting duties to ensure the credit quality of the party seeking the letter of credit, then send notification to the bank of the party requesting the letter of credit (typically a seller or creditor).

Also known as a "non-performing letter of credit") Standby letters of credit are used, for example, to guarantee repayment of loans, to ensure fulfillment of a contract, and to secure payment for goods delivered by third parties.

A 'sight' LC means that payment is made immediately to the beneficiary/seller/exporter upon presentation of the correct documents in the required time frame.

A 'time' or 'date' LC will specify when payment will be made at a future date and upon presentation of the required documents.

A bank guarantee and a letter of credit are similar in many ways but they're two different things. Letters of credit ensure that a transaction proceeds as planned, while bank guarantees reduce the loss if the transaction doesn't go as planned. A letter of credit is an obligation taken on by a bank to make a payment once certain criteria are met. Once these terms are completed and confirmed, the bank will transfer the funds. This ensures the payment will be made as long as the services are performed. A bank guarantee, like a line of credit, guarantees a sum of money to a beneficiary. Unlike a line of credit, the sum is only paid if the opposing party does not fulfill the stipulated obligations under the contract. This can be used to essentially insure a buyer or seller from loss or damage due to nonperformance by the other party in a contract.

These financial instruments are often used in trade financing when suppliers, or vendors, are purchasing and selling goods to and from overseas customers with whom they don't have established business relationships. The instruments are designed to reduce the risk taken by each party