Letter of Credit (LC)
Definition: A Letter of Credit (LC) is a written undertaking by a bank, issued at the request of the buyer (importer/applicant), promising payment to the seller (exporter/beneficiary) on compliance with the terms specified in the credit. It is widely used in international and domestic trade to reduce payment risks.
Why It’s Called “Documentary Credit”
A Letter of Credit is also known as Documentary Credit because payment is made only upon presentation of specific documents (like invoice, bill of lading), not just based on delivery of goods or services.
How Does an LC Work?
- Agreement: Buyer and seller agree to use an LC.
- Issuance: Buyer requests their bank (issuing bank) to issue an LC in favor of the seller.
- Shipment & Documentation: Seller ships goods and submits required documents (invoice, bill of lading, etc.) to the negotiating bank.
- Verification & Payment: Bank verifies documents. If compliant, payment is released to the seller.
- Reimbursement: Buyer reimburses the issuing bank as per credit terms.
Parties Involved in a Letter of Credit
1. Applicant (Buyer/Importer)
- Requests LC issuance from the bank
- Provides required margin/documents
- Reimburses the bank on maturity
2. Beneficiary (Seller/Exporter)
- Receives LC in their favor
- Ships goods as per LC terms
- Submits documents and receives payment
3. Issuing Bank (Buyer’s Bank)
- Issues the LC on behalf of the buyer
- Guarantees payment upon document compliance
- Charges commission and fees
4. Advising Bank (Seller’s Bank)
- Verifies and advises the LC to the seller
- Does not guarantee payment unless also a confirming bank
5. Confirming Bank (Optional)
- Adds its own payment guarantee
- Ensures seller is paid even if issuing bank defaults
- Common in high-risk country transactions
6. Accepting Bank
- Applies to Usance (deferred payment) LCs
- Commits to pay the bill on a future date
7. Negotiating Bank
- Checks document compliance with LC terms
- Disburses payment to seller upon compliance
- Claims reimbursement from issuing bank
8. Reimbursing Bank
- Authorized by the issuing bank to release funds
- Does not verify documents—only processes payment
- Often a large international bank
Summary: A Letter of Credit protects both buyer and seller, ensuring payment only when pre-agreed documentary conditions are fulfilled. It is a secure method of trade finance, especially in international transactions.
Types & Benefits of Letter of Credit (LC)
Types of Letters of Credit
- Revocable LC: Can be modified or cancelled by the issuing bank without the consent of the beneficiary.
- Irrevocable LC: Cannot be altered or cancelled without agreement of all parties. This is the most commonly used LC.
- Sight LC: Payment is made to the seller immediately upon presentation and verification of compliant documents.
- Usance (Deferred) LC: Payment is made at a future date (e.g., 30/60/90 days after shipment or invoice date).
- Confirmed LC: Includes a second guarantee from another bank (usually in the seller's country).
- Back-to-Back LC: A second LC issued based on the original LC, often used in intermediary trade.
- Standby LC: Acts like a guarantee; payment is made only if the applicant fails to fulfill a contract.
- Transferable LC: Allows the original beneficiary to transfer part or all of the credit to another party.
- Red Clause LC: Allows the seller to receive advance payment before shipment to purchase goods.
- Green Clause LC: Similar to Red Clause but includes storage and insurance costs as well.
Advantages of Using Letters of Credit
- Provides security to both buyer and seller.
- Reduces payment risk, especially in international trade.
- Ensures timely shipment and documentation compliance.
- May help buyers obtain credit from their banks.
- Improves trust between new trading partners.
Risks Involved in Letter of Credit
- Document Discrepancies: Minor errors in documents can lead to non-payment.
- Fraud Risk: Fraudulent documents or invoices could be presented by dishonest sellers.
- Country Risk: Political instability or sanctions may affect the payment process.
- Currency Risk: Exchange rate fluctuations may impact the amount received.
- Costly Fees: Multiple banks involved can lead to higher processing fees.
Conclusion
Letters of Credit are vital tools in international and high-value domestic trade. Understanding their types, roles of participants, and potential risks helps in making informed and secure business decisions.