What is a letter of credit?
A letter of credit (LC) can be considered a guarantee issued and backed by a financial institution. It is used when one party needs to assure another party of something—most commonly payment, though it can also cover assurances such as the completion of a project.
In many transactions, the parties involved may have limited familiarity with each other. To demonstrate creditworthiness, a party may approach its primary bank to issue an LC on its behalf.
This provides reassurance to the counterparty, as the buyer’s bank effectively guarantees the transaction. In return for a fee, the buyer substitutes its own creditworthiness—which may be difficult for the seller to assess—with that of a large and reputable financial institution.
Letters of credit are particularly prevalent in cross-border transactions, where trust and timing concerns are amplified by additional factors such as political risk, shipping uncertainties, and restrictions around security registration.
How Much Does a Letter of Credit Cost?
In India, banks typically charge a fee for issuing a letter of credit, usually calculated as a percentage of the total amount being guaranteed. This fee can vary depending on the bank and the size of the credit. For instance, a bank may charge around 0.75% of the guaranteed amount.
The cost also depends on the type of letter of credit. In import-export transactions, an unconfirmed letter of credit is generally more affordable, while a confirmed letter, especially one backed by a bank with strong credit, may involve higher charges.
How does a letter of credit work?
A letter of credit (LC) is a negotiable instrument under which the issuing bank makes payment to the beneficiary (usually the exporter) or to any bank nominated by the beneficiary. The issuing bank typically charges a fee, regarded as a premium, for issuing the LC. If the LC is transferable, the beneficiary can assign the right to draw payment to another entity, such as a corporate parent or a third party.
Step-by-step process:
- Issuance of letter of credit
Once the buyer and seller agree on the sales contract, the importer (buyer) applies to their bank for a letter of credit in favour of the exporter. The issuing bank sends the LC to the advising bank, which verifies its authenticity and forwards it to the exporter. - Shipping of goods
Upon receiving the LC, the exporter proceeds with the shipping and export logistics process. - Submission of documents to the advising/confirming bank
After the goods are shipped, the exporter presents the required documents to the advising or confirming bank. - Settlement of payment and release of goods
The exporter’s bank forwards the documents to the issuing bank, which verifies them before obtaining payment from the importer. The verified documents are then released to the importer, enabling them to take possession of the shipped goods.
Significance of letters of credit
- Minimises the risk of a non-paying importer
A letter of credit issued by a bank guarantees that the exporter will receive payment, provided certain conditions are fulfilled. It serves as a protection against situations where the importer refuses to pay for the goods or becomes insolvent. - Supports effective cash flow management
A letter of credit assures payment and ensures it is made promptly. This is particularly valuable when there is a substantial time gap between the delivery of goods and receipt of payment. - Flexible and adaptable to business requirements
A letter of credit is generally negotiable. Exporters and importers can agree on specific terms in a contract, tailoring the payment arrangements to suit the needs of a particular transaction.
Parties to a letter of credit
Understanding the key players in a letter of credit transaction is crucial:
- Applicant: The buyer or importer who requests the letter of credit from their bank to guarantee payment to the seller.
- Beneficiary: The seller or exporter who is entitled to receive payment once the terms of the letter of credit are fulfilled.
- Issuing Bank: The buyer’s bank that issues the letter of credit, holds the funds, and ensures payment upon successful completion of agreed terms.
- Advising Bank: The bank located in the exporter’s country that receives and forwards the letter of credit to the beneficiary. It also verifies the authenticity of the document.
- Negotiating Bank: The bank that reviews and negotiates the exporter's documents under the letter of credit. It may or may not be the same as the advising bank.
- Confirming Bank: A secondary bank that adds its guarantee to the letter of credit, usually when the exporter lacks confidence in the issuing bank’s creditworthiness.
- Intermediary: A third-party facilitator who helps both the applicant and beneficiary coordinate the terms and details of the letter of credit.
These parties work together to ensure smooth financial transactions, with the issuing bank serving as a bridge between the buyer and the seller.
Types of a letter of credit
The following are some common types of letters of credit used in international trade:
- Commercial letter of credit
A straightforward payment method where the issuing bank makes payment directly to the beneficiary. - Traveller’s letter of credit
Designed for exporters travelling abroad, this letter of credit guarantees that the issuing bank will provide drafts as required, payable at foreign banks. - Confirmed letter of credit
This type involves an additional bank, apart from the issuing bank, that guarantees payment. In international transactions, the issuing bank often requests confirmation to ensure that the confirming bank honours the payment even if the beneficiary or issuing bank defaults. - Standby letter of credit (SBLC)
A legal document in which a bank guarantees payment to the seller if the buyer fails to pay. It acts as a safety net, ensuring payment for goods or services even in unforeseen circumstances. - Sight letter of credit
A document that guarantees immediate payment once the required documents, including bills of exchange, are presented. Payment is made as soon as the beneficiary submits proof of shipment or delivery. - Time or acceptance letter of credit
A time letter of credit guarantees payment to the beneficiary on a specified future date, once the required documents are presented. It allows the buyer a deferred payment period. - Revocable letter of credit
A revocable letter of credit can be modified or cancelled by the issuing bank without the beneficiary’s consent. - Irrevocable letter of credit
An irrevocable letter of credit cannot be changed or cancelled without the agreement of all parties involved. - Back-to-back letter of credit
In this arrangement, two letters of credit are issued to finance a single transaction. It is commonly used when a broker, agent, or intermediary is involved between the importer and exporter, facilitating transactions with suppliers. - Transferable letter of credit
A transferable letter of credit allows the original beneficiary to transfer all or part of the credit to a second beneficiary, typically a supplier. The second beneficiary is not permitted to transfer the credit further. - Restricted letter of credit
A restricted letter of credit specifies a particular bank authorised to pay, accept, or negotiate the credit. - Revolving letter of credit
A revolving letter of credit enables the beneficiary to use the credit repeatedly, based on withdrawals and repayments, without the need to issue a new LC each time.
Letter of Credit Glossary
Here are the most important terms you should know when dealing with letters of credit in international trade:
- Applicant: The buyer who applies for the letter of credit and commits to paying the agreed amount once the terms are fulfilled.
- Issuing Bank: The buyer’s bank that issues the letter of credit and ensures payment to the seller upon compliance with the stated conditions.
- Beneficiary: The seller or exporter entitled to receive payment from the issuing bank after meeting the terms of the letter of credit.
- Confirmed Letter of Credit: A letter of credit guaranteed by a second bank (confirming bank) in addition to the issuing bank, offering added security to the seller.
- Irrevocable Letter of Credit: A type of letter of credit that cannot be altered or cancelled without the approval of all involved parties.
- Standby Letter of Credit: Serves as a backup payment option, activated only if the buyer defaults on the contract.
- Uniform Customs and Practice for Documentary Credits (UCP): A set of international rules developed by the International Chamber of Commerce to regulate the use of letters of credit in global trade.
Example of a letter of credit
A practical example can illustrate the utility of letters of credit. Imagine a company importing machinery from Asia to Europe. The European importer requests their bank to issue a letter of credit to guarantee payment to the Asian exporter. Upon receiving the letter, the exporter ships the machinery and submits the required documents to their bank. Once the terms are verified, the bank processes the payment.
This arrangement ensures that the exporter’s payment is secure, even in an economically volatile region. Such assurances make letters of credit vital for global business.
How to apply for a letter of credit
Letters of credit help prevent costly errors and payment delays. Since industries differ and various types of letters of credit exist, each may require a slightly different approach.
Example in import-export transactions:
- The importer and exporter finalise a sales agreement. The importer's bank must issue a letter of credit that meets the requirements of both the exporter and their bank.
- The importer's bank drafts the letter of credit and sends it to the exporter's bank. The exporter's bank reviews the letter and forwards it to the exporter after approval.
- The exporter ships the goods as specified in the letter of credit and submits the necessary documentation to their bank.
- The exporter's bank checks the documents to ensure all terms and conditions of the letter of credit are met. If approved, the documents are sent to the importer's bank.
- The importer's bank makes payment to the exporter's bank. The importer can then claim the goods shipped.
Documents required for a letter of credit
The following documents are typically required to apply for a letter of credit:
- Completed application form, including address and photograph
- KYC documents of the applicant, co-applicant, partners, or directors (such as passport, voter ID, Aadhaar card, etc.)
- Bill of exchange
- Bill of lading
- Airway bill
- Commercial invoice
- Insurance certificate
- Certificate of origin
- Packing, shipping, and transport documents
- Certificate of inspection
- Any additional documents requested by the bank or lender
Contents of a letter of credit (LC)
A letter of credit must include specific details to ensure clarity and enforceability. The key elements typically mentioned are:
- Date of issue
- Name and address of the beneficiary (seller/exporter)
- Total amount to be credited
- Expiry date of the letter of credit
- Beneficiary’s bank details, LC reference number, and applicable terms and conditions
- Authorised signature of the issuing bank official
Advantages of a letter of credit
- Provides assurance to the seller
A letter of credit guarantees that the seller will receive payment under specified conditions, even if the foreign buyer cancels the order or becomes insolvent. - Acts as evidence of payment commitments
A letter of credit confirms the payment terms, giving suppliers confidence that their payment will be made on time. - Facilitates structured payment arrangements
A letter of credit enables buyers and sellers to agree on flexible payment arrangements tailored to each transaction, including the timing of goods shipment. - Ensures timely payment
A letter of credit guarantees prompt payment, helping sellers manage cash flow and secure financing between shipment and receipt of payment.
Disadvantages of a letter of credit
Some of the disadvantages of a letter of credit include:
- It increases business costs, as banks levy a fee for issuing the LC.
- It may be affected by strict time limitations.
- Any amendments to the LC can lead to delays in the transaction.
- Payment depends on the creditworthiness and reliability of the issuing bank.
Conclusion
Letters of credit simplify international trade by ensuring secure transactions and reducing risks for both buyers and sellers. Businesses can leverage this tool to expand their global operations confidently.
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