A letter of credit plays a pivotal role in international trade, ensuring secure transactions between buyers and sellers. It acts as a guarantee provided by a bank, offering confidence to both parties in completing financial transactions. Due to its reliability, letters of credit are an essential tool for businesses engaged in global commerce.
This article will explain the concept of letters of credit, provide an overview for businesses looking to navigate the details of their types, importance, and process, and introduce a reliable financial solution like the Bajaj Finserv Business Loan to support your trade needs. Check your business loan eligibility to assess how much funding you can avail of for your trade commitments.
What is a letter of credit?
A letter of credit, also known as a credit letter, is a document issued by a bank guaranteeing a buyer’s payment to a seller. If the buyer is unable to pay, the bank ensures the seller receives the due amount. This financial tool is especially significant in international trade, where trust and legal differences can pose challenges.
For instance, a business in India importing goods from Europe can use a letter of credit to assure the European exporter of payment upon delivery of goods. The bank’s guarantee eliminates risks, facilitating seamless transactions. Letters of credit thus bridge the trust gap in global commerce, making trade more efficient.
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.
Documents Required for a Letter of Credit
Here is a list of commonly required documents when applying for a letter of credit:
- Application form with the applicant’s address and photograph
- KYC documents of the applicant, co-applicant, partners, or directors (such as Aadhar card, passport, or voter ID)
- Commercial invoice detailing the goods and transaction amount
- Bill of exchange raised by the exporter for payment
- Bill of lading or
- Airway bill, depending on the mode of transport
- Packing list and shipping documents confirming the items and shipment details
- Certificate of origin specifying the manufacturing country of the goods
- Insurance certificate covering transit risks
- Inspection certificate verifying the goods’ quality and compliance
- Any other documents required by the issuing bank or lender
Significance of letters of credit
Letters of credit are indispensable for businesses engaging in international trade. Here are their key advantages:
- Trust-building: They foster trust between buyers and sellers who may not know each other personally
- Risk mitigation: Sellers receive assurance of payment, even if the buyer defaults
- Legal compliance: They standardise processes in countries with differing legal systems
- Trade facilitation: Letters of credit are governed by the International Chamber of Commerce’s Uniform Customs and Practice for Documentary Credits, ensuring consistency in transactions
- Flexibility: They can be tailored to suit the unique requirements of a trade agreement
By reducing uncertainties, letters of credit empower businesses to expand their international presence confidently. Check your pre-approved business loan offer to explore financing that aligns with your trade expansion plans.
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
Different types of letters of credit are used depending on the nature of the trade transaction. Here are the main types, explained in a simple, structured format:
- Commercial letter of credit: A direct payment mechanism where the issuing bank makes payment to the seller upon fulfilment of terms. Commonly used in international trade.
- Revolving letter of credit: Allows multiple payments under a single credit limit within a set period, ideal for businesses with ongoing or frequent shipments.
- Traveller’s letter of credit: Assures financial access for individuals travelling abroad, enabling them to withdraw funds or make payments through designated foreign banks.
- Confirmed letter of credit: Adds an extra layer of security through a second bank (usually the seller’s bank) that guarantees payment if the issuing bank fails.
- Standby letter of credit: Acts as a financial guarantee or insurance. The bank pays only if the buyer defaults on the contractual obligation.
- Red clause letter of credit: Provides advance funds to the seller before shipment, helping them procure goods or raw materials to fulfil the order.
These letters of credit also interact with bills of exchange, ensuring smooth transactions in international trade.
How a letter of credit works
Here is the step-by-step process of how a letter of credit functions:
- The buyer approaches their bank to issue a letter of credit
- The bank evaluates the buyer’s assets or creditworthiness
- The letter of credit is issued and sent to the seller’s bank
- The seller ships the goods and provides documentation to their bank
- The seller’s bank verifies the documents and forwards them to the issuing bank
- Upon approval, the issuing bank ensures payment to the seller
This structured process minimises risks and ensures that international trade agreements are honoured.
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.
Importance of Letters of Credit
Due to the complexities of international trade, such as geographical distance, differing legal systems, and limited face-to-face interaction, letters of credit serve as a dependable payment method. Their use in global transactions is governed by the Uniform Customs and Practice for Documentary Credits established by the International Chamber of Commerce (ICC).
How to apply for a letter of credit
Applying for a letter of credit requires precision and professional guidance. Here is the process:
- The importer and exporter agree on the terms of the trade
- The importer requests their bank to draft the letter of credit
- The letter is sent to the exporter’s bank for verification
- Once approved, the exporter ships the goods and submits the documentation
- The banks process and verify the documents before releasing payment
Given the complexities, businesses can consider financial solutions like the Bajaj Finserv Business Loan to meet the collateral or asset requirements of the issuing bank
What are the charges for a letter of credit?
Banks charge fees for issuing letters of credit, typically as a percentage of the guaranteed amount. The costs depend on factors such as:
- Type of letter (e.g., confirmed letters have higher fees)
- Credit strength of the issuing bank
- Complexity and duration of the trade agreement
For instance, a bank may charge 0.75% of the guaranteed amount, making it a manageable cost for securing international transactions.
Advantages and disadvantages of a letter of credit
| Advantages | Disadvantages |
| Ensures trust between trade parties | Costs are borne by the buyer |
| Reduces risks in international trade | May not cover unforeseen circumstances |
| Standardises trade processes | Preparation can be time-consuming |
| Flexible and customisable | Terms may need frequent adjustments |
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
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.
To further support your trade endeavours, consider the Bajaj Finserv Business Loan. With quick approvals and competitive interest rates, it can help you meet the financial requirements associated with letters of credit and other trade-related expenses. Apply today and take your business to new heights!
