Letter of Credit Guide - Features, Importance & When To Use It
Being a global trader, you may have come across the term “Letter of credit” but you wonder what it is, how does it work and why do global traders need it? This LC guide/blog can help you get your answers.
What Is A Letter Of Credit?
A Letter of Credit or “Payment Credit Letter” is a legal document issued from a bank, guaranteeing that the seller will receive their payment on-time from the buyer for their delivered services with the said amount. In the event, if the buyer is not capable of making the payment or performing the terms & conditions of the agreement on-time, then, the issuing bank will be responsible to cover the full or remaining amount from the importer.
In other words, a documentary credit letter is a type of legal promise made by an issuing bank or a financial lending institution regarding an on-time payment to the exporters for rendering their services to the importers. But in case if the importer defaults or unable to perform the contractual obligations mentioned in the LC agreement, the remaining or whole amount will be covered by the issuing bank.
What Is The Need For Applying For A Payment Guarantee Letter?
The process starts when a seller and a buyer agree to do business transactions together and enter into a sales contract. Both the parties are unfamiliar with each other and are concerned about the fulfillment of their contractual obligations. On one hand, the importers are not willing to wait for the payment until the goods are shipped from foreign ports to their destination while on the other hand, the importers are at risk of non-performance of the LC agreement. This triggers importers to find a way of guaranteeing payment to exporters and ensure fulfillment of terms & conditions of the contract. This is where a letter of credit helps avoid the associated overseas risks for both importers and exporters.
Features of Letters of Credit:
1. One of the most prominent features of a payment guarantee letter is that the issuing bank is entitled to make the payment solely based on the document presented. They are not required to authenticate the shipping of the goods physically.
2. Payment guarantee letters are also known as documentary credit, and the bank charges a certain fee depending on the type of bank credit letter.
3. The issuing bank can deny the payment of bank credit letters if there is any type of mistake in the buyer’s name, product name, shipping date, etc.
4. Documentary credit letters are issued against collateral that may include buyer’s fixed deposit or bank deposit etc.
5. A certain fee is charged by the LC service provider depending on the type of payment guarantee letter.
Importance Of Letters Of Credit
Different types of payment guarantee letters are issued from the bank to provide security to the global traders at the time of purchasing and selling products or services. But how are they beneficial for both sellers and buyers?
Seller Protection - If a buyer is unable to pay a seller due to any circumstances, the seller can approach the issuing bank to release the payment as long as the seller fulfills all the requirements mentioned in the agreement.
Buyer Protection - Documentary credit letters also protect buyers. If the buyer has paid a seller to provide a product or service and he fails to deliver, the buyer can get the payment using a Standby LC.
Parties Involved In The Issuance of LC:
There are several parties involved in the issuance of a payment guarantee letter(LOC). They are:
2. Beneficiary / Exporter
3. Issuing Bank
4. Advising Bank
5. Confirming Bank
Types of Letter of credit
1. Commercial Letters of Credit
2. Standby LC
3. Revocable LC
4. Irrevocable Bank Credit
7. Back-to-Back Bank Credit Letter (LC)
8. Red Clause Payment guarantee letter
9. Transferable Letter of Credit
10. Non-transferable Payment guarantee letter
Know more: Different Types of Letters of Credit
How Does a Letter of Credit Work?
Since a letter of credit is a negotiable instrument, the letter of credit service provider ie. the issuing bank is entitled to pay either the exporter or any other bank recommended by the exporter. In the case of transferable LC, the exporter can transfer his right to another entity but to receive the payment, the exporter is required to present evidential documents to the bank.
Here is a step by step procedure to open an LC that needs to be followed:
1. Buyer Applies For The LC - After both importers and exporters agree to conduct business together, if the exporter demands an up-front payment, the importer applies his bank and requests for issuing a bank credit in the favor of the exporter. The importer needs to be assured about the terms and conditions of the sales agreement.
2. Filling LC Application Form - After applying for the documentary credit letter, the importer is required to fill an application form known as “Letter of Credit Application Form” or “Documentary Letter of Credit Application Form” for the issuance of LC. The issuing bank then checks the application form and sends it to the importer for approval.
3. Advising Bank Evaluates LC - Then, the Advising bank (Exporter’s Bank) checks the authenticity of the LC sent by the issuing bank ie. letter of credit service provider, and assures the exporter to ship the goods.
4. Exporter Ships The Goods - On receiving LC the exporter ships the goods and services and receives the shipment documents.
5. Presentation of Documents to the Confirming Bank - To get the advance payment against the shipment documents, the exporter presents these documents to the confirming bank. The confirming bank then verifies them and sends them to the issuing bank.
6. Settlement of Payment - On receiving shipment documents, the issuing bank verifies them with the importer and if it finds everything right, it releases the payment to the exporter.
Documents Required For LC
Here are a few documents that are required to obtain a letter of credit:
1. Importer’s financial documents
2. Bills of exchange
3. Certificate of Origin
4. Commercial Invoice
5. Packing, shipping and transport documents
6. Landing airway bills or cargo receipts etc.
Is There Any Difference Between A Loan And A Letter Of Credit?
Yes. Letters of credit are different from a loan. On one hand, a loan is a lump sum amount borrowed and needs to be repaid within a prescribed period in the form of EMIs while on the other hand, a letter of credit is a short-term working capital issued by a bank or an FI where the borrower can withdraw small amounts from the sanctioned limit. Plus, there is no guarantor in the case of a loan while letters of credit include the bank as a legal guarantor for the borrower.
What Is The Difference Between A Bank Guarantee And A Letter Of Credit?
Though bank guarantees are much more similar to letters of credit, there is a slight difference in process between these two trade finance instruments. It means that the process of LC will continue even if the buyer defaults in payment while in the case of a bank guarantee, the bank reduces the loss that occurred.
When To Use A Letter Of Credit?
Any business which trades in large volumes either domestically or internationally is advised to use a letter of credit. It not only reduces the risks of fraud due to non-payment from the buyer but also assures the performance of the terms & conditions of the contract and cash flow of a company.
Here are some cases where using a LC is essential. Let’s have a look:
International Transactions - Import & export LC are widely used in international transactions to mitigate the associated overseas risks for both importers and exporters. For example, different laws & time-zones, and unfamiliarity of the parties to the contract. To decrease the probability of these risks while initiating an international transaction, the overseas importers or exporters of goods prefer to use an LC primarily. It ensures sellers receive on-time payment for the delivered goods & services to overseas buyers in case the buyers have not met the requirements. If the buyer of the goods is unable or unwilling to make the payment, the LC takes effect and the issuing bank covers the remaining payment.
Performance Transactions - The exporters or beneficiaries can use Standby LC in cases where the nature of the transaction is expected to take a significant amount of time to perform and requires inspection until it is completed. For example, hiring a contractor for a building project and if it is not completed on-time, the exporter can present the non-fulfillment of the obligations to the bank. Then, the bank pays the beneficiary.
Recommended Read: Difference Between Bank Guarantee And Letter Of Credit?
Last Resort Payment - A Standby LC can also be used to assure the importer’s creditworthiness to the exporter and make him carry out the end of the bargain without any stress. It serves as a last resort payment for the exporters. In simple words, here the beneficiary can show his part of fulfillment to the bank and is assured that payment would be released subsequently.
Payment for Intermediary’s Transactions - A LC can be essentially used in situations where a transferable LC is issued and the bank is responsible to make the payment to the secondary beneficiary nominated by the original beneficiary.
For Payment Security - It is highly recommended to use an irrevocable LC instead of a revocable LC due to associated high risks for the exporters. The issuing bank can cancel, change, or modify the terms of LC without any prior notice to the beneficiary in case of revocable LC.
Letter of Credit Advantages For The Sellers:
1. The sellers are assured of getting payment on-time as the buyer’s bank is responsible to pay in case of default made by the importer for the shipped goods.
2. The risk of no-payment is transferred from the importer to the issuing bank.
3. Documentary credit letter is one of the most secure methods of payment guarantee for the exporters provided they meet the terms and conditions.
4. The sellers can fulfill their working capital requirements for the period between the shipment of goods and receipt of payment.
5. Sellers have easier access to funds and are capable of transferring all or a part of their LC to another party.
Letter of Credit Advantages For The Buyers:
1. By using a documentary credit letter or a letter of credit service, the buyers can assure the seller that they will be paid on time.
2. The issuing bank will pay the seller upon the presentation of shipment documents to the bank and verify their authenticity in accordance with the terms and conditions of LC.
3. The letter of credit is the legal proof of the buyer’s solvency or creditworthiness.
4. Using bank credit letters, the buyers can avoid or reduce the advance payment to the exporters.
5. The buyers can execute any number of transactions overseas as long as they are backed by a legal institution.
Other Advantages of Letter of Credit
1. Letter of credit services allows parties-to-the-contract to trade with unfamiliar overseas parties and establish new trade opportunities.
2. Both importers and exporters can expand their business quickly in new geographical areas.
3. A letter of credit is a safe, customizable, and flexible type of import trade finance.
4. Both the importers and exporters can put their conditions in the LC agreement as per their convenience and requirements.
Using a letter of credit can significantly help your international business grow and improve, regardless if you are a buyer or seller of goods and services.