A Guide To Letter Of Credit: Features and Its Process
Being a global trader, you may have come across the term “Letter of credit” but you wonder what it is, how it works, and why do global traders need it? This Letter of credit guide can help you get your answers.
What Is A Letter Of Credit?
Also known as “Payment Guarantee Letter”, “Credit Letter”, or “Documentary Credit Letter”, a Letter of Credit is issued by a bank or financial institution as a legal document guaranteeing an on-time buyer’s payment to the seller in a global trade deal. In the event, if the buyer defaults ie. is unable to pay or perform the T&C of the contract, the issuing bank will reimburse the full or the remaining amount on behalf of the buyer.
What Is The Need For Applying For A Payment Guarantee Letter?
International trade deals are often influenced by various overseas factors such as distance, countries differing in-laws, and lack of familiarity of parties to the contract, etc., making them a little bit risky for global importers & exporters. The importers are not willing to pay the exporters until the goods are shipped from foreign ports to their destination while the exporters demand payment as the shipment takes place to further avoid their risk of non-performance.
This LC guide will help you know how a letter of credit in international trade works as an appropriate, suitable & reliable payment mechanism for the global traders. The issuing bank, on behalf of its customer ie. the buyer/importer, assures sellers/exporters that they will get the payment for their rendered services in international trade.
The buyers are assured that the sellers will be paid after presenting shipment documents while the sellers have peace of mind of getting payment, regardless of the buyer’s capability to pay or perform, as the trade deal is backed by the issuance of a LOC.
Also known as “Payment Credit Letter”, an LC can be used for both import & export business with the main purpose of facilitating legally backed assurance to both the buyer & seller of the fulfillment of contractual obligations in global trade transactions. First, the seller’s obligation to deliver the ordered goods as mentioned in the LC agreement, and secondly, the buyer’s obligation to pay for the delivered goods within the predetermined period.
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 responsible for authenticating the shipping of the goods physically.
2. Letters of credit are also known as a 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 they observe 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 the buyer’s fixed deposit or bank deposit etc.
Importance of Letters of Credit
Letter of Credit plays a vital role in global trade transactions. It ensures beneficiaries that they will be paid on time for their rendered services regardless of the buyer’s capacity. A documentary credit letter allows sellers to mitigate the risk of payment failure for delivered goods as the risk is shifted to the issuing bank.
Seller Protection - If a buyer defaults or shows his inability to pay a seller on time due to any circumstances, the seller can approach the issuing bank. As the bank verifies the seller's fulfillment of all the requirements mentioned in the agreement, it releases the payment.
Buyer Protection - Documentary credit letters also protect buyers. If the buyer has paid a seller to provide a particular product or service and the seller fails to deliver, the buyer is authorized to get the payment using a Standby LC.
Parties Involved In The Issuance of LC:
Following parties are involved in the issuance of a payment guarantee letter(LOC):
1. Applicant/Importer - Who requests a bank to issue LC.
2. Beneficiary / Exporter - Who gets the payment from the bank in case of the buyer’s default
3. Issuing Bank - Who issues the LC in import finance on behalf of its applicant
4. Advising Bank - An international bank that transfers the documents to the issuing bank on behalf of the exporters. It is usually located in the exporter’s country.
5. Confirming Bank - The bank that provides an additional guarantee to the undertakings of the issuing bank in case the exporter is not satisfied with the issuing bank’s assurance.
Types of Letter of credit
There are several types of LCs that can be used by global traders in international transactions. However, here we have explained some of the major types of LCs.
1. Commercial LOC
2. Standby LC
3. Revocable LC
4. Irrevocable Bank Credit
6. Unconfirmed LC
7. Back-to-Back Bank Credit Letter (LC)
8. Red Clause Payment guarantee letter
9. Transferable LOC
10. Non-transferable Payment guarantee letter
We have also published a separate guide on Different Types of Letters of Credit that will help you understand their use in detail.
How Does a Letter of Credit Work?
Since Credit Letter (LOC) is a negotiable payment instrument, 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 is also allowed to transfer his right to another entity but the presentation of the evidential documents to the bank is necessary to get the payment.
Here is a step by step procedure to open an LC:
1. Buyer Applies For The LC - The importer approaches his bank and requests for issuing a bank credit letter in the favor of the exporter if the exporter demands an up-front payment after entering into a trade deal with the importer.
2. Filling LC Application Form - The request by the importer for the documentary credit letter is further followed by filling an application form known as “Letter of Credit Application Form”. The issuing bank verifies the given details in the form and sends it to the exporter for approval.
3. Advising Bank Evaluates LC - Then, the issuing bank shares the documents with the Advising bank (Exporter’s Bank) to thoroughly check the authenticity. After getting assured, the advising bank instructs the exporter to initiate the shipment of the goods.
4. Shipment of Goods & Presentation of Documents - The exporter ships the goods & services and receives the shipment documents. Further, To get the advance payment against the shipment documents, the exporter presents these documents to the confirming bank. After verification, the confirming bank sends them to the issuing bank.
5 Settlement of Payment - The issuing bank verifies the documents with the importer and if it finds everything right, it releases the payment to the exporter.
Find our blog “Letter of Credit Frequently Asked Questions” to understand this trade finance instrument better.
Role of the issuing bank in the process of letter of credit is much similar to Escrow service where the bank regulates & controls the payment between the global importers & exporters and only releases funds when all the mentioned T&C are fulfilled.
Documents Required For LC
Here are a few documents that are required to obtain an LC in global trade transaction::
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.
A loan is a lump sum amount borrowed from a third party like a bank to purchase any goods. The borrower needs to repay the money within a prescribed period in the form of EMIs. While, on the other hand, a letter of credit is a short-term trade finance instrument issued by a bank or a Financial institution to assure buyer’s on time payment to the seller.
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?
There is a slight difference between bank guarantee and letter of credit. In a bank guarantee, the bank ensures the seller on time payment if the debtor defaults while in a credit letter, the bank additionally assures fulfillment of contractual obligations on behalf of the buyer apart from the payment assurance.
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 only the loss that occurred.
Checkout our detailed blog on "Difference Between Bank Guarantee and Letter of Credit".
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 an LC is essential:
International Transactions - Import & export letters of credit help the global traders mitigate the associated overseas risks in international transactions. It ensures sellers receive on-time payment for the delivered goods & services in case the buyers are unable to meet the requirements. If the buyer of the goods defaults, the LC takes effect and the issuing bank covers the full or 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.
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.
Advantages of Letter of Credit in Global Trade Deal
For The Sellers:
1. The sellers are assured of getting paid 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.
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 following 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.
Trade finance instruments like an LC can significantly help you reduce foreign trade payment risks and allow you to enter into an international trade deal without any threat of payment failure.