Q. What is Letter of Credit?
Letter of Credit is a document that serves as a guarantee to the seller on the occasion of the buyer’s failure to make a payment. It is mostly used in international trade, where parties being unaware of each other personally involve a third party, that is, the bank to issue a Letter of Credit that gives a guarantee to the seller concerning his payment.
Besides parties being unaware of each other, various factors such as distance between the parties, different laws in both countries increase the importance of a Letter of Credit. In simple words, it acts as a commitment of guaranteed payment from the buyer to the seller.
Q. Who issues Letter of Credit?
At the request of the buyer, the bank issues Letter of Credit. The said bank is called as “Issuing bank” or the “Opening Bank”.
Thus, the issuing bank is responsible for issuing the Letter of Credit at the request of the buyer.
Q. Features of a Letter of Credit
- Issued against Collateral
The Issuing bank issues a Letter of Credit to the buyer against some collateral. Here any bank deposit or fixed deposit is kept as security.
- Fees for issuance of Letter of Credit
The issuing bank charges fees to issue the Letter of Credit. Various factors are considered by the bank to issue a Letter of Credit.
- Guidelines by the International Chamber of Commerce (hereafter referred to as ICC)
The Uniform Customs and Practice for Documentary Credits (UCP) are set of rules on the issuance and use of a Letter of Credit. They are issued by ICC. As the buyer and seller belong to different countries various rules governing transactions might be different in both countries. Thus, to create an equal field for both parties, ICC issues UCP.
Q. What are the advantages of a Letter of Credit?
- Facilitate Trade between unknown parties
A Letter of Credit gives an ability to the parties in a trade to transact with unknown parties or in newly established trade. It facilitates the parties to expand their business in new geographics.
- Provides payment guarantee to the seller
Letter of Credit is safer as it provides a guarantee of payment to the seller. Thus, in case if the buyer goes bankrupt, the issuing bank has to pay the seller an amount as agreed in the Letter of Credit.
- Highly Customizable
A Letter of Credit is highly customizable as it allows the trading parties to put terms and conditions as per their requirement and arrive at a mutual list of clauses. It also allows the parties to have different terms and conditions for different transactions within the same parties.
- Seller to receive the amount in case of dispute
In case of any dispute between the buyer and the seller, the Letter of Credit allows the seller to withdraw the amount as agreed by them in the Letter of Credit and then later resolve in dispute. It further makes the issuing bank to work independently of any disputes between the parties. The work of issuing bank is to just check whether the documents submitted by the seller satisfy the terms and conditions specified in the Letter of Credit. In case it matches, the issuing bank has to pay the seller, the amount as agreed in the Letter of Credit.
- Ensures payment on time
Besides being a guarantee of payment, the Letter of Credit also ensures that the payment arrives on time. This becomes more important when there is a significant gap between the delivery of goods and the payment. Timely payment will ensure the sellers to manage their cash flows.
- Ensures Buyer’s protection
Letter of Credit not only protects the sellers against payment but provides protection to the 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 his payment back using a Letter of Credit.
- Correctness of Letter of Credit important
As in the Letter of Credit document pass from one party and bank to another, it is necessary that the information mentioned in it is correct.
Q. How many types of Letter of Credit exists?
- Revocable and Irrevocable
Revocable Letter of Credit can be amended or cancelled by the issuing bank at any time. It is, therefore, necessary to pay more attention to it. No prior notice or consent of the beneficiary is necessary for such cancellation or amendment and thus they are not considered as safe.
On the other hand, an Irrevocable Letter of Credit cannot be amended or cancelled without the approval of the concerned parties.
- Confirmed and Transferrable
In the Confirmed Letter of Credit, a bank other than the Issuing bank, gives its confirmation to the credit. Such a bank is called as a Confirming Bank. The role of Confirming Bank is to ensure that the Letter of Credit issued by the Issuing bank is valid. Further, it also ensures that the Issuing Bank has the ability to honour the financial undertaking.
- Revolving Letter of Credit
In this type of Letter of Credit, under the terms and conditions, the amount can be renewed without making any amendment to the credit.
Transferrable Letter of Credit
In this type, the exporter/seller is allowed to transfer the credit either fully or partially to other beneficiaries/parties provided the Letter of Credit states that it is transferrable.
Red Clause Letter of Credit
In this type, the Letter of Credit contains a clause that authorizes the nominated bank to extend the facility of advance payment to the seller before he ships the goods to the importer/buyer. This helps the seller to purchase raw materials, processing and package of goods. This advance payment is made against some documentary requirements which includes a written undertaking.
Green Clause Letter of Credit
It is an extension of the Red Clause Letter. In Green Clause, advance payment is made not only for the purchase of raw materials, processing or packaging but also for warehousing and insurance charges, storage facilities are allowed at the port of shipment to the seller by the Issuing bank. Such clause is printed in green ink, therefore, is called “Green Clause Letter of Credit”.
Payment Letter of Credit
In Payment Letter of Credit, payment can be collected at sight by presenting requisite documents to the issuing bank or the nominated bank.
Q. What is the fees charged by the bank to issue a Letter of Credit?
The fees for a Letter of Credit of a bank depends on various factors such as the amount of risk, goods to be traded, the complexity of the transaction, country of trade etc.
Q. How does a Letter of Credit work?
First, an agreement is made as to goods being purchased, how and when the goods are to be shipped and how and when the payment is to be effected. The Letter of Credit is agreed to be used as a payment mechanism here.
The buyer approaches a bank (Issuing bank) to issue a Letter of Credit in the favour of the seller or exporter. The buyer signs the Letter of Credit application form.
The issuing bank verifies all the given details in the form and sends it to the advising bank for checking the authenticity of parties’ names, product names etc.
The advising bank after checking the authenticity sends the Letter of Credit to the seller. After receiving this, the seller becomes assure about the transaction and payment guarantee to him.
The seller exports the goods to the buyer.
The seller receives here the Bill of Lading which he takes to the Nominated or Negotiating Bank. This bank can be the advising bank or a separate bank. The nominated bank will check all the shipping documents and through the Bill of Lading checks whether the goods are shipped properly as per the Letter of Credit.
The nominated bank then makes a payment to the beneficiary.
The nominated bank sends documents to the issuing bank and demands payment from it.
The issuing bank then sends this document to the buyer and takes approval whether the documents are correct and whether the products are shipped properly.
On getting the approval from the buyer, the issuing bank demands payment from the buyer and the buyer makes a payment to the issuing bank.
The issuing bank then makes a payment to the nominated bank.
The issuing bank shares the documents with the Advising bank (Exporter’s bank) to check the authenticity. On being assured, the advising bank instructs the exporter to initiate shipment of goods to the buyer.
Q. What is the difference between a Bank Guarantee and a Letter of Credit?
Bank guarantee and Letter of Credit both are guarantees from the lending institution that the exporter will receive his payment on time.
A bank guarantee is a legal document where the bank provides the guarantee of payment to the seller in case of default made by the buyer.
However, both financial instruments are different from each other. Differences between both are as follows: –
- Letter of Credit is used in the international market.
Bank guarantee is used in the domestic market.
- Letter of credit is used to ensure payment from the seller and delivery of goods to the buyer.
A bank guarantee is used in infrastructure projects to prove their financial credibility.
- Letter of Credit is more favourable for the exporter.
A bank guarantee is more favourable for the importer.
- In Letter of Credit, the primary liability to pay is on the bank and then the bank afterwards collects it from the client.
In Bank guarantee, the liability comes on the bank only on the occasion of non-payment by the client.
- In Letter of Credit, risk is more on bank as compared to the merchant.
A bank guarantee is riskier for the merchant and less for the bank.
- Five or more parties (Buyer, Issuing Bank, Seller, Advising bank, Negotiating bank and Confirming bank in certain cases) are involved in Letter of Credit.
Whereas, in bank guarantee only 3 parties, that is, applicant, beneficiary and the banker are involved.