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Letters of credit are letters that banks issue to verify the credit a business or person has. They are useful because they tell sellers that the bank will back the buyer in the event the buyer can’t pay on his own. A letter of credit, also known as a documentary credit or banker’s commercial credit, or letter of undertaking, is a payment mechanism used in international trade to provide an economic guarantee from a creditworthy bank to an exporter of goods.
Types of Letter of Credit
There are several types of letters of credit, and they can provide security when buying and selling products or services.
- Seller protection: If a buyer fails to pay a seller, the bank that issued a letter of credit must pay the seller as long as the seller meets all of the requirements in the letter. This provides security when the buyer and seller are in different countries.
- Buyer protection: Letters of credit can also protect buyers. If you pay somebody to provide a product or service and they fail to deliver, you might be able to get paid using a standby letter of credit. That payment can be a penalty to the company that was unable to perform, and it’s similar to a refund. With the money you receive, you can pay somebody else to provide the product or service needed.
Importance of Letter of credit
- Customize: A letter of credit is highly customizable. Both the trading partners can put in terms and conditions as per their requirements and arrive at a mutual list of clauses. It can also be customized from one transaction to another with the same trading partners.
- Credit risk free: Letter of credit is safer for the seller or exporter in case the buyer or importer goes bankrupt. Since the creditworthiness of the importer is transferred to the issuing bank, it is the bank’s obligation to pay the amount as agreed in the letter of credit. Thus, a letter of credit insulates the exporter from the importer’s business risk.
- Quick to execute: A letter of credit is quick to execute. As per the initial terms and conditions, the seller or exporter has to present the proof of material type and quantity along with the shipping documents supporting his claim that the goods have been shipped. The advising bank will verify the documents and give the full payment.
- Pre shipment financing available to seller: The exporter can avail pre-shipment financing against a letter of credit. This helps him in plugging the financing gaps if any.
Element of Letter of credit
- Applicant: The buyer of Goods and services.
- Beneficiary: The seller of the goods and services and the ultimate recipient of payment in the business transaction
- Issuing Bank: The issuing bank provides an assurance to the beneficiary that the payment will be paid duly if all the documents presented comply with the stipulations stated in the letter of credit. The issuing bank also needs to examine the documents submitted by the beneficiary. It is absolutely liable to pay once all the terms and conditions in the LC are complete.
- Advising Bank: The advising bank advises the beneficiary and helps him to use the letter of credit. It pays the beneficiary once the issuing bank makes the payment. It also has the responsibility to send the required documents to the issuing bank. The advising bank has no obligation to pay if the issuing bank is unable to pay the beneficiary.
- Confirming Bank: The confirming bank confirms the letter of credit and assumes the same obligation as the issuing bank. The confirming bank is typically the advising bank. The conforming bank does a strict evaluation of the country and the issuing bank before confirming the LC.
The Money behind a Letter of Credit
Under letter of credit a bank promises to pay on behalf of a customer, but where does the money come from?
The bank will only issue a letter of credit if the bank is confident that the buyer can pay. Some buyers must pay the bank up front or allow the bank to freeze funds held at the bank. Others might use a line of credit with the bank, effectively getting a loan from the bank.
Sellers must trust that the bank issuing the letter of credit is legitimate and that the bank will pay as agreed. If sellers have any doubts, they can use a “confirmed” letter of credit, which means that another (presumably more trustworthy) bank will guarantee payment.
Sellers typically get letters of credit confirmed by banks in their home country.
When Does Payment Happen?
For international trade: The seller may have to deliver merchandise to a shipyard to satisfy the requirements of the letter of credit. Once the merchandise is delivered, the seller receives documentation proving that she made delivery, and the documents are forwarded to the bank. In some cases, simply placing the shipment on board a vessel triggers the payment, and the bank must pay even if something happens to the shipment. If a crane falls on the merchandise or the ship sinks, it’s not necessarily the seller’s problem.
Documents matter: To approve payment on a letter of credit, banks simply review documents proving that a seller performed any required actions.
The bank is not concerned with the quality of goods or other items that may be important to the buyer and seller. That doesn’t necessarily mean that sellers can send a shipment of junk. Buyers can insist on an inspection certificate as part of the deal, which allows somebody to review the shipment and ensure that everything is acceptable.
For a “performance” transaction, a beneficiary (the buyer, or whoever will receive the payment) might have to prove that somebody failed to do something. For example, a city might hire a contractor to complete a building project. If the project is not completed on time (and a standby letter of credit is used), the city can show the bank that the contractor did not meet his obligations. As a result, the bank must pay the city. That payment compensates the city and makes it easier to hire an alternative contractor to finish the work.
Meaning of terms used to define Letter of Credit
To better understand letters of credit, it helps to know the terminology:
Applicant: The party who requests the letter of credit. This is the person or organization that will pay the beneficiary. The applicant is often (but not always) an importer or buyer who uses the letter of credit to make a purchase.
Beneficiary: The party who receives payment. This is usually a seller or exporter who has requested that the applicant use a letter of credit (because the beneficiary wants more security).
Issuing bank: Issuing bank is the bank that creates or issues the letter of credit at the applicant’s request. It is typically a bank where the applicant already does business (in the applicant’s home country, where the applicant has an account or a line of credit).
Negotiating bank: Negotiating bank is the bank that works with the beneficiary. This bank is often located in the beneficiary’s home country, and it may be a bank where the beneficiary is already a customer. The beneficiary submits documents to the negotiating bank, and the negotiating bank acts as a liaison between the beneficiary and the other banks involved.
Confirming bank: Confirming bank is the bank that “guarantees” payment to the beneficiary as long as the requirements in the letter of credit are satisfied. The issuing bank already guarantees payment, but the beneficiary may prefer a guarantee from a bank in her home country (with which she is more familiar). This may be the same bank as the negotiating bank.
Advising bank: Advising bank is the bank that receives the letter of credit from the issuing bank and notifies the beneficiary that the letter is available. This bank is also known as the notifying bank, and may be the same bank as the negotiating bank and the confirming bank.
Intermediary: A company that connects buyers and sellers, and which sometimes uses letters of credit to facilitate transactions. Intermediaries often use back-to-back letters of credit (or transferable letters of credit).
Freight forwarder: A company that assists with international shipping. Freight forwarders often provide the documents exporters need to provide in order to get paid.
Shipper: the Company that transports goods from place to place.
Legal counsel: A firm that advises applicants and beneficiaries on how to use letters of credit. It’s essential to get help from an expert who is familiar with these transactions.