Updated July 7, 2023
What is a Letter of Credit?
The term “letter of credit” refers to a payment instrument used primarily in international trade. Under this arrangement, a bank provides a monetary guarantee to a company that imports and exports goods.
The underlying principle is that companies doing business with overseas players must deal with unknown buyers. The sellers seek some payment assurance before starting to work on the consignment. It caters to the need for payment assurance to the suppliers.
Some of the key takeaways of the article are:
- It refers to a document that assures the seller via several participating banks that the buyer will not default on its payment.
- If the buyer fails to repay, the issuing bank must make the repayment.
- The issuing banks charge a fee as a percentage of the letter of credit amount.
- There are different types – credit on sight, time credit, standby letter of credit, revocable credit, irrevocable credit, and transferable credit.
How Does it Work?
Now, let us look at the following steps to understand its works:
1: The buyer/ importer (applicant) approaches a bank (issuing bank) for the issuance of the letter of credit.
2: The seller (beneficiary) will have a bank (advising bank) receive the letter of credit issued and confirm its authenticity.
3: The advising bank will then share this with the seller with the assurance of payment.
4: Once the seller is assured of the payment, the consignment will be shipped as per the buyer’s specifications, after which the buyer will receive the bill of lading.
5: The buyer will present the bill of lading to the negotiating bank to check all the shipping documents and confirm whether or not the consignment is shipped according to the buyer’s instructions.
6: Post confirmation, the nominating bank will pay the seller and demand the same amount from the issuing bank after sharing the shipping documents.
7: The issuing bank will share the documents with the buyer to confirm whether or not all the documents are correct and whether the consignment is shipped.
8: After final confirmation, the buyer will make the payment to the issuing bank, which in turn, will send the cost to the negotiating bank.
Example of Letter of Credit
Let us consider a hypothetical example to understand the concept. Seller Inc., a US-based apparel manufacturer, agreed to ship 50,000 pieces of shirts to Buyer Ltd., a wholesaler in India. However, Seller Inc. requested Buyer Ltd. to furnish a letter of credit. Seller Inc. nominated Negot Bank as the negotiating bank, while Advis Bank is the advisory bank of the issuing Iss Bank. Let us now look at the whole process:
- Buyer Ltd. for a letter of credit with Iss Bank.
- Iss Bank asks for documents from Buyer Ltd., which the latter provides.
- Iss Bank issues the letter of credit in favor of Seller Inc.
- Seller Inc. hands over the letter of credit to Negot Bank.
- Iss Bank submits the documents to Advis Bank, which verifies these documents.
- Seller Inc. ships the consignment, while Negot Bank sends the shipping documents to Iss Bank.
- Iss Bank forwards them to Buyer Ltd. for confirmation.
- Buyer Ltd. confirms and deposits the amount with Iss Bank.
- Iss Bank releases the payment to Negot Bank.
Parties to Letter of Credit
The various parties involved in this transaction are as follows:
- Applicant: The firm that requests the letter of credit as a payment guarantee for the beneficiary is the applicant. It is usually an importer or buyer in the trade.
- Beneficiary: The firm that receives the payment is known as the beneficiary. Usually, a seller or exporter requests a letter of credit from the applicant.
- Issuing Bank: The bank that issues the letter of credit at the applicant’s request is the issuing bank. It is usually located in the applicant’s home country.
- Negotiating bank: The negotiating bank is often located in the beneficiary’s home country. It is a transaction liaison between the beneficiary and the other banks.
- Advising bank: The advising bank receives the letter of credit from the issuing bank and notifies the beneficiary. In some cases, the advising and negotiating banks are the same.
Now, let us look at the different types:
- Credit on Sight: In this type of credit, a company can provide the bill of exchange to the lender and collect the funds immediately based on the sight letter of credit.
- Time Credit: In this type of credit, the payment is made after an agreed period after a company presents the bill of exchange. Thus, the borrower is allowed to repay after receiving the goods.
- Standby Credit: In this credit mechanism, an importer can secure foreign currency funds by providing a standby credit from a domestic bank.
- Revocable Credit: In this type of credit, the issuing bank can amend or cancel the terms and conditions.
- Irrevocable Credit: In this type of credit, the issuing bank can’t amend or cancel the terms and conditions of the letter of credit. Therefore, the bank is to abide by the directions of the letter of credit.
- Transferable Credit: The beneficiary can transfer their rights to a third party in this type of credit.
International trade is inherently complicated due to various factors, such as different laws in each country and lack of personal contact. In such a scenario, it facilitates trading and payment reliably. However, in the absence of a letter of credit, the growth of international trade may experience hindrance, resulting in various other economic misfortunes.
So, it can be seen that it is an excellent credit assurance tool for sellers or exporters. Although the process may be a little stretched, it is pretty simple if executed and streamlined.
This is a guide to a Letter of Credit. Here we also discuss the definitions, their working, examples, parties, and types, along with the importance of a Letter of Credit. You may also have a look at the following articles to learn more –