A letter of credit, or “credit letter” is a letter from a bank guaranteeing payment. They can provide security to a seller that will be received on time and for the correct amount. If the buyer is incompetent to make such a payment, the bank covers the full or the outstanding amount on behalf of the buyer.
A letter of credit is issued against a pledge of securities or cash. Banks typically collect a fee, ie, a percentage of the size/amount of the letter of credit.
Letter of credit is used majorly in international trade. The bank provides a financial guarantee to enterprises that deal in the import and export of goods. Enterprises doing business overseas have to deal with foreign suppliers and they demand certainty of payment before executing any transaction. Therefore, a letter of credit is crucial to provide payment assurance to the suppliers or exporters.
How a Letter of Credit Works?
Because a letter of credit is typically a negotiable instrument. If a letter of credit is transferable, the beneficiary may assign another entity, such as a corporate parent or a third party, the right to draw.
Banks also collect a fee for service, typically a percentage of the size of the letter of credit. The International Chamber of Commerce Uniform Customs and Practice for Documentary Credits oversees letters of credit used in international transactions.
- The buyer must first approach the bank and request to issue a letter of credit.
- The issuing bank, generally an international bank pays the beneficiary or any bank nominated by the beneficiary. The job of the advising bank is to authenticate and check the information in the letter of credit
- After authenticating, the advising bank proceeds to reassure the seller that his money will be processed.
- After the purchased items are shipped by the buyer, the seller receives a bill of landing.
- From here the banks take over as the landing bill is sent to the bank on a charge of negotiations which in turn check the exported goods.
- The shipping documents are then shared with the issuing bank.
- The issuing bank proceeds to disclose all documents to the buyer.
- Finally, the buyer makes the payment to the issuing bank, which in turn forwards the payment to the negotiating bank.
- Banks collect a fee for issuing a letter of credit.
Types of Letters of Credit
1. Commercial Letter of Credit
This is a direct payment method in which the issuing bank makes the payments to the beneficiary. In contrast, a standby letter of credit is a secondary payment method in which the bank pays the beneficiary only when the holder cannot.
2. Revolving Letter of Credit
This kind of letter allows a customer to make any number of draws within a certain limit during a specific period.
3. Traveler’s Letter of Credit
For those going abroad, this letter will guarantee that issuing banks will honour drafts made at certain foreign banks.
4. Confirmed Letter of Credit
A confirmed letter of credit involves a bank other than the issuing bank guaranteeing the letter of credit. The second bank is the confirming bank, typically the seller’s bank. The confirming bank ensures payment under the letter of credit if the holder and the issuing bank default.
5. Transferable Credit
Transferable credit, as the name suggests is a type of LC in which the beneficiary can transfer his/her rights to third parties. The terms and conditions may differ as per the trade and industry.
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