Letter of Credit Explained

Letter of Credit Explained

A letter of credit is a financial instrument issued by any financial institution to a beneficiary guaranteeing the payment of specific amount upon presenting this letter to his bank. It is generally used in international business transactions.
Uncertainty and risk are intrinsic to international trade due to factors like distance, differing laws, possible political instability and lack of familiarity with the transacting party. However, the risk involved in international business can be mitigated by the use of a letter of credit.

What is it?

A letter of credit is a negotiable instrument that is issued by a financial institution, e.g., bank on behalf of the buyer of goods to guarantee the seller or beneficiary, that the latter will be in receipt of the full amount of payment on presenting the advising bank, with the necessary shipping documents that confirm the shipment of goods within the given time frame. A letter of credit is generally irrevocable.

How does it work?

A buyer (importer), who is a credit-worthy customer of some local bank, requests the bank to issue a letter of credit (L/C) with the seller as the beneficiary. The issuing bank then sends a copy of the letter to the advising bank, which is typically the seller's local bank. The advising bank has the responsibility of checking its authenticity. It is also required to dispatch the documents to the issuing bank, confirming the delivery of goods at the predetermined place, within the specified time frame, and in accordance with the terms and conditions specified in the L/C. If the beneficiary is in conformity with the letter of credit terms and conditions, the issuing bank has to make good its obligation to transfer the pre-determined sum of money to the advising bank. The latter then credits the payment to the beneficiary (exporter). Since, L/C is negotiable, it can be sold or transferred, and the bearer would be entitled to the amount specified in it. If the issuing bank fails to make good its obligation, the advising bank is not required to credit the beneficiary unless the letter is confirming.

What are its types?

It has several types depending upon the nature of the transaction and the needs of the transacting parties.

Sight Letter of Credit: It is payable as soon as the necessary documents have been presented to the issuing bank by the advising bank.

Non-performing or Standby Letter of Credit: It is a fall-back option for the beneficiary in case the buyer refuses to make a payment on or before the specified date, despite taking delivery of the imports. In this situation, it comes to the rescue of the beneficiary. However, if the payment is made as promised, it stands canceled.

Confirmed Letter of Credit: This means that not only the issuing bank but also the advising bank assumes the responsibility of paying the beneficiary. In other words, if the issuing bank does not live up to its end of the bargain, the advising bank assumes the responsibility of making a payment, provided all the terms and conditions outlined in the letter are fulfilled.

Revocable Letter of Credit: Although letters of credit are generally irrevocable, the issuing bank may open one that can be canceled or modified after its date of issue.

Advising fee

The beneficiary is required to pay some fees such as advising, communication, payment, discrepancy, and reimbursement fee. Of these, the advising fee and the discrepancy fee can be done away with, upon fulfillment of certain conditions. The buyer also has to incur certain fees for opening a letter of credit. The amount varies depending upon the country, the amount involved, and the type of letter. For instance, the cost of the standby letter of credit varies between 1 and 8 percent of the face value of the transaction.