LETTER OF CREDIT

A letter of credit is a document that guarantees the buyer’s payment to the

sellers. It is Issued by a bank and ensures the timely and full payment to
the seller. If the buyer is unable to make such a payment, the bank covers
the full or the remaining 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.

Importance of letters of credit

Since the nature of international trade includes factors such as distance,
different laws in each country and the lack of personal contact during
international trade, letters of credit make a reliable payment mechanism. The
International Chamber of Commerce Uniform Customs and Practice for
Documentary Credits oversees letters of credit used in international transactions

Parties to a letter of credit

 Applicant (importer) requests the bank to issue the LC

 Issuing bank (importer’s bank which issues the LC [also known as the
Opening banker of LC])
 Beneficiary (exporter)

EXAMPLE
A letter of credit is a bank's written promise that it will make a
customer's (the holder) payment to a vendor (called the beneficiary) if the
customer does not.

Company XYZ wants to import $100,000 worth of Goods manufactured by

Company ABC, but Company ABC is concerned about XYZ's ability to pay for
them.

To address this, Company XYZ gets a letter of credit from its bank, Axis bank,
indicating that Company XYZ will make good on the $100,000 payment in, say,
60 days, or Axis bank will pay the bill itself. Axis bank , then sends the letter
of credit to Company ABC,(or ABC’s bank), which then agrees to ship the
goods.
After the shipment goes out, Company ABC (or Company ABC's bank) then
asks for its $100,000 by presenting a written draft (also called a bill of
exchange) to Axis bank.
Although letters of credit mostly benefit sellers, they also protect buyers,
because Company ABC must present Axis bank with written proof of the goods
shipment in order to get paid. This proof usually includes a commercial
invoice, bill of lading, or an airway bill. After Axis bank pays Company ABC, it
turns to Company XYZ for reimbursement (usually by debiting Company
XYZ's bank account). Banks usually require a pledge of securities
or cash collateral in order to issue a letter of credit to a holder. Banks also
collect a fee for issuing letters of credit; the fee is usually a percentage of the
size of the letter of credit.

To better understand letters of credit, it helps to know the terminology.

1.Applicant: The party who requests the letter of credit. This is the person or
company that will pay the beneficiary. The applicant is typically (but not always)
an importer or buyer who uses the letter of credit to make a purchase.

OR

Applicant: The applicant in a LC transaction is usually the buyer or importer of

goods. The applicant of the LC has to make payment if documents, as per the
conditions of the LC are delivered to the Bank.

2.Beneficiary: The beneficiary is the party to whom the LC is addressed, i.e.,

the seller or exporter. The beneficiary would receive payment from the
nominated bank against submission of documents as per the LC condition.

OR

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).

3.Issuing Bank: The issuing bank is the Banker to the importer or buyer which
lends its guarantee or credit to the transaction. The issuing bank is liable for
payment once the documents as per the conditions of the LC are received by it
from the Negotiating Bank.

OR

Issuing bank: 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: The Negotiating Bank is the beneficiary’s bank. Beneficiary

in a LC transactions would be the seller or exporter. The negotiating bank
would claim payment from the issuing bank or the opening bank.

OR

Negotiating bank: The bank that works with the beneficiary. This bank is
generally located in the beneficiary’s home country, and may be a bank where
the beneficiary already conducts business. The beneficiary will submit
documents to the negotiating bank, and the negotiating bank acts as a liaison
between the beneficiary and other banks involved.

Confirming bank: A bank that “guarantees” payment to the beneficiary as long

as the requirements in the letter of credit are met. 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.

Types of Letter of Credit

1. Irrevocable LC. This LC cannot be cancelled or modified without consent

of the beneficiary (Seller). This LC reflects absolute liability of the Bank
(issuer) to the other party.

2. Revocable LC. This LC type can be cancelled or modified by the Bank

(issuer) at the customer's instructions without prior agreement of the
 beneficiary (Seller). The Bank will not have any liabilities to the
beneficiary after revocation of the LC.

3. Stand-by LC. This LC is closer to the bank guarantee and gives more
flexible collaboration opportunity to Seller and Buyer. The Bank will
honour the LC when the Buyer fails to fulfill payment liabilities to Seller.

4. Confirmed LC. In addition to the Bank guarantee of the LC issuer, this

LC type is confirmed by the Seller's bank or any other bank. Irrespective
to the payment by the Bank issuing the LC (issuer), the Bank confirming
the LC is liable for performance of obligations.

5. Unconfirmed LC. Only the Bank issuing the LC will be liable for payment
of this LC.

6. Transferable LC. This LC enables the Seller to assign part of the letter of
credit to other party(ies). This LC is especially beneficial in those cases
when the Seller is not a sole manufacturer of the goods and purchases some
parts from other parties, as it eliminates the necessity of opening several
LC's for other parties.

7. Payment at Sight LC. According to this LC, payment is made to the seller
immediately (maximum within 7 days) after the required documents have
been submitted.
Or

Sight Letter of Credit

Payment under a sight letter of credit occurs as soon as the beneficiary submits
acceptable documents to the appropriate bank. The bank has a few days to
review the documents and ensure that they meet the requirements in the letter
of credit. If the documents are compliant, payment is made immediately.
 8. Deferred Payment LC. According to this LC the payment to the seller is
not made when the documents are submitted, but instead at a later period
defined in the letter of credit. In most cases the payment in favor of Seller
under this LC is made upon receipt of goods by the Buyer.

or

Deferred Payment Letter of Credit

With this type of letter of credit, payment does not happen immediately after
the documents are accepted. Some agreed-to period of time passes before
the seller receives cash. A deferred payment letter of credit is obviously a
better deal for buyers than for sellers. These are also known as term or
usance letters of credit.

9. Red Clause LC. The seller can request an advance for an agreed amount
of the LC before shipment of goods and submittal of required documents.
This red clause is so termed because it is usually printed in red on the
document to draw attention to "advance payment"

10. Revolving Letters of Credit

A revolving letter of credit can be used for multiple payments. If a buyer and
seller expect to do business continually, they may prefer not to obtain a new
letter of credit for every transaction (or for every step in a series of
transactions). This type of letter of credit allows businesses to use a single
letter of credit for numerous transactions until the letter expires (typically up to
one year).