What is a Letter of Credit (LC)?
Letter of Credit is a payment mechanism which gives an economic guarantee to the exporter for the agreed payment amount by the issuer’s bank in case of buyers default. Also, known as documentary credit or bankers credit, LC is used by buyers to mitigate the credit risk in international trading.
- An L/C from the bank provides a guarantee of the payment of the specified amount in a specified currency in case of the seller meeting precisely defined terms and conditions and submits the required documents within the mentioned time frame.
- The required documents include air waybill or bill of lading, commercial invoices and certificate of origin. (L/C) plays a very important role in cases of international dealings since various factors like distance, different laws of different countries, etc. come into play.
- For issuing an L/C to the seller or exporter also known as the beneficiary the buyer or the applicant either pays the entire amount to the issuing to LC from bank or may negotiate credit.
How Does Letter of Credit Work?
It gives security while buying and selling. For seller protection, if the buyer is unable to pay then the issuing to LC from the bank will pay the seller if the seller is able to meet all the terms mentioned in the letter. Again for buyer protection if delivery does not happen then the buyer gets his payment by using standby LC. This payment is like a refund and is a penalty to the company due to its inability to perform. Thus LC provides security when buyers and sellers are in different countries.
9 Type of Letter of Credit
There is various type of LC used for international dealings. They are as follows:
#1 – DP LC or DA
It is a type of LC in which the payment is required to be made on the date of maturity in accordance with the terms of credit. The papers of title to goods are given to the buyer when the documents for payments are accepted. The buyer then has to make the payment of the amount on the due date of the maturity of the letter of credit. This is the type of LC where payment is given against documents on presentation.
#2 – LC Irrevocable and Revocable
The type of letter of credit irrevocable that which can be canceled or amendments can be made only with the consent of the beneficiary, applicant and confirming the LC from a bank. A revocable LC can be canceled or amendments can be made at any time without giving prior notice to the beneficiary. Most of the letters of credit irrevocable in nature.
#3 – Restricted LC
A restricted LC is that one wherein the specific bank is designated to pay, accept or negotiate the LC. The authorization of the issuing into LC from a bank is restricted to a specific bank as nominated.
#4 – LC with or without Recourse
If the beneficiary takes himself to be liable to the holder of the bill in case of any dishonor then that Letter of credit is considered with recourse. If the beneficiary doesn’t take himself as liable the credit is known to be without recourse.
#5 – Confirmed LC
A confirmed LC is the one where the advising bank at the request of the issuing bank makes an addition of confirmation that payment will be made. The confirming bank is liable in the same way as that of the issuing to LC from the bank. The confirming bank needs to honor the payment if tendered by the beneficiary.
#6 – Transferable LC
It is the type of LC which can be transferred by the beneficiary in whole or part to a second beneficiary which is usually supplied to the seller. The second beneficiary cannot transfer it further to another beneficiary.
#7 – Back to Back LC
In this type of LC, the second LC is opened by the beneficiary in the name of the second beneficiary wherein the first LC is kept as security for the second one. This type of letter of credit is generally opened for suppliers.
#8 – Standby LC
This is a type of letter of credit which is like a performance bond or guarantee issued by the bank in the form of the LC. The beneficiary can ask for its claim by providing the required documents as mentioned in the LC document.
#9 – Resolving LC
Here the applicant is allowed to use the LC facility again based on the withdrawals and the payment made against the LCs.
- This is a formal, negotiable financial or trade instrument. So the issuing of LC from bank pays the beneficiary or any bank nominated by the beneficiary.
- In cases where the LC is transferable then the beneficiary can assign any other bank or a third party or corporate parent the right to withdraw the money on its behalf. It is used in those situations where the seller is not very willing to give credit to the buyer.
- This is a non-negotiable instrument but it can be transferred with the consent of the applicant.
- In the case of the LC, the international banking system comes into play and acts as an intermediary between the sellers and buyers who are the distance apart and unknown to each other.
- But even though the banking system acts as a mediator it does not have any responsibility for the quality of goods, the genuineness of documents or other provisions or conditions mentioned in the agreement of sale. The International Chamber of Commerce has given specific guidelines and terms for writing the LC which are globally accepted and used.
Video on Letter of Credit (LC)
So here we understand that A Letter of Credit LC is a written commitment to pay which is issued by a buyer’s or importer’s bank i.e. the issuing of LC from bank to the seller’s or exporter’s bank i.e. accepting bank, negotiating bank or paying the bank. It is a letter that guarantees on-time buyer’s payments to a seller and for the correct amount. If the buyer is unable to complete the payment on purchase then the bank has to cover the full or remaining amount of the purchase.
This has been a guide to what is Letter of Credit and its meaning. Here we discuss how the LC works, its types and its important features.You may also have a look at these articles below to learn more about Credit –