What is a Letter of Credit & How Does it Works?
Parties Involved; Types & Documents Required
A letter of credit is an independent undertaking from the issuer, promising that subject to fulfillment of specific terms and conditions the party in whose favor the undertaking has been issued will get paid even if the party on whose behalf the issuer has given the undertaking refuses to pay. Generally issued by an importer’s bank, the letter of credit ensures the beneficiary will be paid once the conditions of the letter of credit have been met.
The letter of credit can be used for both inland and cross-border trade. It is normally issued by the buyer’s bank as an undertaking to the seller.
Parties Involved in Letter of Credit
- APPLICANT– The buyer of the goods/services (importer) on whose behalf the letter of credit is issued by the issuing bank.
- BENEFICIARY – The seller of the goods/services (exporter) in whose favor the letter of credit is issued and who obtains payment on presentation of documents complying with the terms and conditions of the LC.
- ISSUING BANK– The bank which issues the credit and undertakes to make the payment on behalf of the applicant as per terms of the L/C.
- ADVISING BANK– Banks which advise the LC, certifying its authenticity to the beneficiary, and is generally a bank operating in the country of the beneficiary.
- CONFIRMING BANK– A bank that adds its irrevocable undertaking to the LC opened by another Bank and thereby undertakes responsibility for payment/ acceptance/ negotiation/incurring deferred payment under the credit in addition to that of the Issuing Bank. It is normally a bank operating in the country of the beneficiary and hence its undertaking adds to the acceptability of the LC for the beneficiary. This is being done at the request/authorization of the Issuing Bank.
- NOMINATED BANK- A Bank in the exporter’s country which is specifically authorized by the Issuing Bank to receive, negotiate, etc., the documents and pay the amount to the exporter under the LC.
- REIMBURSING BANK – Bank is authorized to honor the reimbursement claim made by the paying, accepting, or negotiating bank. It is normally the bank with which Issuing Bank has Nostro Account from which the payment is made to the nominated bank.
Type of Letter of Credit:
- SIGHT/USANCEL/C: Letters of credit can permit the beneficiary to be paid immediately upon presentation of specified documents (sight letter of credit), or at a future date as established in the term/usance letter of credit.
- CONFIRMED L/C: Confirmed letter of credit is an arrangement where a confirming bank adds its undertaking in addition to that of issuing bank to honor a complying presentation. It is an irrevocable undertaking issued by another bank/entity.
- REVOLVING L/C: In order to avoid credit that has been partially utilized, a revolving credit may be used for the value of the credit to be restored.
- TRANSFERABLE L/C: In this type of letter of credit, the seller is allowed to transfer the credit either fully or partially to one or more parties provided the L/C clearly states that it is a transferable letter of credit, also the L/C cannot be transferred by the second beneficiary to a subsequent beneficiary.
- BACK-TO-BACK L/C: A back-to-back letter of credit involves two letters of credit to secure financing for a single transaction. These are usually used in a transaction involving an intermediary between the buyer and seller. Back-to-back letters of credit are used primarily in international transactions.
The list of documents normally required in the LC transaction:
- LC Draft
- Commercial Invoice
- Customs Invoice
- Bill of Lading
- Air waybill
- Packing list
- Certificate of origin
- Certificate of inspection