A letter of credit is a bank guarantee of payment that exists independently of the selling or other contracts on which it is based. It’s a technique for lowering the financial risks that come with moving products.
More precisely, it is a written undertaking by a financial institution (issuing bank) given to the vendor (beneficiary) at the request of the buyer (applicant) to impact payment.
That is, to make a payment, or to accept or negotiate bills of exchange — up to a specified amount, against specified documents, and within a given time limit.
It’s also known as an ‘irrevocable’ letter of credit. Revocable Letters of Credit are no longer useful, so all new Letters of Credit are irrevocable.
Importance of letters of credit
It’s because of the payment’s protection. Perhaps, it’s the next best means of ensuring you will have compensation for your products or services after getting payment in full in advance.
It’s a particularly appealing choice, for example, when you have a high-value order request with whom you have no prior international trading experience. In some countries, payment by Letter of Credit is also necessary, therefore there are no alternative options.
Letters of credit are a reliable payment instrument in international trade because of issues such as distance, differing regulations in each country, and the lack of physical interaction during international trade.
A letter of credit’s parties
- The applicant (importer) requests that the bank provide a letter of credit..
- Issuing bank (also known as the LC’s Opening banker): the bank that issues the LC to the importer.
- Beneficiary (exporter).
Types of letter of credit
The following are the many types of letters of credit:
Revocable letter of credit
The issuing bank or the buyer can modify or revoke the revocable LC at any time without notification. This form of LC is totally in the buyer’s interest. It is hardly used in current international trade since it offers no protection to either the buyer or the seller.
Letter of credit confirmation
A confirmed letter of credit is one in which another bank or financial institution guarantees the LC. It is useful when the seller doesn’t have faith in the buyer’s or issuing bank. It gives the seller more security, but it also raises the cost of the LC.
In a back-to-back credit, the exporter (beneficiary) asks his banker to issue an LC in his supplier’s name so that he can purchase raw materials and items using the export LC he obtained. Back-to-Back credit is the name for this form of LC.
Although an LC is not a negotiable instrument, the Bills of Exchange drawn on it are. A beneficiary can transmit his rights to third parties under a Transferable Credit. This type of LC should clearly state that it is transferable.
Credit for acceptance/time credit
Bills of Exchange are issued and paid after a while. These invoices have acceptance upon delivery and the payment occurs on their due dates under acceptance credit.
A corporation, for example, buys items from a source and receives them the same day. Although the bill departs with the items, the corporation has up to 30 days to pay it.
Sight Credit LC
This requires the advising bank or seller’s bank to pay upon sight, on-demand, or upon presentation of documentation. The seller submits documentation by the LC’s terms and conditions. The advising bank instantly releases the due payment after verification.
The draft is drawn on the producing or corresponding bank at the end of the agreed-upon usage period in a deferred payment LC. The bank may receive the documentation before the products are sent, but the payment is not complete until the usage period ends.
This allows the buyer a grace period during which he can pay after a specified amount of time has passed since receiving the items.
A standby letter of credit
SBLC, or Standby Letter of Credit, is a type of bank guarantee that is more widespread in the United States. Even if the buyer fails to fulfill according to the agreement, the seller can recover payment from the bank.
Negotiable terms letter of credit
Any bank can become a nominated bank under the Freely Negotiable LC if it is ready to pay, accept, undertake a late payment undertaking, or negotiate the LC. The LC must state that it is not bound to any particular bank for negotiation and that it may take place in any bank.
Revolving letter of credit
A revolving credit card is one in which the amount borrowed is resumed following payment, eliminating the need for a new credit card. It is useful when a shipment contains a diversified set of items or a recurrent set of the same goods that trade over some time.
Red clause LC
In a Red clause LC, the seller or beneficiary receives payment in part or in advance before the item departs and after the seller provides the bank with paperwork and verification. This sort of LC helps the seller meet his working capital requirements for raw material purchases, shipping, and processing.
Green clause LC
Green Clause LC is a variant of Red Clause LC with certain unique characteristics. The seller receives additional payment not only for the purchase of raw materials, wrapping, and processing of goods but also for the cost of pre-shipment storage and insurance under a green clause LC.
To conclude, the foregoing is to provide a straightforward explanation of Letters of Credit, particularly in international trading settings.
The truth is that Letters of Credit are complex, whether it’s a standby letter of credit SBLC or a confirmation letter of credit. Perhaps, the massive fines associated with errors committed during the process make them intimidating and off-putting.
This isn’t the case. They only need a proper setup and management. Letters of Credit are a type of payment that allows you to expand your exporting options and reach new markets for your goods and services.
With accessibility to export in charge of your Letters of Credit, you can rest assured that the handling of the procedure will be proper.