What is letter of credit?
A letter of credit, or LC, is a legal document that ensures the buyer will pay the seller. It is provided by a bank and guarantees prompt and complete payment to the vendor. If the buyer cannot make such a payment, the bank pays the entire sum or the outstanding balance on the buyer’s behalf.
Types of letter of credit
The following groups can be made up of letters of credit:
- Sight Credit
Documents covered by this LC are payable immediately upon the provision of the necessary paperwork. For instance, a businessperson can get the money they need by giving a lender a bill of exchange and a sight letter of credit. A sight letter of credit is more immediate than other letters of credit.
- Acceptance Credit/Time Credit
Usance bills are bills of exchange that are drawn and payable after some time. Under acceptance credit, these bills are accepted upon presentation and eventually paid on their respective due dates.
For instance, a business might order supplies from a supplier and get the products the same day. The invoice will be sent with the delivery of the products; however, the business may have up to 30 days to make payment. The sale is in effect during this 30-day window.
- Revocable and Irrevocable Credit
Revocable LCs are credits that can have their terms and conditions changed or revoked by the issuing bank. The recipients will not be informed in advance of this termination. An irreversible credit is one whose terms and conditions cannot be changed or revoked. As a result, the LC’s stated pledges bind the opening bank.
- Confirmed Credit
Only irrevocable LC may be confirmed. A confirmed letter of credit (LC) is one in which a banker other than the issuing bank adds its own confirmation to the credit.
The beneficiary’s bank would deliver the paperwork to the confirming banker in the case of confirmed LCs.
- Traveller’s Letter of Credit
This letter assures travellers that issuing banks would accept draughts made at specific foreign banks.
- Standby letter of credit
If the buyer or the bank’s client fails on the contract, a standby letter of credit (SLOC) is a legal document that ensures the bank’s commitment to making payment to the seller.
A standby letter of credit facilitates international trading between businesses unfamiliar with one another and operating under various legal and regulatory frameworks.
A SLOC does not ensure that the buyer will be satisfied with the items, even though the buyer and seller are assured of receiving the goods and payment, respectively.
Parties involved in Letter of Credit
- Applicant: The person who asks his bank to issue a letter of credit is referred to as the applicant.
- Beneficiary (exporter): A beneficiary is a seller paid according to the process.
- Issuing bank: The buyer requests a letter of credit issued by the issuing bank (also known as an opening bank).
- Advising bank: The advising bank, which is often situated in the exporter’s nation, is in charge of transferring papers to the issuing bank on the exporter’s behalf.
- Confirming bank: The issuing bank’s undertaking is further guaranteed by the confirming bank. This issue arises when the exporter is dissatisfied with the issuing bank’s guarantee.
- Negotiating bank: The LC documents submitted by the exporter are negotiated by the negotiating bank. In exchange for repayment under the credit, it pays payments to the exporter, subject to the correctness of the papers.
- Reimbursing bank: The payment account is created by the issuing bank at the reimbursing bank. The reimbursing bank accepts the claim, which resolves the negotiations, acceptance, and payment received through the negotiating bank.
- Second Beneficiary: A person who can act in the original beneficiary’s place in their absence is the second beneficiary. Under these circumstances, the second beneficiary receives the exporter’s credit, subject to the transfer agreement’s restrictions.
FAQs on letter of credit
Who issues a letter of credit?
The letter of credit, often issued by an importer's bank, ensures the beneficiary that payment will be made once the terms of the letter of credit have been satisfied.
What is the beneficiary under the letter of credit?
The buyer of the products, or the importer, is often the bank's client. They collaborate with the bank to issue the letter of credit to the beneficiary. Exporters, also known as sellers or suppliers of products, are the beneficiaries.
Is a party involved in the opening letter of credit?
Opening a letter of credit is done by the issuing bank.
Are letters of credit secure?
Yes. Widely utilised for international commercial transactions, a letter of credit is a secure payment form.
How much does a letter of credit cost?
Usually, letters of credit cost 1% of the contract's agreed-upon sum. But depending on several other circumstances, the price may range from 0.25 to 2 percent.