Get all the information about letter of credit, which includes the definition, types and all the processes also.
Companies that regularly engage in international trade frequently use Letters of Credit (LC), a form of credit. Banks and non-bank financial companies (NBFCs) provide this service as a payment guarantee to exporters. If a payment delay or default happens, businesses involved in the import and export trade can rely on a Letter of Credit, a payment instrument offered by banks and non-bank financial companies.
Companies with international operations typically work with unidentified vendors, who must be guaranteed payment before they engage in any business dealings. Therefore, a Letter of Credit is a financial instrument that guarantees payment to Import and Export businesses.
What Is Letter of Credit?
A commercial letter of credit is a legally binding agreement between two banks (the “issuing bank” and the “confirming or advising bank”) whereby the “issuing bank” promises to pay the “beneficiary bank” (the “buyer bank”) for goods or services that the “buyer bank” has purchased (seller). The issuing Bank agrees with the applicant (the buyer) to honor the credit upon presentation of documents that comply with the terms and conditions of the credit upon the request of the beneficiary (the person who will ultimately benefit from the letter of credit). As a result, the issuing Bank stands in for the Bank’s customer as the payment recipient.
Features of Letter of Credit
- The Collateral/Security may include the Buyer’s Fixed Deposits, Bank Deposits, etc., against which the LC is issued.
- Depending on the type of Letter of Credit, the Bank may impose additional fees.
- The International Chamber of Commerce (ICC) issues guidelines for any Letters of Credit.
- This process involves no physical transfer of goods or services and only the exchange of documents, so the letters of credit must be correct. The letter should be accurate regarding the seller’s name, the date, the amount, the product’s name and quantity, etc.
- Incorrect information about the buyer, the product, the expected delivery date, etc., can cause a bank to reject a payment.
- Because the only thing any parties are trading is paper rather than actual goods or services, any potential flaws in the latter won’t affect how much money gets exchanged hands.
Types of Letter of Credit
Credit on Sight
In this form of credit, a business owner only needs to present a bill of exchange and a sight letter to a lender to receive immediate funding. Regarding availability, a sight letter is the fastest type of letter of credit.
Time credit is a bill of exchange in which the payment is made at the end of a specified period negotiated between the lender and the borrower. This type of credit is tied to a specific time frame. A borrower can get a few days to repay the loan after receiving the goods, thanks to the grace period defined in the letter of credit.
Standby Letter of Credit (SBLC)
To obtain foreign currency funds from international lenders, importers can use a credit mechanism known as a Standby Letter of Credit (SBLC), which is issued by a domestic bank and guarantees payment to an overseas lender if the borrower fails to repay the loan on time.
The issuing Bank of a revocable credit LC has the authority to alter or terminate the LC’s terms and conditions at any time. If there is a change to the letter of credit, the issuing Bank need not notify the beneficiaries.
For an LC to be considered “Irrevocable,” the issuing Bank must be unable to alter the terms and conditions in any way. The Bank is obligated to follow the terms of the letter of credit.
As the name implies, a transferable LC is one in which the beneficiary’s rights can be transferred to a third party. The precise conditions may vary based on the specific business or industry.
Importance of Letters of Credit
A letter of credit is a reliable payment mechanism since international trade involves factors such as distance, differences in laws among countries, and the lack of personal contact. Documentary credit letters are governed by the Uniform Customs and Practice for Documentary Credits of the International Chamber of Commerce.
Letter of Credit Process
- The Purchaser and the Vendor Conclude a Business Transaction 1. The seller requires a letter of credit as payment assurance.
- The buyer submits a request to his Bank for a letter of credit to be issued in favor of the seller.
- The buyer’s Bank accepts the buyer’s credit risk and issues and sends the credit to the correspondent bank (advising or confirming). Typically, the seller’s location and the correspondent bank’s location are the same (beneficiary).
- The original credit will be sent to the seller after the advising Bank verifies it (beneficiary).
- After the goods have been shipped, the seller (the beneficiary) verifies and creates the necessary documentary requirements to support the letters of credit. There may be significant variations in the documentation needed to do business with different companies.
- Payment is processed after the Seller submits the necessary documents to the advising or confirming Bank.
- The documents are reviewed by the advising or confirming Bank to ensure they adhere to the letter of credit’s conditions.
- If all the paperwork checks out, the advising or confirming Bank will collect the money by doing the following:
- Having the issuing Bank’s account credited with the money.
- Waiting for the issuing Bank to make a transfer after receiving the necessary paperwork.
- Reimburse to a different bank as specified in the credit.
- The Bank that is providing advice or confirmation will then send the paperwork to the Bank that is issuing the money.
- The issuing bank will check the paperwork to ensure it’s in order. If everything is in order, the buyer’s account will be debited by the issuing Bank.
- The Bank issues the documents and then sends them to the buyer.
Benefits of a Letter of Credit for the Purchasers?
A letter of credit usually supports a beneficiary or a seller in an exchange agreement, ensuring the seller receives the payment from the buyer or the issuing bank.
Letters of credit are also useful if a purchaser makes a payment to a seller for an order and the seller fails to deliver the order on time. Using a letter of credit, the purchaser will be able to get paid with the money he or she spent. Hence, this way, the purchaser will get a refund.
Today’s generation has globalized the buying and selling process. These days, India trades internationally with a wide variety of nations. A high level of trust and confidence is required for international business transactions.
A letter of credit, which acts as a buyer’s certificate of authentication and keeps the buyer and seller together at this crucial juncture, is vital. The primary benefit of a letter of credit is that the issuing Bank will cover the entire purchase price of the product if the buyer defaults on payment. Vakilsearch is the one-stop destination when it comes to getting all the information about Letters of Credits.
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