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What is a Letter of Credit and how is it useful in exports?

A Letter of Credit is a document sent from a bank or financial institute that guarantees that the exporter will receive the importer’s payment on time, for the full or remaining amount.

In any business, whether domestic or international, receiving timely payments from customers is important. A Letter of Credit (LC) is a payment method used by businesses – it is a document issued by a bank or a financial institution that guarantees that the exporter will receive payment from the importer on time for the full or remaining amount.

What is a Letter of Credit?

A Letter of Credit is a legal document provided by a bank or a financial institution, that guarantees that the exporter will be paid the full and correct amount on time. If the customer or importer backs out and is unable to make a payment on the purchase as per the Letter of Credit agreement, the bank will make the remaining payment to the exporter. A Letter of Credit is commonly used in international trade^1.

How does a Letter of Credit work?

A Letter of Credit is a negotiable instrument, where the issuing bank pays the beneficiary (exporter) or any bank nominated by the beneficiary. First, it is important for the importer to prove to the respective bank that he/she has enough assets to make the required payment, before the bank guarantees the payment to the exporter. The bank takes the entire responsibility that the exporter will be paid. The bank usually charges a fee, as a sign of premium, after sending a Letter of Credit. In case the Letter of Credit is transferable, the beneficiary (exporter) can assign another business, such as a corporate parent or a third party, the right to draw².

Here’s a detailed step-by-step process:

1. Issuance of Letter of Credit

After the parties involved in the trade activity agree to the contract and use of a Letter of Credit, the importer applies to the issuing bank for a Letter of Credit in favour of the exporter. LC is then sent by the issuing bank to the advising bank. The advising bank (of the exporter) verifies the authenticity of the Letter of Credit and forwards it to the exporter.

2. Shipping of goods

After receiving a LC receipt, it is the duty of the exporter to verify the same and initiate the shipping and export logistics process.

3. Providing documents to the confirming bank

After the goods are shipped, the exporter presents the documents to the advising/confirming bank.

4. Settlement of payment from importer and possession of goods

The bank sends the documents to the issuing bank. The amount is paid, accepted or negotiated. The issuing bank verifies every document and then obtains payment from the importer. The documents are then sent to the importer, who uses it in order to get possession of the shipped goods.

Importance of Letter of Credit

Reduces risk of non-paying importer

A Letter of Credit from a bank guarantees that the exporter will receive payment as long as certain conditions are met. It acts as a safeguard against situations where the importer refuses to pay for goods, or if the importer goes bankrupt.

Customization of Letter of Credit

The best part about a Letter of Credit is that it is usually customizable – the exporter and the importer can come to a mutual contract where they can set payment terms for any particular transaction.

Helps the exporter manage cash flow

Apart from guaranteeing payment, a Letter of Credit ensures that the payment is made on time. This is particularly important if there is a significant gap between delivery of goods and payment.

Who are the parties involved in a Letter of Credit issuance?

Below are some of the parties involved³:

1. Applicant

The party in the transaction requesting the Letter of Credit from the bank or financial institution, i.e. the importer.

2. Beneficiary

A beneficiary is the exporter who receives payment under this process. A beneficiary is a party in the entire transaction, who is able to draw and view the payment, based on terms of the Letter of Credit.

3. Issuing bank

The financial institution that reviews and approves the applicant for the Letter of Credit and holds onto the funds involved in the transactions.

4. Negotiating bank

The negotiating bank negotiates the documents related to the Letter of Credit, submitted by the exporter. They work on behalf of the beneficiary’s side.

5. Advising bank

The advising bank is a bank or any financial institution that upon receiving the Letter of Credit, informs the beneficiary when the applicant’s bank approves the Letter of Credit. The advising bank is responsible for the transfer of documents to the issuing bank on behalf of the exporters and is generally located in the country of the exporter.

6. Confirming bank

The confirming bank provides an additional guarantee to the undertaking of the issuing bank. The confirming bank only comes in the entire transaction, when the exporter is not satisfied or has any questions about the issuing bank that is guaranteeing the payment.

7. Intermediary

A third party that can help applicants and beneficiaries sort out details of a Letter of Credit.

Documents required for a Letter of Credit

Below are the documents required to apply for a Letter of Credit⁴:

• Application form with address and photograph
• KYC of the applicant, co-applicant, partners, directors (passport, voter ID card, Aadhar card, etc.)
• Bill of Exchange
• Bill of Lading
• Airway bill
• Commercial invoice
• Insurance certificate
• Certificate of Origin
• Packing, shipping and transport documents
• Certificate of Inspection
• Any other document required by the lender

Types of Letters of Credit

The types of letters of credit include:

1. Commercial Letter of Credit

This is a direct payment method in which the issuing bank makes the payment to the beneficiary.

2. Traveller’s Letter of Credit

For exporters planning to go abroad, this Letter of Credit will guarantee them that issuing banks will issue drafts as and when needed, made at foreign banks.

3. Confirmed Letter of Credit

A Confirmed Letter of Credit involves another bank, other than the issuing bank, guaranteeing payment of the Letter of Credit. The issuing bank in international transactions typically requests this arrangement, making sure that the confirmed bank makes payment under the Letter of Credit, if both the holder and issuing bank are at default.

4. Standby Letter of Credit

Standby Letter of Credit is a credit mechanism in which an importer can get foreign currency funds internationally by providing the issuance of standby Letter of Credit from the domestic bank that guarantees payment to the international bank, if the borrower fails to repay the amount before the due date.

Format of a Letter of Credit with example

Some of the key details to be mentioned in a Letter of Credit are:
• Current date
• Name and address of the beneficiary (exporter)
• Amount to be credited
• Expiration date
• Beneficiary bank details, LC number and terms and conditions
• Sign of the appropriate bank official

Below is an example of a commonly used Letter of Credit format:

Conclusion

Letter of credit is a commonly used mode of payment in exports. This protects the exporter if the importer is not able to pay on time, while also benefitting the importer. It is important for exporters to submit documents in strict compliance as per the terms and conditions of LC. Any sort of non-adherence can lead to non-payment or delay and disputes in payment. With e-commerce exports, reaching international customers and receiving payments is easy and simple. Amazon Global Selling not just enables you to sell across 200+ countries and territories but also receive payments directly in your bank in INR or other currency of your choice.

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More blogs on Letter of Credit

1. Letter of Credit at Sight: Meaning, process and its benefits

2. What is a Transferable Letter of Credit?

3. Irrevocable Letter of Credit: Meaning, process and benefits

4. Green Clause Letter of Credit: Definition, example and features

5. Documentary Letter of Credit: Overview and working

6. Revocable Letter of Credit: Everything you need to know about its uses

7. Red Clause Letter of Credit: Meaning, example and types

8. Standby Letter of Credit (SBLC): Overview, process and types

9. Usance Letter of Credit: Overview, meaning and process

10. Revolving Letter of Credit: Overview, meaning and process

11. Back to Back Letter of Credit: Overview, meaning and process

Frequently Asked Questions

How much do banks charge for a Letter of Credit?

The charges of a bank for a Letter of Credit depends on a variety of factors like volume and nature of the business, profitability of the business, etc.

How long does it take to get a Letter of Credit?

The time duration to get a Letter of Credit depends on the guarantor of the bank, offering the loan. The normal time of approving a loan might take around 10-15 working days, depending on the circumstances.

Can a Letter of Credit be cancelled?

In most cases, Letter of Credits is irrevocable and cannot be cancelled without the agreed consent of all parties.

Is Letter of Credit safe?

A Letter of Credit is one of the safest modes of payment used in business transactions. After receiving a Letter of Credit in your name as a beneficiary, your overseas importer will send you a copy via mail.

Can a Letter of Credit be discounted?

Yes, a Letter of Credit is applicable for discount. While getting the Letter of Credit discounted, it is the duty of the holder of Letter of Credit, that he must verify that the issuing bank is on the list of approved banks, with the discounting bank. Once the Letter of Credit gets approved, the discounting bank charges an amount for releasing the funds.

Who is the issuer of a Letter of Credit?

A Letter of Credit is issued by an importer's bank, guaranteeing the beneficiary (the exporter) will be paid once every condition of the Letter of Credit is duly met.

Published on September 29, 2022.

Sources:
1. https://www.investopedia.com/terms/l/letterofcredit.asp
2. https://www.unionbankofindia.co.in/pdf/hkb_20_auditpolicylettersofcredit.pdf
3. https://smallbusiness.chron.com/commercial-letter-credit-work-56259.html
4. https://www.researchgate.net/publication/340792141_Application_of_letter_of_credit_in_international_trade
5. https://instruction2.mtsac.edu/rjagodka/Importing_Information/Letter_Of_Credit_Guide.pdf
6. https://www.thebalance.com/types-of-letters-of-credit-315040

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