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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 trade1.
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:
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.
Which parties are 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
• 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.
5. Sight letter of credit
Documents covered by this Letter of Credit are payable immediately or when proper identification is presented. A businessman could, for instance, show a bill of exchange and a sight letter of credit to a lender to get the money they need right away. A sight letter of credit can be used immediately, unlike other types.
6. Acceptance or timed letter of credit
Usance bills refer to Bills of Exchange that have a deferred payment period. In the context of acceptance credit, these bills are accepted when presented and later settled on their scheduled maturity dates.
7. Revocable letter of credit
As the name implies, the issuing bank may revoke a letter of credit without the beneficiary's consent.
8. Irrevocable letter of credit
If an individual requests a duty credit script against a confirmed and unchangeable letter of credit or an unconditionally co-accepted, endorsed bill of exchange, the exporter's bank must validate and confirm this in an appropriate Bank Certificate of Export and Realization. The receipt of export proceeds will be deemed as successfully achieved. An irrevocable letter of credit will be adequate for those designated as Status Holders.
9. Back-to-back letter of credit
In the context of a back-to-back letter of credit (LC), the initial recipient (original beneficiary) initiates a second LC in favour of a secondary recipient (2nd beneficiary), backed by the security of the original LC. Typically, a back-to-back LC is established to facilitate transactions with suppliers.
10. Transferable letter of credit
When the recipient has the ability to assign all or a portion of a letter of credit (LC) to a second recipient, often a supplier of the original seller, the LC is considered transferable. It's important to note that the second recipient (2nd beneficiary) is not authorized to further transfer the LC.
11. Restricted letter of credit
A restricted LC is one that names a particular bank as the one that will pay, accept, or negotiate the LC.
12. Revolving letter of credit
A revolving loan contract (LC) allows the borrower to utilise the capacity of the LC on the basis of withdrawals from and payments made against the LCs.
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:
• 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:
How to apply for a letter of credit?
1. The exporter and their bank need to be assured of the importer's bank's financial reliability. After finalizing the sales agreement, the importer requests their bank to initiate a Letter of Credit in the exporter's favor.
2. The importer's bank then creates the Letter of Credit, adhering to the terms and conditions of the sales agreement, and sends it to the exporter's bank. The exporter's bank reviews and endorses the Letter of Credit before forwarding it to the exporter.
3. Subsequently, the exporter ships the goods according to the specifications outlined in the letter of credit and submits the necessary documents to their bank. Sometimes, a freight forwarder might be employed to facilitate this process.
4. The exporter's bank meticulously examines the documents to ensure they comply with the terms and conditions of the Letter of Credit. Any document errors or discrepancies must be rectified and resubmitted. Upon approval, the exporter's bank presents the compliant documents to the importer's bank.
5. The importer's bank releases the payment to the exporter's bank, and the importer's account is debited. The documents are then handed over to the importer, enabling them to claim the goods and complete the customs clearance8.
2. The importer's bank then creates the Letter of Credit, adhering to the terms and conditions of the sales agreement, and sends it to the exporter's bank. The exporter's bank reviews and endorses the Letter of Credit before forwarding it to the exporter.
3. Subsequently, the exporter ships the goods according to the specifications outlined in the letter of credit and submits the necessary documents to their bank. Sometimes, a freight forwarder might be employed to facilitate this process.
4. The exporter's bank meticulously examines the documents to ensure they comply with the terms and conditions of the Letter of Credit. Any document errors or discrepancies must be rectified and resubmitted. Upon approval, the exporter's bank presents the compliant documents to the importer's bank.
5. The importer's bank releases the payment to the exporter's bank, and the importer's account is debited. The documents are then handed over to the importer, enabling them to claim the goods and complete the customs clearance8.
Advantages of a letter of credit
1. A bank-issued Letter of Credit (LC) provides assurance that a seller will be paid under specific conditions. For instance, if a foreign buyer alters or cancels an order, the LC guarantees that the buyer's bank will compensate the seller for the delivered goods, mitigating production risks. Additionally, an LC serves as a protection mechanism in cases where a buyer declines to make payment for the goods or undergoes bankruptcy.
2. In case your small or medium-sized enterprise (SME) is making a significant purchase, whether it involves acquiring inventory, equipment, or other assets, a letter of credit (LC) functions as evidence to assure your supplier that you will meet your payment commitments. This becomes particularly crucial when your business requires timely supplies or equipment, and any delays related to the transaction are simply unacceptable.
3. One of the advantages of using a Letter of Credit (LC) is its typically high level of adaptability. This means that the purchaser and seller can collaborate to establish a payment arrangement that suits their specific transaction. In the event that different payment terms are needed for another business deal, the buyer's bank can tailor a distinct agreement for that purpose. Furthermore, an LC allows international buyers to determine the timing of goods shipment.
4. In addition to securing payment, a Letter of Credit (LC) guarantees that the payment is punctual. This becomes especially crucial when there is a substantial time gap between the delivery of goods and the actual payment, particularly in cases of deferred payment. Implementing an LC ensures that sellers receive their payments promptly, greatly assisting them in managing their cash flow effectively. Additionally, sellers can access financing between the goods' shipment and payment receipt, which can offer an extra cash infusion in the short run.
2. In case your small or medium-sized enterprise (SME) is making a significant purchase, whether it involves acquiring inventory, equipment, or other assets, a letter of credit (LC) functions as evidence to assure your supplier that you will meet your payment commitments. This becomes particularly crucial when your business requires timely supplies or equipment, and any delays related to the transaction are simply unacceptable.
3. One of the advantages of using a Letter of Credit (LC) is its typically high level of adaptability. This means that the purchaser and seller can collaborate to establish a payment arrangement that suits their specific transaction. In the event that different payment terms are needed for another business deal, the buyer's bank can tailor a distinct agreement for that purpose. Furthermore, an LC allows international buyers to determine the timing of goods shipment.
4. In addition to securing payment, a Letter of Credit (LC) guarantees that the payment is punctual. This becomes especially crucial when there is a substantial time gap between the delivery of goods and the actual payment, particularly in cases of deferred payment. Implementing an LC ensures that sellers receive their payments promptly, greatly assisting them in managing their cash flow effectively. Additionally, sellers can access financing between the goods' shipment and payment receipt, which can offer an extra cash infusion in the short run.
Disadvantages of a letter of credit
Some of the disadvantages associated with a letter of credit are:
• It may be expensive.
• It may be vulnerable to time constraints.
• A Letter of Credit mandates modifications in case of alterations, thereby causing transaction delays.
• The dependability of payment through the Letter of Credit relies on the issuing bank.
• It may be expensive.
• It may be vulnerable to time constraints.
• A Letter of Credit mandates modifications in case of alterations, thereby causing transaction delays.
• The dependability of payment through the Letter of Credit relies on the issuing bank.
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
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
7. https://www.indiafilings.com/learn/letter-of-credit/
8. https://www.trade.gov/letter-credit
9. https://www.dbs.com/in/sme/businessclass/articles/business-strategy/5-advantages-of-using-a-letter-of-credit.page
10. https://grow.exim.gov/blog/pros-and-cons-letters-of-credit
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
7. https://www.indiafilings.com/learn/letter-of-credit/
8. https://www.trade.gov/letter-credit
9. https://www.dbs.com/in/sme/businessclass/articles/business-strategy/5-advantages-of-using-a-letter-of-credit.page
10. https://grow.exim.gov/blog/pros-and-cons-letters-of-credit
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*Map not to scale. The map has been used for design and representational purpose only, it does not depict the geographical boundaries of the country. These do not conform to the external boundaries of India recognized by the Survey of India.
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