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Letter of credit: Know the meaning, types, working, and benefits

A letter of credit is a document issued by a bank or a financial institution that guarantees that the exporter will be paid the amount on time. Learn more about it.

Receiving timely payments from customers is important in any business, whether domestic or international. A letter of credit (LC) is a payment method used by businesses in international trade. 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 (LC)?

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. The issuing 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 draw.²

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

1. Issuance of letter of credit

After the trading parties agree to the sales contract, the importer or buyer applies to the issuing bank for a letter of credit in favor of the exporter. The letter of credit 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 the LC, the exporter initiates 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 exporter’s bank sends the documents to the issuing bank, which verifies every document and then obtains payment from the importer. The documents are then sent to the importer, who uses them 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.

Helps the exporter manage cash flow

A letter of credit guarantees payment and ensures that it is made on time. This is particularly important if there is a significant gap between the delivery of goods and payment.

Can be customized to suit business needs

A letter of credit is usually customizable. The exporter and the importer can come to a mutual contract where they can set payment terms for any particular transaction.

Types of letters of credit

The following are some of the common types of letters of credit used in international trade:

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

A standby letter of credit (SBLC) is a legal document where a bank guarantees payment to a seller if the buyer defaults. It acts as a safety net, ensuring the seller receives payment for goods or services even if unforeseen circumstances prevent the buyer from paying.

5. Sight letter of credit

A sight letter of credit a document that guarantees payment for goods or services when presented with the necessary documents. A sight LC becomes payable immediately after the beneficiary presents proof of delivery or shipment.

6. Acceptance or timed letter of credit

A time letter of credit is a financial document that guarantees payment to the beneficiary at a specified future date once the required documents are presented. This allows the buyer a deferred payment period, providing more time to make the payment.

7. Revocable letter of credit

A revocable letter of credit can be altered or canceled by the issuing bank without the beneficiary's consent.

8. Irrevocable letter of credit

An irrevocable letter of credit cannot be changed or canceled without agreement from all parties involved.

9. Back-to-back letter of credit

In a back-to-back letter of credit (LC), two letters of credit are raised to finance a single transaction. It is usually used in cases where there is a broker, agent or intermediary involved in the process between the importer and exporter. 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 a transferable letter of credit. It's important to note that the second recipient (2nd beneficiary) is not authorized to transfer the LC further.

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 letter of credit allows the borrower to utilize the capacity of the LC on the basis of withdrawals from and payments made against the LCs.

Which parties are involved in a letter of credit issuance?

Below are some of the parties involved:

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.

3. Issuing bank

The financial institution reviews and issues 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. The negotiating bank can either be the advising bank or a separate bank.

5. Advising bank

The advising bank acts on behalf of the exporter, and receives the letter of credit from the issuing bank. The advising bank is responsible for the transfer of documents to the issuing bank 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.³

Contents of a letter of credit (LC)

Some 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

Format of a letter of credit

Example of a letter of credit

Let us consider an example to understand how a letter of credit works. Let’s assume an importer in the US wants to purchase electronics from a manufacturer in India. To ensure payment, the Indian manufacturer requests a letter of credit from the importer's bank. The U.S. bank issues a letter of credit in favor of the manufacturer, guaranteeing payment upon the presentation of shipping documents, such as a bill of lading and an invoice. Once the goods are shipped and the required documents are submitted to the bank, the bank releases the payment to the manufacturer. This process secures the transaction for both parties, ensuring the importer receives the goods and the manufacturer gets paid.

Documents required for a letter of credit

Below are some of the documents required to apply for a letter of credit:

• 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 lender⁴

Advantages of a letter of credit

1. Provides assurance to the seller

An LC guarantees that a seller will be paid under specific conditions, even if a foreign buyer cancels an order or goes bankrupt.

2. Serves as evidence of payment commitments

An LC serves as evidence of payment terms, assuring suppliers that payment commitments will be met in a timely manner.

3. Helps sellers and buyers establish a payment arrangement

An LC allows buyers and sellers to establish adaptable payment arrangements tailored to specific transactions, including the timing of goods shipment.

4. Helps sellers get paid on time

An LC guarantees punctual payment, helping sellers manage cash flow and access financing between shipment and payment receipt.

Disadvantages of a letter of credit

Some of the disadvantages associated with a letter of credit are:

• It adds to the cost of doing business as banks charge an LC fee.
• It may be vulnerable to time constraints.
• Modifications to a LC can cause transaction delays.
• The dependability of payment relies on the issuing bank's reliability.

Conclusion

In international trade, letters of credit are invaluable for ensuring secure and reliable transactions. They provide assurance of payment, foster trust between buyers and sellers, and enable flexible payment arrangements, mitigating many risks associated with cross-border commerce. As global trade continues to evolve, understanding key documentation like letters of credit is crucial for e-commerce exporters. For support with compliance, documentation, or other aspects of e-commerce exports, exporters can leverage the tools and services offered by e-commerce exporters like Amazon Global Selling.

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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?

A bank's charges for a letter of credit depend on various factors, such as the volume and nature of the business, and its profitability.

How long does it take to get a letter of credit?

The time it takes to get a letter of credit depends on the bank. It may take up to 10-15 working days, depending on the circumstances.

Can a letter of credit be canceled?

In most cases, letters of credit are irrevocable and cannot be canceled without the agreed-upon consent of all parties.

Is a letter of credit safe?

Yes, a letter of credit is considered safe as it ensures payment once specific terms are met. The involvement of reputable banks in issuing and confirming the letter of credit adds an extra layer of security.

Can a letter of credit be discounted?

Yes, a letter of credit can be discounted. This means the beneficiary can receive immediate payment before the due date by selling the letter of credit to a bank or financial institution at a discount. This practice helps improve cash flow and provides quicker access to 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.

What are the uses of a letter of credit?

1. It lowers the possibility of unpaid purchasers: It ensures that a seller will get payment as long as certain requirements are fulfilled.
2. It facilitates buyers' demonstration of solvency: It confirms to suppliers that buyers will fulfill payment obligations, which gives them the confidence to make significant purchases to fulfill an order.
3. It facilitates cash flow management for vendors: It guarantees timely payment to sellers, helping them manage cash flow effectively.

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

What is a non-transferable letter of credit?

What is an unconfirmed letter of credit?

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