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What is a restricted letter of credit?

Restricted LC is a financial instrument like other LCs where the issuing bank imposes limitations on redemption of the credit. Learn more about its meaning in this blog.

In international trade and finance, letters of credit play a crucial role in ensuring smooth and secure transactions. A letter of credit is a financial instrument issued by a bank that guarantees payment to the seller or exporter once certain conditions are met. It provides a level of assurance to both importer and exporter, reducing the risk associated with cross-border transactions. One of the various types of letters of credit is the restricted letter of credit. Unlike its counterparts, the restricted letter of credit carries certain limitations and conditions that must be adhered to. These limitations are set by the issuing bank and are designed to mitigate specific risks associated with the transaction. Understanding the intricacies of a restricted letter of credit is crucial for businesses engaged in international trade.

What is a restricted letter of credit?

Restricted LC is a financial instrument like other types of letters of credit where the issuing bank imposes limitations on redemption of credit. In this arrangement, the customer or importer can only redeem the letter of credit from a designated bank specified by the issuing bank (importer’s bank). This restriction serves as an additional safeguard for the parties involved in the transaction. This type of LC limits negotiation and payment authorization to a specific bank nominated by the issuing bank. This restriction streamlines the payment process and provides added security for all parties involved in the transaction¹.

Example of a restricted letter of credit

Company X, based in Country A, is buying goods from Company Y, located in Country B. In this transaction, Bank A acts as the issuing bank for the letter of credit, while Bank B is the nominated bank for negotiation. Under the terms of the restricted LC, Company Y can only present the required documents and receive payment from Bank B. If Company Y attempts to negotiate the letter of credit with any other bank, Bank A will not be obligated to honor the payment.

Restricted letter of credit vs freely negotiable letter of credit

Restricted LC

• Specifies a particular bank for negotiation
• If the named bank refuses to negotiate, the opening bank is liable to pay
• Provides greater control over the negotiation process
• Reduces the risk of payment default by limiting negotiation to a trusted bank
• Offers a higher level of security for the parties involved in the transaction
• Requires adherence to the terms and conditions specified by the issuing bank
• Commonly used in situations where the issuing bank wants to limit risks and control the transaction

Freely negotiable LC

• No specific bank is mentioned for the negotiation
• Any willing bank chosen by the beneficiary can negotiate
• Offers more flexibility in selecting the negotiating bank
• Allows for a range of negotiating options
• Carries a relatively lower level of security due to the freedom of negotiation
• Does not impose any specific conditions or restrictions on negotiation
• Suitable when the beneficiary prefers flexibility in choosing a negotiating bank

Problems that might occur with a restricted letter of credit

A challenge might occur if the beneficiary or exporter’s bank lacks a swift authentication process with the opening or issuing bank, leading to delays and complications in negotiation and processing of the LC. A swift authentication process is a secure messaging system used by banks to exchange financial information and documents.

To mitigate this issue, issuing banks often opt to send the letter of credit to their correspondent bank in the exporter’s country. This approach provides a more reliable and streamlined process for the negotiation and execution of the restricted letter of credit.

In addition to addressing authentication challenges, restricting the letter of credit to the correspondent bank also serves as a precautionary measure to ensure compliance with the terms and conditions specified by the issuing bank. It helps maintain control over the transaction and minimizes the risk of unauthorized negotiation or delays caused by incompatible banking systems.

Restricted LC serves as a vital document or financial instrument in international trade, providing control and security for transactions. By understanding its nuances and potential obstacles, businesses can navigate the complexities effectively, ensuring smoother operations and leveraging the benefits of restricted letters of credit in their global trade endeavors.

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Frequently Asked Questions

Can the bank directly send the documents to the LC issuing bank without going through the negotiating bank?

No, in most cases, the bank cannot directly send the documents to the LC issuing bank without going through the negotiating bank. The negotiating bank acts as an intermediary to verify and authenticate the documents before forwarding them to the LC issuing bank for payment.

What is a restricted negotiable letter of credit?

A restricted negotiable letter of credit is a type of LC where the payment authorization to the beneficiary is limited to a specific nominated bank. The beneficiary can only negotiate and receive payment from the designated bank specified by the issuing bank, offering a controlled and secure transaction process.

Published on October 18, 2023.

Sources:
1. https://connect2india.com/finance/letter-of-credit/restricted-letter-of-credit.html
2. https://www.tradefinanceglobal.com/letters-of-credit/restricted-letters-of-credit/#:~:text=A%20Restricted%20Letter%20of%20Credit,LC%20from%20a%20specific%20bank

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What is a restricted letter of credit?

What is a restricted letter of credit?

Example of a restricted letter of credit

Restricted letter of credit vs freely negotiable letter of credit

Restricted LC

Freely negotiable LC

Problems that might occur with a restricted letter of credit

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