Letter of Credit

DEFINITION OF 'LETTER OF CREDIT'

A letter from a bank guaranteeing that a

buyer's payment to a seller will be received on

time and for the correct amount. In the event
that the buyer is unable to make payment on
the purchase, the bank will be required to
cover the full or remaining amount of the
purchase.

Letters of credit are often used in international

transactions to ensure that payment will be received.

Due to the nature of international dealings including
factors such as distance, differing laws in each
country and difficulty in knowing each party
personally, the use of letters of credit has become a
very important aspect of international trade.
The bank also acts on behalf of the buyer (holder of
letter of credit) by ensuring that the supplier will not
be paid until the bank receives a confirmation that
the goods have been shipped.

A letter of credit is a legal document from a

bank or financial institution. It represents a

promise to pay the holder,ifthe holder fulfills
certain obligations.
Sellers in commercial transactions often
require buyers to give them a letter of credit
before they ship goods, because a bank then
takes on the obligation of paying the seller,
thus ensuring that the seller will be paid.

Letters of credit, or LOCs, are often used when

buyers and sellers do not know each other.

They are especially common in international
trade when great distances and different
languages, laws and customs make it hard to
know whether a buyer will pay. But they are
also used in everyday domestic business.

Banks require every word, name, date and detail

to be as specific and clear as possible. The

slightest mistake can cause the bank to not pay,
and to require a new Letter of Credit. For
example, shipping a day late, or misspelling a
name may cause the bank to not pay until a new
Letter of Credit is created and accepted.
Its also important to note that the bank pays
the seller based strictly on the soundness of the
LOC, with no regard for other factors such as
about the buyers satisfaction.

Advantages of an LOC for the seller include:

Reduced production risk in case the order is

changed or canceled, and

Protection for the seller in case the buyer doesn't
pay.
Advantages of an LOC forthebuyer include:
The buyer is certain to receive the goods
stipulated in the letter of credit, and
A letter of credit shows solvency for the buyer, and
allows them to reduce or eliminatean initial
payment.

Types of letter of credit

There are five commonly used types of letter of credit.

Each has different features and some are more secure

than others. The most common types are:
irrevocable
revocable
unconfirmed
confirmed
transferable
Other types include:
standby
revolving
back-to-back

Revocable and Irrevocable letters of

credit
A revocable letter of credit can be changed or
cancelled by the bank that issued it at any
time and for any reason.
An irrevocable letter of credit cannot be
changed or cancelled unless everyone
involved agrees. Irrevocable letters of credit
provide more security than revocable ones.

Confirmed and unconfirmed letters of credit

Confirmed LC
The opening bank can request its correspondent bank

or another bank in the buyers country to add their

confirmation to the credit. The bank, which is
confirming the credit, is known as the confirming
bank. Confirmation guarantees the payment if the
terms and conditions stipulated in the credit have
been complied with. Confirmation is an additional
guarantee to the seller that in the event of the
opening bank failing to meet the claims, the
confirming bank will make the payment.

Unconfirmed LC:
The unconfirmed letter of credit does not

have confirmation by another bank. Therefore,

the reimbursement under the LC is the
responsibility of the issuing bank.

Transferable letters of credit

A transferable letter of credit can be passed from

one 'beneficiary' (person receiving payment) to

others. They're commonly used when
intermediaries are involved in a transaction.
Standby letters of credit
A standby letter of credit is an assurance from a
bank that a buyer is able to pay a seller. The
seller doesn't expect to have to draw on the
letter of credit to get paid.

Revolving letters of credit

A single revolving letter of credit can cover several

transactions between the same buyer and seller.

Back-to-back letters of credit
Back to back letter of credit is a letter of credit opened
based on another letter of credit. For e.g if an exporter
receives a letter of credit for supply of certain quantity
of goods, he can request his bankers to open another
letter of credit in favour of his suppliers for supply of
the raw materials. Since the performance under the
first letter of credit depends on the performance of the
second one, it is back to back letter of credit.

RED CLAUSE LC:

some letters of credit may have a provision to

extend cash advance to the buyer for financing

shipment. this clause is usually printed in red. Hence
such letter of credit are known as red clause LC.
GREEN CLAUSE LC:
Banks sometimes issue letters of credit to travelers
to enable them draw cash from banks when they are
on tour. this clause is usually printed in green. Hence
such letter of credit are known as green clause LC.

INLAND LC:
When the buyer, seller and issuing banks are in

the same country, such credits are known as

Inland LC or Domestic LC. In this case the amount
will be denominated in the domestic currency.
FOREIGN LC:
In Foreign LC or Cross border LC, the buyer will be
in one country, the seller will be in another
country and the amount will be denominated in
foreign currency, i.e either in sellers currency or a
third country currency.

Letter of Credit

Process of letter of credit

1. Buyer and seller agree to conduct business. The

seller wants a letter of credit to guarantee payment.

2. Buyer applies to his bank for a letter of credit in

favor

of

the

seller.

3. Buyer's bank approves the credit risk of the buyer,

issues and forwards the credit to its correspondent

bank (advising or confirming). The correspondent
bank is usually located in the same geographical
location
as
the
seller
(beneficiary).

4. Advising bank will authenticate the credit and forward

the

original

credit

to

the

seller

(beneficiary).

5. Seller (beneficiary) ships the goods, then verifies and

develops the documentary requirements to support the
letter of credit. Documentary requirements may vary
greatly depending on the perceived risk involved in
dealing
with
a
particular
company.

6.Seller presents the required documents to the advising or confirming

bank

to

be

processed

for

payment.

7.Advising or confirming bank examines the documents for

compliance with the terms and conditions of the letter of credit.
8.If the documents are correct, the advising or confirming bank will
claim
the
funds
by:
Debiting
the
account
of
the
issuing
bank.
- Waiting until the issuing bank remits, after receiving the documents.
- Reimburse on another bank as required in the credit.

9. Advising or confirming bank will forward the

documents

to

the

issuing

bank.

10. Issuing bank will examine the documents for

compliance. If they are in order, the issuing bank will
debit
the
buyer's
account.
11. Issuing bank then forwards the documents to the
buyer.