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Published : December 12, 2023, Updated : January 23, 2024

Letter of Credit (LC) Unveiled: Meaning, Process, and its Vital Role in Global Trade

Letter of Credit (LC) Unveiled: Meaning, Process, and its Vital Role in Global Trade

An Example of a Letter of Credit

Let’s consider a hypothetical example to illustrate how a Letter of Credit (LC) works in an international trade transaction:

Initiation

A buyer (importer) and a seller (exporter) decide to engage in an international transaction. The buyer wants to ensure that the seller ships the goods before making payment, while the seller wants assurance of payment upon fulfilling their obligations.

Agreement on Terms

The parties agree to use a Letter of Credit as the payment method. The buyer approaches their bank (issuing bank) to open an irrevocable LC in favor of the seller. The LC specifies details such as the amount, shipping terms, and required documents.

Issuing the Letter of Credit

The issuing bank issues the LC and sends it to the advising bank (seller’s bank), which is often located in the seller’s country. The advising bank confirms the authenticity of the LC and notifies the seller of its existence.

Shipment and Documentation

The seller prepares and ships the goods according to the terms outlined in the LC. Simultaneously, they gather the required documents, such as the commercial invoice, bill of lading, packing list, and any other documents specified in the LC.

Presentation of Documents

The seller presents the shipping documents to the advising bank, which checks for compliance with the terms of the LC. If the documents meet the criteria, the advising bank forwards them to the issuing bank.

Payment to the Seller

Upon verifying that the documents align with the LC terms, the issuing bank makes the agreed-upon payment to the seller. The buyer receives the shipping documents and can claim the goods from the carrier.

Closure of the Letter of Credit

The LC is considered fulfilled, and the issuing bank notifies the buyer that the payment has been made. Any remaining funds are released, and the LC is officially closed.

In this example, the Letter of Credit serves as a secure mechanism, ensuring that the buyer only makes payment when the seller fulfills their obligations, and the seller receives payment upon presenting the required documents. This process minimizes the risk for both parties and facilitates smoother international trade transactions. Keep in mind that the specific details and terms of an LC can vary based on the agreement between the buyer and seller.

Process of a Letter of Credit

The process of a Letter of Credit (LC) involves several stages, ensuring a secure and structured framework for international trade transactions. Here is a step-by-step overview of the LC process:

Agreement on Terms

The buyer (importer) and seller (exporter) agree on the terms of the transaction, including the use of a Letter of Credit as the payment method. They outline details such as the type of LC, amount, shipping terms, and required documents.

LC Application by the Buyer

The buyer applies for the LC at their bank (issuing bank). The application includes details about the transaction and the terms agreed upon with the seller.

LC Issuance

The issuing bank evaluates the buyer’s creditworthiness and, if satisfied, issues the LC. The LC is then sent to the advising bank (usually located in the seller’s country) or directly to the seller.

Advising the LC

The advising bank verifies the authenticity of the LC and notifies the seller of its existence. In some cases, the advising bank may also confirm the LC, providing an additional layer of assurance to the seller.

Shipment of Goods

The seller prepares and ships the goods according to the terms specified in the LC. Simultaneously, they gather the required shipping documents, such as the commercial invoice, bill of lading, packing list, and any other documents stipulated in the LC.

Document Presentation

The seller presents the shipping documents to the advising bank, demonstrating compliance with the terms of the LC. The advising bank carefully reviews the documents for accuracy and conformity.

Document Examination by the Issuing Bank

The advising bank forwards the documents to the issuing bank. The issuing bank thoroughly examines the documents to ensure they align with the terms of the LC.

Payment to the Seller

Upon verification, the issuing bank makes the agreed-upon payment to the seller. The buyer receives the shipping documents, allowing them to claim the goods from the carrier.

Notification to the Buyer

The issuing bank notifies the buyer that the payment has been made and provides any remaining documents. Any discrepancies in the documents are communicated to the buyer for resolution.

Closure of the LC

The LC is considered fulfilled, and any remaining funds are released. The issuing bank officially closes the LC, marking the conclusion of the transaction.

Throughout this process, communication between all parties—buyer, seller, and banks—is essential to ensure a smooth and efficient international trade transaction. The structured nature of the LC process helps minimize risks and build trust among the involved parties.

Different Types of Letter of Credit

There are several types of Letters of Credit (LC), each designed to cater to specific needs and circumstances in international trade. Here’s an overview of some common types:

Irrevocable Letter of Credit

This type of LC cannot be modified or canceled without the consent of all parties involved, providing a high level of assurance to the seller.

Revocable Letter of Credit

Unlike its irrevocable counterpart, a revocable LC can be modified or canceled by the issuing bank without prior notice, but it is rarely used due to the increased risk for the seller.

Confirmed Letter of Credit

In addition to the commitment from the issuing bank, a confirming bank adds its guarantee, providing an extra layer of security for the seller.

Unconfirmed Letter of Credit

This type relies solely on the commitment of the issuing bank and does not involve a confirming bank. It is a more straightforward form of LC.

Transferable Letter of Credit

Allows the original beneficiary (seller) to transfer all or part of the credit to another party, often used in complex supply chain scenarios.

Standby Letter of Credit (SBLC)

Functions are more like a guarantee than a payment mechanism and are often used as a backup in case the buyer fails to fulfill their contractual obligations.

Red Clause Letter of Credit

Includes a specific clause that allows the advising bank to provide pre-shipment finance to the beneficiary (seller).

Green Clause Letter of Credit

Similar to the red clause, but it goes a step further by allowing for post-shipment financing as well.

Back-to-Back Letter of Credit

Involves the use of two separate LCs, where the first is used as collateral to secure a second LC, often used in intermediary trade scenarios.

Deferred Payment Letter of Credit

Allows the buyer to delay payment until a specified future date, providing flexibility in managing cash flow.

Revolving Letter of Credit

Automatically renewed after each transaction, providing a continuous line of credit for ongoing business relationships.

Transferable Revolving Letter of Credit

Combines features of both transferable and revolving LCs, offering flexibility in both transferability and continuous availability of credit.

What is the Importance of a Letter of Credit?

The importance of a Letter of Credit (LC) in international trade cannot be overstated, as it serves multiple crucial functions that benefit both buyers and sellers engaged in cross-border transactions. Here are some key reasons why an LC is of paramount importance:

Risk Mitigation

Payment Security: For sellers, an LC provides a guarantee of payment as long as they comply with the terms and conditions specified in the document. This minimizes the risk of non-payment, especially when dealing with unfamiliar or distant buyers.

Trust Building

Facilitating Trust Between Parties: The involvement of banks in the LC process adds an additional layer of trust to the transaction. Both the buyer and the seller can rely on the financial institutions involved, reducing the perceived risk associated with international trade.

Global Trade Facilitation

Enabling Cross-Border Transactions: The use of LCs facilitates trade between entities in different countries, overcoming challenges such as varying legal systems, currencies, and business practices. It helps create a standardized and widely accepted method for international transactions.

Compliance and Documentation

Ensuring Compliance: LCs outline specific conditions and requirements that must be met for the payment to be executed. This ensures that both parties adhere to agreed-upon terms and follow the necessary legal and regulatory procedures.

Working Capital Efficiency

Optimizing Cash Flow: Buyers can negotiate favorable payment terms with their banks, allowing them to optimize their working capital by delaying payment until certain conditions are met, such as the receipt of goods or required documentation.

Expanding Market Access

Encouraging New Market Entry: For businesses looking to expand globally, the use of LCs can be a catalyst for entering new markets. The assurance of payment through a recognized financial instrument can make sellers more willing to explore business opportunities in different regions.

Dispute Resolution

Providing a Framework for Dispute Resolution: The terms and conditions specified in an LC offer a clear framework for resolving disputes. This helps in minimizing the potential for disagreements between buyers and sellers, as well as between banks.

In summary, a Letter of Credit is a linchpin in international trade, fostering a secure and efficient environment for transactions. Its importance lies in mitigating risks, building trust, and providing a standardized mechanism that facilitates global commerce, contributing to the growth and sustainability of businesses involved in cross-border trade.

Documents Required for a Letter of Credit

Shipping Bill of Lading
Airway Bill
Commercial Invoice
Insurance Certificate
Certificate of Origin
Packing List
Certificate of Inspection

How a Letter of Credit (LC) Works?

In essence, a Letter of Credit serves as a structured mechanism where the issuing bank ensures payment to the exporter, either directly or through authorized intermediary banks, based on the agreed-upon terms and conditions specified in the LC. This process provides security and confidence to both the importer and exporter in international trade transactions.

Issuing Bank’s Role

The issuing bank acts based on the request and instructions of the applicant (importer) or autonomously.

Payment to the Beneficiary

The issuing bank has the capability to make a payment directly to the beneficiary (exporter) or to their order.

Acceptance of Bills of Exchange

Alternatively, the issuing bank can accept bills of exchange or drafts drawn by the exporter as part of the payment process.

Authorization for Advising/Nominated Banks

The issuing bank has the authority to authorize advising or nominated banks to either make payments or accept bills of exchange on its behalf.

Fees and Charges Associated with a Letter of Credit (LC)

In the realm of Letters of Credit, various fees and reimbursements are integral, with all parties typically involved in managing the payment process. The fees imposed by banks encompass:

Opening Charges

This includes commitment fees, payable upfront, and usance fees, which are charged for the agreed-upon tenure of the LC.

Retirement Charges

Payable at the conclusion of the LC period, retirement charges consist of:

  • Advising Fee: Charged by the advising bank.
  • Reimbursements: Paid by the applicant to the bank for foreign law-related obligations.
  • Confirming Bank’s Fee: If applicable, this fee is paid to the confirming bank.
  • Bank Charges: Payable to the issuing bank for managing the LC process.

Understanding these fees is crucial for all parties involved in a Letter of Credit arrangement, providing transparency in the financial aspects of international trade transactions.

Considerations Before Obtaining a Letter of Credit

Here are some of the major things that you must consider before obtaining a letter of Credit. By considering these factors, exporters can navigate the complexities of obtaining a Letter of Credit more effectively, fostering a secure and transparent international trade transaction.

Strict Document Adherence

It is imperative for exporters to meticulously adhere to the terms and conditions specified in the LC. Any deviation from these terms may result in non-payment, delays, or payment disputes.

Reputation and Strength of Issuing Bank

Prioritize choosing an issuing bank with a robust reputation and financial stability. This ensures that the bank possesses the strength and reliability to honor the LC when the need arises.

Cost Allocation Clarification

Clearly define the responsibility for bearing costs before opting for an LC. Allocating costs to the exporter without clarity can escalate the overall cost of recovery. Additionally, carefully assess the cost-benefit of choosing an LC over alternative payment methods.

Evaluation of Cost-Effectiveness

Beyond cost allocation, consider the overall cost-effectiveness of utilizing an LC compared to other export payment options. Assess whether the benefits provided by the LC justify the associated costs.

Understanding Terms and Conditions

Thoroughly understand and negotiate the terms and conditions of the LC with all parties involved. This includes aspects such as shipping terms, document requirements, and any specific conditions outlined in the LC.

Communication and Coordination

Maintain open communication with all relevant parties, including the buyer, issuing bank, and advising bank. Clear coordination ensures that everyone is on the same page, reducing the likelihood of misunderstandings.

Legal and Regulatory Compliance

Ensure that the proposed LC complies with applicable legal and regulatory requirements. This step is crucial for avoiding complications and ensuring a smooth and lawful transaction.

Risk Mitigation Strategies

Develop and implement risk mitigation strategies to address potential challenges. This may include having contingency plans in place for unexpected events that could impact the fulfillment of the LC.

Final Words

In the world of global trade, the Letter of Credit is the unsung hero, providing a secure bridge between buyers and sellers worldwide. Its role in reducing risks, building trust, and streamlining transactions cannot be overstated.

Understanding the intricacies of this financial instrument is not just beneficial; it’s essential for businesses navigating international waters. From initiation to closure, the Letter of Credit ensures a smooth and reliable journey for all parties involved.

So, whether you’re a buyer, a seller, or a bank, embracing the Letter of Credit is not just a choice—it’s a key to unlocking seamless global transactions. It’s more than a document; it’s a symbol of trust and collaboration in the vast landscape of international trade.

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