Letter of Credit
A Letter of Credit (LC) is a trade payment term mostly used in cross border trade transactions. In this payment term, the importer or buyer (called “applicant” in banking terminology) instructs their bank in their country to open a LC in favour of their supplier (called beneficiary in banking terminology). The applicant’s bank becomes a guarantor of payment and guarantees payment to the supplier incase shipping documents are submitted exactly as per the terms and conditions of the credit.
The letter of credit is transmitted via the international SWIFT system by the bank of the applicant to the bank of the beneficiary. As soon as the shipment is made the seller/beneficiary collects all the documents required under the credit and submits them to their bank to negotiate payment from the applicant’s bank. The docs are first scrutinized by the beneficiary’s bank to see if they comply to their terms of credit and the beneficiary is asked to rectify any discrepancy if found, depending on the instructions of the beneficiary (resubmission of documents after rectification or to forward documents as they are under collection basis) the documents are then sent by the beneficiary’s bank to the applicant’s bank in original via courier service as per instructions/address provided on the letter of credit.
Upon receipt of the shipping documents the applicant bank scrutinizes the documents to determine if they are according to terms of its credit. The applicant’s bank is under obligation to pay within 5 days of receipt of compliant shipping document under a letter of credit payable at sight & on the day of promise of payment under a usance or a deferred payment letter of credit. In case of discrepant documents, the applicant bank informs the applicant’s bank informs the beneficiary of the discrepancies found on the document and asks for instruction to either accept the discrepancies for release of payment or to have the discrepancies rectified or to reject and return the shipping documents all together.
Once the documents are accepted the shipping documents are handed over to the importer/buyer/applicant enabling them to collect the shipment from the shipping company after the custom clearance procedure has been completed.
This payment term is considered a secured payment term for both the buyer and seller due to the involvement of bank and its guarantee to make payment.
There are different types of letter of credits that are being used to make trade transactions, such as.
Irrevocable letter of credit.
Most letter of credits issue are Irrevocable. An irrevocable letter of credit is where under no condition the LC can be revoked unless agreed by the beneficiary.
Confirmed letter of credit.
In a confirmed letter of credit, the bank of the beneficiary/supplier/exporter or any other bank in the country of the beneficiary/supplier/exporter adds its guarantee in addition to the guarantee of the LC issuing bank. This is done so, usually, against a charge, called LC confirmation charges. Once the LC is confirmed by the foreign bank the confirming bank is under obligation to make payment to the beneficiary/supplier/exporter under their risk and responsibility upon submission of clean shipping documents.
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