Understanding Letter of Credit: Meaning, Types, and Process

A Letter of Credit (LC) is a bank-issued guarantee ensuring timely payment between buyer and seller, crucial in international trade. It minimizes transaction risks by providing financial security if the buyer defaults. LC costs range from 0.5% to 1.5% of the transaction value and cover issuance, negotiation, and amendment fees.

What Is a Letter of Credit?

A Letter of Credit is a financial instrument issued by a bank that guarantees a seller will receive payment from a buyer within an agreed timeframe. Commonly used in international trade, this document ensures that the payment will be received on time and for the correct amount. If the buyer is unable to make a payment on the purchase, the bank covers the full or remaining amount owed. It serves as a crucial tool to mitigate risks in transactions involving significant distances and unfamiliar parties, thereby facilitating smoother and more reliable trade relationships between companies across borders. A small business loan can provide the necessary funds to cover substantial expenses, such as expanding operations or purchasing equipment, and can be secured using a letter of credit to ensure transaction trustworthiness.

Parties to a Letter of Credit

• Applicant (Importer): The party initiates the process of requesting their bank to issue a letter of credit. The applicant is typically the buyer in an international trade transaction, and they use the LC to assure the seller that the payment will be made once the agreed-upon terms are fulfilled. 
• Issuing Bank (Importer’s Bank): The issuing bank, also known as the opening bank, is the financial institution that creates and issues the letter of credit on behalf of the applicant. This bank is responsible for ensuring payment to the beneficiary, provided that all conditions outlined in the LC letter are met. 
• Beneficiary (Exporter): The beneficiary is the party whose favor the letter of credit is issued. Usually, this is the seller or exporter in the transaction. The beneficiary is assured of receiving payment from the issuing bank once they present the necessary documents that comply with the terms specified in the LC.

Importance of Letters of Credit

Letters of credit are essential in international trade because they address the complexities and risks associated with cross-border transactions. When businesses engage in international trade, they face challenges such as different legal systems, geographical distances, and a lack of direct interaction between the buyer and seller. 

A letter of credit offers a dependable payment method that mitigates these risks, It acts as a financial guarantee provided by a bank. It ensures that the seller will receive the payment as long as the specified terms and conditions are met.

The International Chamber of Commerce (ICC) oversees these transactions through the Uniform Customs and Practice for Documentary Credits (UCP 600). This standardizes and regulates the use of letters of credit globally. Thus, they provide a secure and predictable framework for international trade. 

How a Letter of Credit Works

A working capital loan helps manage daily business operations, and securing it through a letter of credit can assure lenders of timely repayment, especially in international dealings. A Letter of Credit (LC) works as a guarantee from a bank that a seller will receive payment from the buyer as long as the terms specified in the LC are met. When a transaction is initiated, the buyer requests their bank to issue an LC in favor of the seller. The seller then ships the goods and presents the required shipping documents to their bank, which are forwarded to the buyer’s bank. If all documents comply with the LC’s terms, the issuing bank makes the payment to the seller. This process significantly reduces the risk of non-payment, providing security to both parties involved.

What is the Difference Between a Letter of Credit and a Bank Guarantee?

A letter of credit (LC) is a written commitment from a bank that guarantees payment to a seller once specific documentary conditions are met. This proves that the seller has fulfilled the contractual obligations. This means that the buyer’s bank ensures the seller receives payment for the sale of goods, minimizing the seller’s risk.

On the other hand, a Bank Guarantee (BG) is a promise from a bank to cover the financial obligations of its customer to a third party if the customer defaults. In essence, the bank assures the third party that payment will be made, even if the customer fails to meet the commitments. 

An LC involves the bank making a payment to the seller upon presentation of the required documents. Conversely, a BG only results in payment to the beneficiary if the customer fails to fulfill their contractual obligations. Therefore, an LC is focused on ensuring payment for goods or services is rendered, while a BG provides a safety net for third parties against the customer’s potential non-performance. 

Advantages of Letter of Credit:

1. Facilitates Trade with Unknown or New Partners: Allows transacting with unfamiliar or new trade partners, enabling business expansion into new markets or geographies more confidently.
2. Risk Mitigation for Sellers: Provides security for exporters in case the importer defaults or goes bankrupt. The bank’s creditworthiness substitutes that of the importer, ensuring that the agreed amount will be paid by the issuing bank, thus protecting the exporter’s interests.
3. Customizable Terms and Conditions: Both parties can negotiate and agree upon specific terms and conditions tailored to their needs for each transaction, fostering flexibility and mutual agreement.
4. Payment Security Amid Disputes: Ensures the exporter receives payment according to the terms of the letter of credit, regardless of disputes or disagreements between the trading partners. This mechanism allows for payment before resolution of any disputes (“pay now, litigate later”).

Disadvantages of a Letter of Credit:

1. Costs: A letter of credit increases the cost of transactions due to bank fees, which can escalate with additional features.
2. Fraud Risk: There is a risk of fraud because banks pay based on shipping documents, not the actual quality of goods.
3. Time Limit: The letter of credit has an expiration date, imposing a delivery deadline on exporters, which can lead to rushed shipments.

How Much a Letter of Credit Costs

The cost of a Letter of Credit can vary widely based on the complexity of the transaction, the amount involved, and the risk assessment by the issuing bank. Generally, fees can range from 0.5% to 1.5% of the total transaction value. This typically includes issuance fees, negotiation fees, and possibly amendment fees if the terms of the LC need to be changed after issuance. Additionally, there may be handling charges and communication fees that banks charge for processing the necessary documentation. These costs are usually borne by the buyer, who is requesting the Letter of Credit to facilitate the transaction.

Did you know, both SME/MSME loans and MUDRA loan aim to support small businesses in scaling and maintaining operations; using a letter of credit for these loans can help facilitate international trade transactions, enhancing credibility and reducing payment risks.

Types of Letters of Credit

1. Commercial Letter of Credit: This is the most common type, primarily used in international trade for guaranteeing payment from the buyer to the seller. It ensures that the seller receives payment once the delivery terms and conditions outlined in the LC are met. The commercial letter of credit plays a crucial role in reducing the risk for both parties in a transaction. It makes it a vital tool for international trade.
2. Standby Letter of Credit: Acts as a safety net, used if the buyer fails to fulfill the financial obligations. It’s more of a guarantee than a direct payment mechanism. This type of LC is often used in scenarios where a performance guarantee is needed. It can be construction contracts or large service agreements. The standby trade letter assures the beneficiary that they will be compensated in case of non-performance by the applicant.
3. Revolving Letter of Credit: Suitable for multiple transactions over a long period. The credit limit replenishes after each use, ideal for ongoing business relationships. This type of Letter of Credit is particularly beneficial for businesses that engage in frequent transactions with the same party. This is because it eliminates the need to issue a new LC for each transaction. It simplifies the process and reduces administrative costs.
4. Transferable Letter of Credit: Allows the original beneficiary to transfer all or part of the credit to another party, typically used in intermediary trade transactions. This is especially useful in supply chain transactions where intermediaries, such as traders or brokers, need to pass on the benefits of the LC to the actual suppliers. It provides flexibility in handling multiple parties with a single transaction.
5. Confirmed Letter of Credit: Adds an additional guarantee from the seller’s bank, ensuring payment even if the buyer’s bank defaults. This extra layer of security is often required in transactions involving high-value goods or trading with countries that have higher economic or political risks. The confirming bank’s involvement provides the beneficiary with greater confidence in receiving payment.
6. Unconfirmed Letter of Credit: Relies solely on the buyer’s bank’s guarantee without involving the seller’s bank. While this Letter of Credit can be less expensive than a confirmed Letter of Credit, it carries a higher risk for the seller. It is especially so if the buyer’s bank is located in a country with unstable economic conditions. Sellers must carefully evaluate the creditworthiness of the issuing bank when accepting an unconfirmed LC.
7. Red Clause Letter of Credit: Provides an advance to the beneficiary before the goods are shipped or services are provided. This type of Letter of Credit is useful for exporters who need working capital to produce or procure the goods to be shipped. The advance payment is typically used for purchasing raw materials or covering production costs. It makes sure the seller has the necessary funds to fulfill the order.
8. Green Clause Letter of Credit: Similar to the Red Clause, but with an additional provision for storage costs needed before shipping the goods. This type of LC covers not only the advance payment for production but also the expenses related to storing the goods until they are shipped. It provides comprehensive support to exporters, particularly those dealing with large or bulky goods that require significant storage space. 
9. Sight Letter of Credit: A Sight Credit requires payment to be made immediately upon presentation of the appropriate documentation. This type of letter of credit is used when the seller needs prompt payment. For instance, a business owner can present a bill of exchange alongside a sight letter of credit to a lender and receive the necessary funds without delay. This immediacy makes Sight Letter of Credits particularly useful in transactions requiring rapid turnover.
10. Acceptance Letter of Credit: Acceptance Credit, also known as Time Credit, involves bills of exchange that are payable at a future date. These bills, referred to as usance bills, are accepted upon presentation but are honored on their due dates. For example, a company may purchase and receive the goods immediately, but they have up to 30 days to pay the invoice. This grace period, known as usance, allows the buyer to manage cash flow more efficiently. It can be done while ensuring the seller receives payment as agreed. 
11. Revocable and Irrevocable Letter of Credit: Revocable Credits allow the issuing bank to amend or cancel the terms and conditions of the credit without prior notice to the beneficiaries. This flexibility, however, can pose risks to the seller. In contrast, Irrevocable Credits cannot be altered or canceled without the consent of all parties involved. It provides a higher level of security and commitment from the issuing bank. The certainly provided irrevocable credits make them a preferred choice for international trade transactions. 
12. Back-to-Back Letter of Credit: Back-to-back Credit allows an exporter to secure a Letter of Credit for their supplier based on the export Letter of Credit received from the buyer. This arrangement helps the exporter procure raw materials or goods needed for fulfilling the order. For example, an Indian exporter receiving an LC from a client in Ireland can request their bank to issue an LC in favor of a local supplier. Thai creates a chain of credits that facilitates smoother transaction flows and better resource management. 

The format of a letter of credit specifies the documentation and terms required for payment, while the process of a letter of credit involves issuing, advising, fulfilling terms, verifying documents, and making payments.

Example of a Letter of Credit

Now, to help you understand the concept better let us look at an example of a letter of credit. Consider a scenario where an Indian textile manufacturer agrees to sell goods to a retailer in France. The French retailer requests their bank to issue a Letter of Credit in favour of the Indian manufacturer to secure the transaction. Upon issuing the LC, the manufacturer ships the textiles and submits the shipping and invoice documents to their bank. These documents are then verified against the LC’s terms. Once everything is confirmed as correct, the Indian bank requests payment from the French bank, which disburses the funds accordingly. This ensures the Indian manufacturer receives payment as soon as the conditions of the LC are fulfilled, safeguarding against non-payment.

Before Applying for a Letter of Credit

Letters of Credits are a highly secure payment method, ideal for mitigating risks in international trade. However, they come with labor-intensive procedures and can be relatively costly due to bank fees. These instruments are particularly useful in high-risk scenarios. For instance, one can use it when the importer’s creditworthiness is questionable, new establishing new trade relationships, or when extended payment terms are necessary. 

The documentation required for an LC is intricate and susceptible to errors. To prevent delays and avoid additional costs, these documents must be prepared by experienced professionals. Accurate preparation ensures compliance with the terms of the LC, facilitating smooth transactions. 

Exporters should engage with their banks before the importer initiates the LC application. This consultation should address:

• Suitability: Determine what type and scale of export transactions are appropriate for using an LC. 

• Cost: Understand the fees associated with an LC and who will be responsible for covering these costs.
• Dispute Resolution: Clarify how any potential disputes between the importer and the exporter will be resolved to ensure both parties are protected. 

By addressing these points upfront, exporters can better navigate the complexities of LCs and ensure a secure and efficient trade process.

Documents for Letter of Credit:

Category	Documents
Shipment	– Bills of Lading – Airway Bills – Cargo Receipts (for road transport) – Documents for railway transportation
Insurance	– Open Cover Insurance Certificate – Original Insurance Policy
Commercial	– Packing List – Commercial Invoice – Certificate of Inspection

 

How to Apply for a Letter of Credit

1. Buyer and Seller Agreement: Initially, the buyer and seller agree on terms including the use of a Letter of Credit for the transaction.
2. Application Submission: The buyer applies for a Letter of Credit at their bank, providing detailed information about the seller, the transaction, and the agreed terms.
3. Bank Assessment: The buyer’s bank assesses the risk involved, including the creditworthiness of the buyer and the details of the transaction.
4. Issuance of LC: Upon approval, the bank issues the Letter of Credit and sends it to the seller’s bank, either directly or through an intermediary bank.
5. Advising: The seller’s bank advises the seller that the LC has been opened in their favor.
6. Fulfillment of Terms: The seller ships the goods or provides the service and then presents the required documents (like invoice, shipping details, etc.) to their bank.
7. Document Verification: The seller’s bank verifies the documents to ensure they comply with the LC terms.
8. Payment: Once verified, the seller’s bank requests payment from the buyer’s bank. The buyer’s bank then makes the payment to the seller’s bank, which in turn pays the seller.

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Frequently Asked Questions

1. What are 4 types of letters of credit?

Four common types of Letters of Credit are: Commercial LC (used for direct payment in transactions), Standby LC (serves as a payment guarantee), Revolving LC (automatically renews to cover multiple shipments), and Transferable LC (allows the beneficiary to transfer credit to another party).

2. What is LC and types of LC?

LC, or Letter of Credit, is a financial instrument issued by a bank guaranteeing a buyer’s payment to a seller. Types include Commercial, Standby, Revolving, and Transferable LCs, each serving different purposes and transactional needs in international and domestic trade.

3. What is the LC method of payment?

The LC method of payment involves a bank issuing a Letter of Credit on behalf of a buyer, guaranteeing payment to the seller under specified conditions. Once the seller fulfils these conditions and submits the required documents, the bank releases the payment, ensuring transaction security.

4.What is the difference between LC and BG?

A Letter of Credit (LC) guarantees payment for goods or services once terms are met, while a Bank Guarantee (BG) ensures compensation under a contract if the client fails to meet obligations. LC is transaction-specific, whereas BG covers broader contractual performance risks.