Understanding Letters of Credit (LC)

Understanding Letters of Credit (LC)

Letters of credit (LCs) are financial instruments used in international trade to ensure that payment will be made from a buyer to a seller. There are several types of LCs, each designed to meet different needs and circumstances in trade transactions:
Understanding Letters of Credit (LC)

What is Revocable Letter of Credit:

• A revocable LC can be amended or canceled by the issuing bank without prior notice to the beneficiary (the seller). It’s rarely used in international trade due to the risk it poses to the seller’s payment security.

What is Irrevocable Letter of Credit:

• An irrevocable LC cannot be changed or canceled without the agreement of all parties involved, including the buyer, seller, and the issuing bank. This type provides more security for the seller, as it assures payment upon fulfillment of the terms and conditions outlined in the LC.

Confirmed Letter of Credit:

• In a confirmed LC, a second bank (usually in the seller’s country) adds its confirmation to the credit, providing an additional guarantee of payment. This type of LC is beneficial for the seller, especially when dealing with a less-known or overseas buyer.

Transferable LC:

• A transferable LC allows the beneficiary (the first seller) to transfer all or part of the payment obligation to another supplier or intermediary. This is helpful when the beneficiary cannot fulfill the entire contract and needs to involve others to fulfill the order.

Standby Letter of Credit (SBLC):

• An SBLC serves as a backup payment method in case the buyer fails to fulfill their obligations. It is often used when a buyer may default on payment and provides assurance to the seller that payment will be made.

Revolving Letter of Credit:

1. Revolving Letter of Credit:

• A revolving LC allows for the amount of credit to be restored after it has been used. It’s beneficial for ongoing trade relationships, where multiple shipments and payments are involved.

The process of how these LCs work generally involves:
Understanding Letters of Credit (LC)

• Issuing Stage: The buyer and seller agree to use an LC for the transaction. The buyer’s bank (issuing bank) issues the LC in favor of the seller, detailing the terms and conditions.
• Advising and Confirmation: If necessary, the LC is sent through another bank (advising bank) or confirmed by a third-party bank, providing assurance to the seller.
• Shipment and Compliance: The seller ships the goods and presents the necessary documents to the bank, conforming to the terms of the LC.
• Payment: Upon verification that the seller has complied with the terms, the issuing bank releases payment to the seller or, in some cases, to the confirming bank, which then pays the seller.

Each type of LC has its advantages and considerations depending on the specific requirements of the trade transaction, the relationship between the buyer and seller, and the level of risk the parties are willing to undertake.

Understanding Letters of Credit (LC)
FAQ

1. What is a letter of credit (LC)?
   A letter of credit is a financial instrument used in international trade transactions. It’s a guarantee from a bank that ensures the seller will receive payment upon fulfilling the terms and conditions outlined in the LC. It serves as a form of security for both the buyer and the seller in cross-border trade.
2. How does an LC work in international trade?
   In an LC transaction, the buyer and seller agree to use this method of payment. The buyer’s bank issues the LC, detailing the terms and conditions for payment. The seller ships the goods and presents the required documents to the bank, conforming to the terms of the LC. Upon verification, the bank releases payment to the seller.
3. What are the parties involved in an LC?
   There are typically four parties involved:

• Applicant/Buyer: The party who requests the LC from their bank.
• Beneficiary/Seller: The party who will receive payment upon meeting the terms of the LC.
• Issuing Bank: The buyer’s bank that issues the LC on behalf of the buyer.
• Advising Bank: The bank in the seller’s country that advises or confirms the LC to the seller.

1. What is the role of the issuing bank in an LC?
   The issuing bank is responsible for issuing the LC based on the applicant’s instructions and creditworthiness. It ensures that the terms and conditions of the LC are accurately reflected and that the seller’s compliance will lead to payment.
2. What is the beneficiary’s role in an LC?
   The beneficiary, or seller, is obligated to fulfill the terms and conditions stipulated in the LC. This includes providing the required documents and ensuring that the goods shipped meet the specifications outlined in the LC to receive payment.

What is the difference between a confirmed and unconfirmed LC?

The primary difference between a confirmed and unconfirmed Letter of Credit (LC) lies in the level of assurance or risk mitigation offered to the seller (beneficiary) in an international trade transaction. Here’s a breakdown of the differences:

1. Unconfirmed LC:

• In an unconfirmed LC, only the issuing bank’s undertaking to pay is involved. The seller relies solely on the creditworthiness and commitment of the issuing bank to honor the LC’s terms.
• There’s no additional guarantee provided by any other bank. Therefore, if the issuing bank defaults or fails to honor the LC, the seller’s recourse might be limited to the issuing bank’s reliability.

1. Confirmed LC:

• In a confirmed LC, a second bank (the confirming bank) typically located in the seller’s country adds its guarantee to the LC, independent of the issuing bank. This confirmation is an additional undertaking to honor the LC’s terms.
• The confirming bank’s confirmation provides an extra layer of security for the seller, as it assures payment even if the issuing bank defaults. Essentially, the confirming bank guarantees payment, adding a level of assurance beyond the issuing bank’s commitment.

Key Points:

• Unconfirmed LC relies solely on the issuing bank’s creditworthiness, potentially posing more risk for the seller.
• Confirmed LC involves an additional guarantee by a second bank (confirming bank), reducing the risk for the seller by providing an added layer of assurance for payment.

When choosing between confirmed and unconfirmed LCs, sellers often consider the credibility of the issuing bank, their relationship with the buyer, and the level of risk they’re willing to undertake in the transaction. A confirmed LC generally offers greater security but might come with additional fees or costs due to the involvement of the confirming bank.

How does the advising bank function in an LC?

1. Receipt and Authentication: The issuing bank sends the LC to the advising bank (usually located in the seller’s country) for notification to the beneficiary. The advising bank verifies the authenticity of the LC and ensures that it complies with international rules (such as the UCP 600 – Uniform Customs and Practice for Documentary Credits).
2. Advising the LC: Once verified, the advising bank advises or notifies the beneficiary of the existence of the LC and its terms. This advice may be transmitted through authenticated SWIFT messages or physical documents, depending on the agreement between the banks.
3. Confirming (if applicable): In some cases, the advising bank may also confirm the LC if requested by the issuing bank or agreed upon by the beneficiary. Confirming the LC adds an additional layer of security to the beneficiary by providing a guarantee of payment, ensuring that the issuing bank’s obligation is also backed by the advising bank.

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1. Guidance and Compliance: The advising bank may offer guidance to the beneficiary regarding the required documents, compliance with the LC terms, and any necessary actions to ensure smooth document presentation to the issuing bank for payment.
2. Document Handling: When the seller fulfills the terms and conditions of the LC, they submit the required documents (like invoices, bills of lading, certificates of origin, etc.) to the advising bank. The advising bank reviews these documents to ensure they comply with the LC terms before forwarding them to the issuing bank.
3. Communication Channel: Additionally, the advising bank serves as a communication channel between the beneficiary and the issuing bank, facilitating any necessary clarifications or amendments to the LC terms if required.

What is the validity period of an LC?

1. Defined Duration: The validity period is explicitly stated in the LC itself. It’s typically indicated in the terms and conditions section, specifying the exact dates or the number of days/months from the issuance date until the LC expires.
2. Timeframe for Presentation: Within the validity period, the seller must present the required documents and fulfill the conditions specified in the LC to claim payment. These documents typically include invoices, bills of lading, certificates of origin, inspection certificates, etc.
3. Adherence to Expiry Date: If the seller fails to present compliant documents or fulfill the LC’s terms before the expiry date, the LC becomes void, and the seller loses the right to claim payment using that specific LC.
4. Extension/Renewal: In certain cases, the validity period of an LC can be extended or renewed by mutual agreement between the buyer and the issuing bank. This might happen when the original timeframe is insufficient due to unforeseen circumstances or delays in the transaction.
5. Impact on Trade Transactions: The validity period is crucial for both parties. For the buyer, it ensures a defined timeframe for the seller to fulfill obligations. For the seller, it sets the deadline for compliance and document presentation to secure payment.

How does a standby LC differ from a commercial LC?

Standby LCs and commercial LCs serve different purposes in international trade, primarily offering different forms of financial assurance. Here’s how they differ:
Understanding Letters of Credit (LC)

Commercial Letter of Credit (LC):

• Used for Trade Transactions: A commercial LC is primarily utilized in actual trade transactions where goods or services are being bought and sold between a buyer (importer) and a seller (exporter).
• Payment Assurance: It serves as a guarantee for the seller that they will receive payment if they comply with the terms and conditions specified in the LC, typically involving the shipment of goods or provision of services.
• Documentary Requirements: The commercial LC requires specific documents, such as invoices, bills of lading, inspection certificates, etc., to be presented by the seller to the issuing bank for payment.

Standby Letter of Credit (SBLC):

• Financial Guarantee: Unlike a commercial LC, an SBLC is not meant for trade itself but acts as a financial backup or guarantee.
• Payment Assurance Against Default: It serves as a form of payment security for the beneficiary (seller or service provider) in case the buyer (applicant) defaults on payment or fails to fulfill its obligations.
• Varied Uses: SBLCs can be used in various scenarios beyond trade, such as construction contracts, performance guarantees, bid bonds, or as a credit enhancement for borrowing purposes.
• Documentation and Payment: Similar to a commercial LC, the SBLC requires the beneficiary to present compliant documents or fulfill specified conditions to claim payment if the applicant fails to meet their obligations.

In essence, while both commercial LCs and standby LCs involve banks providing a payment guarantee, their primary difference lies in their intended use. Commercial LCs facilitate actual trade transactions by ensuring payment upon compliance, while standby LCs act as a backup form of payment security in case of default or non-performance by the applicant in various non-trade scenarios.
Understanding Letters of Credit (LC)

What types of LCs are commonly used in trade?
Understanding Letters of Credit (LC)

In international trade, several types of Letters of Credit (LCs) are commonly used, each catering to different needs and circumstances of trade transactions. The commonly used types include:

1. Irrevocable Letter of Credit (ILC): This is the most widely used type. It cannot be amended or canceled without the agreement of all parties involved, providing a secure form of payment for the seller.
2. Confirmed Letter of Credit: Involves a second bank (confirming bank) adding its confirmation to the credit, guaranteeing payment in addition to the issuing bank’s obligation. It’s particularly beneficial for sellers dealing with less-known or overseas buyers.
3. Transferable Letter of Credit: Allows the original beneficiary (first seller) to transfer all or part of the credit to another supplier or intermediary. This type is useful when the initial beneficiary is not capable of fulfilling the entire contract.
4. Standby Letter of Credit (SBLC): Acts as a backup payment method if the buyer fails to fulfill their obligations. It’s often used as a secondary or contingency payment option.
5. Revolving Letter of Credit: Allows for the amount of credit to be restored after it has been used, beneficial for ongoing trade relationships with multiple shipments and payments.
6. Back-to-Back Letter of Credit: Involves two separate LCs, one issued in favor of the seller by the buyer and the other issued by the seller to their supplier. It’s used when the seller needs to use the buyer’s LC as collateral to obtain their own LC to purchase goods.

The choice of LC type depends on various factors such as the nature of the transaction, the relationship between the buyer and seller, risk mitigation needs, and the specific requirements of the trade deal. Each type has its advantages and considerations, providing flexibility and security for different trade scenarios.
Understanding Letters of Credit (LC)

How does an irrevocable LC differ from a revocable one?

The primary difference between an irrevocable Letter of Credit (ILC) and a revocable Letter of Credit lies in the level of commitment and security they offer to the beneficiary (seller) and the flexibility they afford to the buyer and issuing bank.
Understanding Letters of Credit (LC)

Irrevocable Letter of Credit (ILC):

• Commitment and Security: An ILC cannot be amended, canceled, or modified without the consent of all parties involved (buyer, seller, and issuing bank). This provides a higher level of security for the seller, assuring them of payment upon compliance with the terms and conditions specified in the LC.
• Legal Obligation: Once issued, the ILC creates a legally binding commitment by the issuing bank to make payment to the beneficiary upon presentation of compliant documents or fulfillment of the terms outlined in the LC.
• Common Usage: Irrevocable LCs are the standard type used in international trade due to the security and assurance they offer to the seller, providing a guarantee of payment as long as the conditions are met.

Revocable Letter of Credit:

• Flexibility and Alteration: Unlike an ILC, a revocable LC can be amended, modified, or canceled by the issuing bank without prior notice to the beneficiary. This lack of commitment makes it less secure for the seller.
• Rare Usage: Revocable LCs are rarely used in international trade due to the inherent risk they pose to the seller. The uncertainty of the LC being revoked at any time without the seller’s knowledge or consent makes it less attractive for trade transactions.

In summary, the key difference lies in the level of commitment and security offered to the beneficiary. An irrevocable LC provides a higher degree of security for the seller by creating a binding payment obligation upon compliance, while a revocable LC allows for alterations or cancellations by the issuing bank, offering less assurance to the seller. As a result, irrevocable LCs are the standard choice for ensuring payment security in international trade transactions.
Understanding Letters of Credit (LC)

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