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  • A letter of credit is very important for all buying and selling operations. A letter of credit refers to a letter that is given by a bank with a guarantee or an affirmation that a purchaser in a certain agreement will make the payment to his or her seller promptly with the accurate amount. In case the purchaser fails to make the payment to the seller, then the bank will need to pay the entire amount or the outstanding amount that originally needs to be paid by the purchaser.

    It is utilised very mandatorily in foreign transactions wherein there are exporters and importers. Exporting refers to the selling of products and services that are manufactured in one country to a different country. The seller of these products and services is known as the exporter. Importing refers to the process of purchasing goods and services from a different nation across a national border. The one who buys these goods and services is known as an importer.

    A letter of credit is very frequently used in international trade. An importer requests a bank to sanction a commitment in writing, which is known as the letter of credit, and in the letter, it is mentioned that the importer will pay the right amount to the exporter. It is very helpful when the importer (buyer) and the exporter (seller) do not know each other due to distance. It also plays a significant role when the buyer and seller are situated in different nations that have varying laws and rules and regulations.

    Each nation will also have different trading customs. When two nations are involved in buying and selling activities, there can be a few confusions and complications due to multiple reasons. In order to avoid such situations, letter of credit serves as a great tool for ensuring a smooth foreign transaction.

    How Does a Letter of Credit Work?

    Whenever a letter of credit is issued, the products that are ordered by the buyer will be in possession of the bank. Until the buyer either makes the full payment or makes a payment to the bank for all the documents with an undertaking that the bank will take full responsibility, the possession of the products will not be released by the bank to the purchaser.

    When the purchaser fails to make the payment due to a shortage of funds or any other reason, then the seller will place a demand to the bank asking the bank to make the payment. Then the bank will take a look at the demand placed by the seller or the beneficiary. If the demand matches with the details specified in the letter of credit, then the bank will meet the demand. If it does not match with the letter’s terms and conditions, then the bank will have a discussion with the seller and make appropriate payments.

    When a purchaser requests a bank to issue and sign a letter of credit, then the buyer will need to provide a relevant collateral to the bank. The buyer will also be required to pay a particular fee for the documents and for the issuance of the letter to the bank. This fee will typically be a certain percentage of the amount that is taken care of by the letter of credit.

    A letter of credit is a negotiable instrument. In this arrangement, when the buyer cannot pay the full outstanding amount, the bank that issues the letter of credit will need to make the payment to the seller. Sometimes, in certain cases, the seller will select a banker, and that banker will need to make the payment. If a letter of credit is transferable in nature, then the seller can choose another entity or party to make the payment.

    Types of Letter of Credit

    Letter of credit offers protection to both sellers and buyers. There are several kinds of letter of credit. There are mainly 9 types of letter of credit.

    • The first one is known as a commercial letter of credit. It involves a payment which is made directly wherein the bank that issues the letter of credit will need to pay the seller or the beneficiary.
    • The second kind of letter of credit is known as a standby letter of credit where a secondary payment is made. Here, the banker will make the payment to the seller only if the buyer is unable to make the payments.
    • The third type is known as traveller’s letter of credit. This is a very well-known type of letter of credit. A lot of people are aware of this type. It is very helpful to anyone who goes on foreign trips for personal or official purposes. It is a kind of letter of credit wherein the issuing bank guarantee to honour drafts that are signed at specified foreign banks.
    • The fourth form of letter of credit is termed as a revolving letter of credit. With this facility, a buyer can go for any number of withdrawals during a specific period within a particular limit of amount.
    • The fifth type of letter of credit is the confirmed letter of credit. It refers to a facility wherein there is a bank apart from the bank that issues the line of credit (issuing bank). The other bank will be the confirming bank in this arrangement and it is generally the bank of the seller. This confirming bank has the responsibility of making sure that the payment is done in case the issuing bank and the purchaser fail to make the full payment within the due date. In many international trading agreements, mostly the issuing bank requests this type of letter of credit.
    • The sixth form of letter of credit is known as a sight letter of credit. Under this type, the letter of credit payment is made immediately when the seller furnishes relevant documents to the concerned bank. The bank may take some time to check all the documents that are submitted in order to make sure that they meet the needs of the letter of credit. If they do, then the seller will receive the payment instantly.
    • The seventh form of letter of credit is called an irrevocable letter of credit. It is a letter of credit that cannot be altered or even cancelled unless every party in the agreement approves to the changes.
    • The eighth type of letter of credit is known as a back-to-back letter of credit. It enables various intermediaries to get in touch with both buyers and sellers. In this facility, 2 letters of credit are created as this will help both the parties in receiving separate payments. Here, the purchaser will get the payment from the intermediary and the seller or supplier will get the payment from the intermediary. The intermediary and the buyer will make use of a ‘master letter of credit’, whereas the intermediary and the seller will utilise a letter of credit as per the master letter.
    • The ninth kind of letter of credit is known as a deferred payment letter of credit. In this arrangement, the beneficiary will not receive the payment right after the documents are furnished to the bank. There will be a fixed gap before the payment is made to the seller. This kind of facility is beneficial to buyers when compared to sellers. This type is also known as a usance or a term letter of credit.

    How Does a Letter of Credit Help Purchasers?

    Typically, a letter of credit supports a seller or a beneficiary in an exchange agreement wherein the bank will make sure that the seller receives the amount either from the purchaser or from the issuing bank itself. This letter of credit arrangement also assists a purchaser in certain cases such as the purchaser making a payment to the seller for an order and the seller not delivering the order on time. In such a situation, with the help of a letter of credit, the purchaser will get paid with the money that was spent by him or her. Hence, this way, the purchaser will get a refund.

    When the purchaser receives the payment, the payment will be a penalty incurred by the seller or the beneficiary that did not deliver the consignment of goods on time. With the help of this refund amount, the buyer can make a purchase from another party.

    Where Does a Bank Get Funds for a Letter of Credit?

    In a letter of credit facility, a bank enters into an agreement with a buyer and a seller to pay money for a product or service if the customer is unable to make the payment on time. However, one may wonder how a bank will get funds to make this payment on behalf of the buyer.

    The letter of credit is always issued by the bank. This issuing will be done only if the bank is assured and firm that the purchaser will be able to make the payment. For this, the buyer may directly pay the full money directly to the bank or the buyer may go for a line of credit with the bank. This refers to a facility where the bank will offer funds to the buyer on credit. A line of credit is a popular form of lending.

    On the other hand, from a seller’s perspective in a letter of credit arrangement, the seller needs to have an assurance that the issuing bank is a trustworthy bank that will make the payment on behalf of the buyer if required. Whenever a seller is unsure if the issuing bank will not make the payment, then the seller and buyer can go for a confirmed letter of credit. In this type of letter of credit, there will be a different bank that will affirm that the issuing bank will make the payment.

    When Does a Seller or a Beneficiary Receive the Payment from the Bank?

    • In a letter of credit facility, the seller or beneficiary will get the payment from the bank only if the seller complies with the terms mentioned in the letter of credit document.
    • When it is an international trading transaction, the seller is required to deliver the goods to the accurate shipyard. This is when the seller meets all the requirements of the letter of credit.
    • When the delivery is made on time, he or she will get relevant documents to prove that the delivery was made.
    • Now, these documents will need to be sent to the bank so that the bank understands that the requirements have been met. After this step is done, the bank will need to pay the letter of credit without fail.
    • Sometimes, the goods may get damaged due to weather conditions, transportation, mishandling of the package, or any other reason. Even in such situations, the issuing bank must make the payment as per the conditions mentioned in the letter of credit. This is because the seller has completed his or her duty of delivering the goods to the shipyard.

    However, the seller cannot send any product with a defect. The seller will need to make sure that he or she is sending good-quality products to the buyer. The buyer has the option of getting an inspection certificate for his or her order so that he or she can be certain that only quality goods are sent. The buyer can also check the inspection certificate to evaluate the entire consignment of goods.

    Whenever a buyer feels that the seller has not met the required obligations, he or she will need to make arrangements for proper proof as evidence so that the issuing bank can take necessary steps to resolve the problem.

    Common Terminology Used in Letter of Credit

    In a letter of credit facility, there are many financial terms that are commonly used. It is very important to know the meaning of these terms as it will help you in having a stress-free experience. You can also stay away from anyone trying to cheat you or trick you when you go for a letter of credit option.

    • Applicant: An applicant refers to the party in the transaction who makes the purchase. He or she is also known as the buyer or purchaser.
    • Beneficiary: A beneficiary refers to the party in the transaction who makes the sale and who receives the final payment. He or she is also known as the seller.
    • Irrevocable agreement: When you come across this term in your letter of credit agreement, it means that the letter of credit should not be altered or terminated without the approval from all parties involved in the agreement.
    • Issuing bank: This is the bank that issues the letter of credit and agrees to pay on behalf of the buyer.
    • Advising bank: This bank refers to the bank that assists the seller in meeting the requirements that need to be met for a letter of credit. The seller will also get support from the advising bank to utilise the letter of credit sensibly.

    A letter of credit is a formal trading instrument that has helped both buyers and sellers for several years now. It also assists in having smooth global trading relations. There may be certain cases when a buyer’s payment gets delayed due to political unrest or any delay in banking transactions, especially when 2 different countries are involved. In such situations, a letter of credit comes to the rescue by making sure that the seller receives the payment. It works towards making sure that all trading transactions go on without any obstruction.

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