Letter of Credit

What Letter of Credit?

A Letter of Credit (LC) or a Credit Letter is a piece of document that guarantees payment to the seller on behalf of the buyer. This letter is issued by a bank and offered as a facility. It is also called documentary credit. It serves as a promise of timely payment of the total amount to the seller.

If the buyer defaults or is unable to fulfill his obligation of paying the due balance, the bank makes payment on behalf of the buyer. Bank issues this letter against pledging of securities or cash. It collects a fee which is a certain percentage of the amount of the letter.

Importance Of Letter of Credit

Since the factors of international transactions are distance, no personal contact in international trade, and differences in-country laws, LC becomes a suitable and reliable payment method. Letter of credit used in international trade is overseen by the International Chamber of Commerce Uniform Customs and Practice for Documentary Credits.

Parties Involved In Letter of Credit

  • An importer or the applicant.
  • Opening banker or issuing bank who issues the letter of credit, also known as an importer’s bank.
  • An exporter or the beneficiary.

What are the different types of a letter of credit?

Sight letter of credit:

On presenting the correct document, these documents are payable at sight. For instance, a trader can show a bill of exchange to a creditor and a sight letter of credit and take the funds from him. A sight LC is an immediate form of a letter of credit which is different from other forms of LC.

Time Letters of Credit/ Acceptance Letters of Credit:

These are the usance bills drawn and payable after a particular time. Per the rules of acceptance credit, these bills are generally accepted on presentation. They are further honored on the date they fall due for payment.

For instance, a firm incurs some purchases from a seller and receives the material on the same day. This bill would be sent with the material itself, but the firm may have around a month to pay for it. This one month is called a usance for sale.

Revocable or irrevocable letter of credit

Revocable is a letter of credit with terms and conditions that can be canceled or amended by the issuing bank. The cancellation or amendment can be without any prior notice to the parties. An irrevocable letter of credit is credit with terms and conditions that can neither be canceled nor amended. Therefore, the issuer bank is bound by the terms and conditions given in LC.

Revolving letter of credit

This provision allows customers to make any number of draws during a specific time frame and within a certain amount limit.

Traveler’s letter of credit

This letter serves as a guarantee for those traveling abroad that issuing banks will be obligated for drafts made at certain foreign banks.

Confirmed credit

It can only be an irrevocable letter of credit. In this case, when a banker, other than the opening bank, adds its confirmation to the letter. In this case, the beneficiary’s bank submits the documents to the confirming bank. Another bank is usually the seller’s bank. It makes sure the payment is made in case the holder or issuing bank makes any default.

CTransferable letter of credit

A letter of credit may not be a transferable instrument, but bills of exchange drawn under LC are negotiable bills. Therefore, a transferable letter of credit allows the holder to transfer his rights to other parties. Such LC must have a clear indication that it is a ‘transferable’ LC.

What are the advantages of a letter of credit?

  • It allows trading partners to deal with new unknown parties and helps expand a business with new geographical boundaries.
  • A letter of credit is a safe exit for the seller or exporter if the importer or buyer makes any default or goes bankrupt. The buyer's creditworthiness is also transferred to the opening bank, and it must pay the agreed amount. Hence, the seller is insulated from the buyer’s business through the medium of a letter of credit.
  • Both trading parties can add terms and conditions per their needs and arrive at a mutual arrangement of all the clauses in a letter of credit. It is also possible to customize it from one transaction to another within the same parties.
  • In case of disputes between parties, a letter of credit enables the seller to withdraw funds per the agreement letter and resolve the conflict later
  • Right to claim the total amount per the saying ‘pay now, litigate later', among the courts.

What are the disadvantages of a letter of credit?

  • Banks charge a certain fee for providing this facility, which can increase sharply if the involved parties want to add on some additional features.
  • This letter poses a risk of fraud to the bank as it will pay the seller on verification of shipping documents and not after checking the goods. Disputes can arise even in the case when quality is different than the agreed one.
  • This letter has an expiry date; therefore, the seller has a limited time within which the goods have to be delivered. At times, this can create chaos.

Letter Of Credit Related Frequently Asked Questions

  1. In what cases is a letter of credit needed?
  2. It is typically needed in long-distance and international trade. It helps in reducing the risk of non-payment of the goods.

  3. On what basis is the fee decided?
  4. It is decided upon several factors like the type of letter of credit and the amount of risk involved.

Frequently Asked Questions


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