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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.
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.
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.
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 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.
This provision allows customers to make any number of draws during a specific time frame and within a certain amount limit.
This letter serves as a guarantee for those traveling abroad that issuing banks will be obligated for drafts made at certain foreign banks.
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.
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.
It is typically needed in long-distance and international trade. It helps in reducing the risk of non-payment of the goods.
It is decided upon several factors like the type of letter of credit and the amount of risk involved.
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