Letter of Credit or Documentary Credit
Letter of Credit (LC) originated from Latin word “accreditivus” which means trust and adapted from a French word “accreditation” which means a power to do something.
Letter of Credit (LC), also known as Documentary Credit (DC), is one of the most common modes of payment in international trade. It is one of the modern financial services provided by the commercial banks across the world.
Letter of Credit is a letter issued by a bank guaranteeing the payment of the trade-transaction to the seller as per the agreed trade terms. Letter of Credit is a contingent liability of the buyer where the issuer bank guarantees to fulfill the obligation of the payment once the certain criteria are met. Letter of credit confirms the confidence of trade-deal by ensuring the payment.
Bank and Financial Institution Act, 2073 has defined ‘Letter of Credit’ as a letter written by one bank or any financial institution in the name of another any or financial institution stating thereon to accept cheques, drafts, or bills of exchange of any specified person within the limit of the amount specified therein.
Letter of Credit has changed the course of performing international business by making the transaction process planned and by ensuring the payment to the seller. Both the operational risks and default risks involved in international business are minimized by LC.The representative bank of the importer ensures the payment to the representative bank of the exporter.
Letter of Credit involves some steps to follow;
- Importer requests to open a ‘Letter of Credit’ to the importer’s representative bank.
- Importer’s representative bank prepares a Letter of Credit and sends the details to the exporter’s representative bank and exporter.
- Exporter delivers the goods to the importer with the details of the shipment.
- Importers’ representative bank makes the payment to the exporter’s representative bank upon fulfilling the shipment terms.
Letter of Credit transaction involves various parties during its complete procedure. Due to its significance in international business, it is essential to understand all the parties involved.
- Application: Applicants are the buyer of the goods or importer of the goods. Applicant requests for Letter of Credit with the issuing bank.
- Beneficiary: Beneficiary is the exporter or seller of the goods for which Letter of Credit is directed towards.
- Issuing Bank: Issuing bank is the bank of applicant which issues Letter of Credit on the behalf of applicant.
- Nominated Bank: Nominated bank is the bank with which credit is available.
- Advising Bank: Advising bank is that bank which advises the credit at the request of the issuing bank.
- Confirming Bank: Confirmation bank is that bank that provides extra assurance to the credit. If the issuing bank fails to perform its obligation to the beneficiary, confirming bank pays the beneficiary.
Characteristics of Letter of Credit
Letter of Credit is considered as a negotiable instrument and can be treated and transferred as money. The parties involved can negotiate and agree to time and mode of payment during defining the terms and conditions of the translation.
Letter of Credit can be revocable or irrevocable. In irrevocable letters of credit, terms and conditions cannot be changed without the consent or agreement of all the affected parties wherein in a revocable letter of credit, it is possible for the parties to revoke or modify the terms, condition and obligation to pay at any time and for any reason.
- Transfer and Assignment
There is a wide accepted practice of transferring letters of credit. In the domestic market, letters of credit can be transformed multiple times. Beneficiaries can transfer the whole or part of LC payment to the second beneficiary.
- Sight and Time Drafts
In a letter of credit, there are two possible characteristics to lead an obligation to pay; sight and time. Sight draft suggests the payment to the beneficiary when the letter is presented for payment and in time draft payment is made after a certain time period has passed. In both sight and time draft, bank has full authority to review the terms and validity
Importance of Letter of Credit
- International Business Expansion
Letter of credit is a documented arrangement hence it is one of the most credible approaches for conducting international business transactions. Letter of Credit is regulated by the rules and regulation of participant countries, this makes it a more effective approach for international business transactions. Letter of Credit allows buyers to have more credibility to participate and attract exporters for the business operation. Letter of credit provides a secure method of payment in International business and makes a favourable environment to successfully operate in other countries. LC has become a prime factor in business expansion internationally.
- Benefit to Seller
Letter of Credit guarantees or confirms the payment of the transaction to the seller. Sellers will receive the money when the transaction terms are fulfilled. The representative bank of the importer will guarantee the payment. Hence, for sellers, LC will minimize the payment default risk or credit risk. The creditworthiness of the importer is transferred to the LC issuing bank minimizing the credit default risk.
- Benefit to Buyer
The major benefit of LC for buyers is that LC allows buyers to explore the international market by assuring safe international transactions. LC provides leverage to the buyer regarding the control of time period for shipping of goods. LC also saves buyers from advance payment or prepayment for the transaction.
Difficulties in Letter of Credit
- Letter of Credit involves various domestic and international charges therefore it is a costly approach and it is important to be aware of such changes. It is necessary to properly analyze the cost-benefit factor before involving in any such transaction.
- Letter of credit involves different parties i.e. applicant, beneficiary, issuing bank, nominated bank etc . The rules and regulations to be followed for the complete transaction involve strict terms. The documentation procedures involved needs careful consideration and all the participants need to follow the mentioned terms. Letter of Credit is more regulated document.
- The execution of Letter of Credit is totally dependent on parties involved i.e. buyers and sellers. The terms and implications of LC can be delayed or changed due to various intentions and administrative problems.
LETTER OF CREDIT SAMPLE
(Beneficiary’s Address) Expiration Date:
Attention: (Concerned Individual, Department, Division)
We hereby issue this Irrevocable Letter of Credit in your favor which is available against your drafts at sight on ____________ (name of bank). Each draft hereunder must bear upon its face “Drawn under letter of Credit No. ___________, dated _____________, of the ___________ (name of bank), __________ (address of bank),” and be accompanied by the following documents: Your written statement that ____________ (The applicant) has failed to satisfactorily perform, prior to the expiration of this Letter of Credit, all or part of the terms and conditions of the (Concerned Individual, Department, Division) Agreement pertaining to the _______ (name of project) or any plans approved by and on file with the_________ (concerned department), in consequence entitled to the amount of the accompanying draft. In addition to the location listed above, this letter of credit may be drawn at a local office of ______________ (name of bank). A draw at a local office shall be deemed made when received by the local office and shall have the same cause and effect as a draw at the main office of ________________ (name of bank).