What is LETTER OF CREDIT.

A Letter of Credit is a written undertaking issued by a bank guaranteeing the buyer’s payment towards the seller. It is also called as irrevocable LC, Import LC, LC at Sight, LC MT700, DLC MT700. Further, it assures the seller that they will receive the payment for the supply of goods, once they submit the shipping documents.

Due to the nature of international trade dealings & its risks factors including distance, different laws in each country, and trust issues between the traders, the use of Letter of Credit has become the vital part of global trade. When a buyer & a seller from two different parts of the world decided to do business, there might be an uncertainty of trust and payment will arise. To bridge the gap between the traders & to build the trust, LCs are being used.

There are different types of LCs available. Usually Letters of Credit or LC at Sight valid for 90 days and 180 days are always irrevocable. It means a bank provide an irrevocable commitment that the seller will get paid once they comply with the terms stated in the issued Irrevocable Letter of Credit. Also, it assures that in case of some unforeseen crisis, if the buyer is unable to make the payment or the buyer went bankrupt, then the bank will take the responsibility to fulfill the payment commitment as agreed in the contract. Hence this is an irrevocable commitment made by the bank on behalf of the buyer towards the seller, LCs are mostly preferred as the Payment Term in International Trade.

How Does a Letter of Credit Work?

When it comes to global trade, buyers run the risk of not receiving goods from the supplier for which they have already paid. And, sellers run the risk of nonpayment by the buyer for the supplied goods. Hence, the traditional payment method used earlier for global trade has failed. And then, MT700 has been introduced by International Chamber of Commerce (ICC) to secure the interests of both parties involved in trading.

While using LC Payment Term, the buyer’s bank assures to pay the seller for the supplied goods; upon complying with all terms & the submission of documents as stated in the issued DLC. In case, if the seller fails to submit the documents before the deadline, the LC will be expired. And then the bank will return the funds to the buyer’s bank account which they deposited while LC Opening. In this way, the risk of non-payment & the non-delivery of goods goes down to zero percent.

Parties Involved in LC Issuance

In general, the following are the parties involved with Letters of Credit. Here is what each party role and what it does:-

• Applicant: The Applicant or the buyer who requests the bank to issue the DLC MT700 in favor of their supplier.
• Beneficiary: The supplier who receives the MT700 in their bank account, called LC Beneficiary.
• Issuing Bank: The bank who issues the MT700 on behalf of their customer, called LC Issuing Bank.
• Advising Bank: The advising bank receives the MT700 from the issuing bank and advises the LC towards the seller's bank.
• Negotiating Bank: The seller's bank who receives the LC works also as a negotiating bank on their client's behalf.

Letter of Credit Benefits

Not just the importer, but the exporter also gains lots of benefits by using Import LC as a payment term. And it includes:

For Exporter

• The buyer can't cancel or alter an order without the approval of the seller. Hence, the production risk becomes zero.
• The buyer's bank has the obligation to pay for the shipped goods.
• The buyer can't refuse to pay for the supplied goods. Once the seller complies with the terms of credit.
• Payments secured; if the buyer opts for a deferred payment.

• The bank is liable for the payment of goods or services on a precondition. If the seller would provide all the documents required, according to the terms of MT700.
• Through an LC, the importer is indeed proving their solvency.
• In most cases, the buyer is able to control the shipping of goods.
• If the seller provides a deferred payment option, it means that the seller has granted a credit period for the payment.
• Pre payments become negligible under import LC.

Types of Letter of Credit

This type of Letters of Credit cannot be amend or changed without the consent of all parties involved. Most of the traders prefer Irrevocable LCs. This is because Irrevocable LC gives the security that most suppliers want.

As it indicates, this can be transferable to the principle supplier upon request of the 1st beneficiary. This is because, in some cases, the first party is playing the role of a middle party under this type of Letters of Credit.

In some cases, sellers may not trust issuing bank that provides LC on behalf of the buyer. So, they might require a bank in their home country to confirm the LC.

This type of LC commonly used in domestic and global trade. This guarantees that the bank will release the payment, once the seller submits all the documents as mentioned in the credit.

This type of Letter of Credit Back to Back normally issues against the Master LC. Here, at first, the LC opened in favor of an exporter from an importer’s bank. Then, on the basis of the Master LC and the credit facility available in the exporter’s account. The exporter’s bank will open a new LC, in favor of their principal supplier.

Letters of Credit Cost

The cost of a Letters of Credit may vary based on the amount & its tenure. Usually, the cost may include bank commission, processing fee & swift charges. Further, the cost is borne by the Applicant (buyer). And it should be clearly stated on the issued LC. For more info on the Cost, Contact us.

Disclaimer:

Keonie Global helps Local and International firms access business finance, working directly with businesses and their trusted advisors. We are a brokerage firm and do not provide loans ourselves. All finance and quotes are subject to status. Guarantees and Indemnities may be required. Keonie Global can introduce applicants to a number of providers based on the applicants' circumstances and creditworthiness. Keonie Global may receive a commission or finder’s fee for effecting such introductions.