A letter of credit is a written assurance from a bank or other financial institution that the exporter will receive payment from the importer on schedule, in full, or in part. It’s crucial for any company, domestic or foreign, to receive payments from clients on schedule. It is a document from a bank or financial institution that ensures that the exporter will receive payment from the importer on schedule for the remaining amount. It is a payment method used by businesses.
A letter of credit: what is it?
This document is issued by a bank or other financial institution, and it ensures that the exporter will get payment in whole and on schedule. The bank will pay the remaining amount to the exporter if the buyer or importer cancels and cannot make a payment on the purchase per the letter of credit agreement. It is frequently employed in international trade.
How do letters of credit function?
With this document, the beneficiary (the exporter) or any other bank chosen by the beneficiary will be paid by the issuing bank. Before the bank guarantees the payment to the exporter, the importer must show the appropriate bank that he or she has sufficient assets to make the necessary payment. The bank assumes full responsibility for paying the exporter. After sending this document, the bank often assesses a fee as a premium. Let us understand the functioning in a step-by-step process:
1. Letter of credit issuance
The importer requests this document in favour of the exporter from the issuing bank once the parties to the trade activity agree to the contract and its use. The issuing bank then sends the LC to the advising bank. It is sent to the exporter after being authenticated by the exporter’s advising bank.
2. Shipping of products
The exporter must check the LC receipt after getting it before starting the logistics of shipment and export.
3. Giving the confirming bank documents
The exporter provides the paperwork to the advising/confirming bank once the products have been dispatched.
4. Agreement on importer payment and transfer of ownership
The documents are sent by the bank to the issuing bank. The price is agreed upon, paid, or negotiated. Every paperwork is verified by the issuing bank, which then asks the importer for payment. The importer receives the documents and utilizes them to take possession of the delivered items.
The vitality of a letter of credit
Individualization of a letter of credit
This document is typically adaptable, allowing the exporter and the importer to agree on the payment terms for every given transaction.
Aids in managing the exporter’s cash flow
In addition to promising payment, a letter of credit guarantees timely payment. This is crucial if there is a long period of time between the delivery of the products and the payment.
Who are the parties involved in the issuance of a letter of credit?
Some of the parties involved are listed below:
the importer, who is the party to the transaction, and who is asking the bank or other financial institution to issue a Letter of Credit.
The exporter who receives payment through this process is a beneficiary. According to the conditions of the letter of Credit, a beneficiary is a party to the entire transaction who has the authority to draw and inspect the payment.
3. The issuing bank
the financial institution that examines and accepts the letter of the credit application and retains the transaction’s funds.
4. Recommend a bank
When a letter of credit is received, a bank or other financial institution known as the advising bank notifies the beneficiary when the applicant’s bank approves the letter of credit. On behalf of exporters, the advising bank, which is often based in the exporter’s nation, transfers paperwork to the issuing bank.
6. Verifying the bank
The undertaking of the issuing bank is further guaranteed by the confirming bank. Only when the exporter is dissatisfied with or has any concerns about the issuing bank that is guaranteeing the payment does the confirming bank enter the transaction as a whole.
7. A middleman
A neutral entity who can guide applicants and beneficiaries through the letter of credit’s details is required.
The necessary paperwork for the issuance of a letter of credit
The paperwork needed to apply for a letter of Credit is listed below:
• Application form with address and photo
• KYC (passport, voter ID card, Aadhar card, etc.) of the applicant, co-applicant, partners, and directors
• Packing, shipping, and transport documentation;
• Bill of Lading;
• Airway bill;
• Commercial invoice;
• Insurance certificate;
• Certificate of Origin;
• Certificate of Inspection;
• Any additional document requested by the lender
Letters of Credit: Types
Letters of credit can take the following forms:
1. Commercial letters of credit
This is a direct payment method where the beneficiary receives the payment directly from the issuing bank.
2. Letter of credit for travelers
This Letter of Credit will assure exporters who want to travel overseas that issuing banks will issue draughts produced at foreign banks as and when required.
3. A letter of credit confirmation
When a letter of credit is confirmed, a bank other than the one that issued it stands behind its payment. In international transactions, the issuing bank often requests this arrangement to ensure that the confirmed bank fulfills its payment obligations under the Letter of Credit in the event that both the holder and the issuing bank are in default.
4. Standing letter of credit
An importer can obtain foreign currency funds internationally through a standby letter of credit issued by a domestic bank and guarantees payment to an international bank if the borrower fails to make the required repayments by the due date.
A bank’s letter of credit assures that the exporter will be paid if certain requirements are completed. It serves as a safety in case the importer defaults on payment for the products or files for bankruptcy.