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Letter of Credit (LC)


A documentary letter of credit is a guarantee that provides assurance to the beneficiary that he will get the payment which has been mentioned in the documentary letter of credit. There is a condition that the compliant presentation should be under the documentary letter of credit. This documentary letter of credit is commonly used for international transactions where both the buyer and the supplier have a new relationship and operate from different countries.

A documentary letter of credit is a really crucial financial instrument for meeting the short-term needs. It enables the recipients for obtaining the important credit for financing the project. The recipients hope of getting sufficient return for settling the due amount in the provided time frame.

The documentary letter of credit showcases the documents and information that are needed by the beneficiary on presentation which includes the expiry information like date and time of the letter. The compliant presentation is a kind of guarantee given to the beneficiary by the documentary letter of credit for in order to get paid. The only criterion is that the delivery conditions should be met.

It is the responsibility of the bank that writes the letter of credit on the applicant’s behalf to ensure that the terms and conditions which are required for documentation purposes under the credit are met duly before any amount is paid to the supplier. Documentary letter of credits come under the governance of the International Chamber of Commerce (ICC) rules. These rules for the letter of credit are known as Uniform Customs and practice for documentary Credit (UCP). The current version which is in effect is the UCP600 from July 1st, 2007. The concerned parties to a documentary letter of credit are the issuing bank and the beneficiary.

In these cases the credit worthiness of the issuer stands in place of the credit worthiness of the buyer – giving the supplier greater comfort that he will be paid.

Letter of Credit (LC)

LC or Letter of Credit is a Non-Fund Based Limit given to someone who wants to issue the payment guarantee to the counter party. In many businesses, the supplier is not ready to dispatch the goods, unless there is an advance or LC issued in his favor.

In layman’s language, it is like a Bank Draft with Future Date. Cheque can bounce, but the Drafts never bounces. Similarly, LCs can never be dishonored by the Bank. Also, since it is a promise to pay in future, the actual utilization of funds don’t occur while issuing the LC.

Some very important benefits of LCs are:

It is also known as non-fund based working capital financing. Letter of credit and bank guarantee has a very thin line of difference. Bank guarantee is revoked and the bank makes payment to the holder in case of non-performance of the opposite party whereas, in the case of a letter of credit, the bank will pay the opposite party as soon as the party performs as per agreed terms. So, a buyer would buy a letter of credit and send it to the seller. Once the seller sends the goods as per the agreement, the bank would pay the seller and collects that money from the buyer.

A letter of credit is a document that a financial institution issues to a seller of goods or services which says that the issuer will pay the seller for goods/services the seller delivers to a third-party buyer. The issuer then seeks reimbursement from the buyer or from the buyer’s bank. The document is essentially a guarantee to the seller that it will be paid by the issuer of the letter of credit regardless of whether the buyer ultimately fails to pay. In this way, the risk that the buyer will fail to pay is transferred from the seller to the letter of credit’s issuer.

Letters of credit are most common in international transactions, where buyers and sellers may not know each other well or laws and conventions may make certain transactions difficult. For example, let’s assume that Company XYZ sells widgets in Alabama and Company ABC manufactures widgets in Lithuania. Company XYZ wants to import $100,000 worth of widgets manufactured by Company ABC, but Company ABC is concerned about XYZ’s ability to pay for them.

To address this, Company XYZ gets a letter of credit from its bank, Bank of Alabama, indicating that Company XYZ will make good on the $100,000 payment in, say, 60 days, or Bank of Alabama will pay the bill itself. Bank of Alabama then sends the letter of credit to Company ABC, which then agrees to ship the widgets.

After the shipment goes out, Company ABC (or Company ABC’s bank) then asks for its $100,000 by presenting a written draft (also called a bill of exchange) to Bank of Alabama. Although letters of credit mostly benefit sellers, they also protect buyers, because Company ABC must present Bank of Alabama with written proof of the widget shipment in order to get paid. This proof usually includes a commercial invoice, bill of loading, or an airway bill. After Bank of Alabama pays Company ABC, it turns to Company XYZ for reimbursement (usually by debiting Company XYZ’s bank account).

Banks usually require a pledge of securities or cash collateral in order to issue a letter of credit to a holder. Banks also collect a fee for issuing letters of credit; the fee is usually a percentage of the size of the letter of credit. The International Chamber of Commerce Uniform Customs and Practice for Documentary Credits governs letters of credit used in international transactions. In the United States, the Uniform Commercial Code governs letters of credit used for domestic transactions.

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There are several kinds of letters of credit:

A commercial letter of credit

is one of the most common and is reflected in the example above. This kind of letter acts as the primary payment mechanism between the customer and the beneficiary; that is, the issuing bank makes the actual payments to the beneficiary every time. So in our example above, Bank of Alabama pays Company ABC directly, even if Company XYZ has the cash and the means to fulfill its obligation to Company ABC.

A standby letter of credit,

on the other hand, is a secondary payment mechanism, meaning that the bank pays the beneficiary only when the holder cannot. Both parties to a standby letter of credit never hope to have to use it. In our example above, Bank of Alabama would only pay Company ABC directly if Company XYZ couldn’t.

A revolving letter of credit

lets the customer make any number of draws for a certain period as long as they do not exceed a certain limit.

A traveler’s letter of credit

is a promise that the issuing bank will honor drafts made at certain foreign banks.

A confirmed letter of credit

is a letter of credit that has another bank besides the issuing bank standing behind it. This second bank is called the confirming bank, and it is usually (but not always) the seller’s bank. The confirming bank ensures payment under the letter of credit if the holder and the issuing bank default on the letter of credit. This is usually done at the request of the issuing bank in international transactions.

Letters of credit are usually negotiable instruments meaning that the issuing bank must pay the beneficiary or any bank nominated by the beneficiary. In some cases, letters of credit are also transferable, meaning that the beneficiary has the right to assign the right to draw to another entity (such as a corporate parent or even a third party).