Letter of Credit (LC)

A Letter of Credit (LC) is a document that guarantees the buyer’s payment to the sellers. Businesses widely use this assured form of payment in trade transactions. It is issued by a bank and ensures timely and full payment to the seller. If the buyer cannot make such a payment, the bank covers the full or the remaining amount on behalf of the buyer. This document minimizes the risks in international trade for both the buyer and seller. A letter of credit is one of the most secure payment methods for sellers as long as the conditions are fulfilled. In this article, we look at the basics of a Letter of Credit (LC) transaction and types of letters of credit.

What is an LC (Letter of Credit)?

LC full form stands for 'Letter of Credit'. A Letter of Credit (LC) is a financial instrument commonly used in international trade to ensure payment security for transactions. It serves as a guarantee from a bank that the seller will receive payment from the buyer, provided the agreed-upon terms and conditions are met. By mitigating risks for both parties, LCs facilitate smooth trade operations. Typically, an LC can be issued against a pledge of securities or cash, and banks charge a fee, usually calculated as a percentage of the LC’s total size or amount

Basics of a Letter of Credit Transaction

Applicant: The applicant in an LC transaction is usually the buyer or importer of goods. The applicant of the LC has to make the payment if documents, as per the conditions of the LC, are delivered to the Bank. Beneficiary: The beneficiary is the party to whom the LC is addressed, i.e., the seller or exporter. The beneficiary would receive payment from the nominated bank against the submission of documents as per the LC condition. Issuing Bank: The issuing bank is the Banker to the importer or buyer, which lends its guarantee or credit to the transaction. The issuing bank is liable for payment once the documents are per the conditions of the LC received from the Negotiating Bank. Negotiating Bank: The Negotiating Bank is the beneficiary’s bank. The beneficiary in an LC transaction would be the seller or exporter. The negotiating bank would claim payment from the issuing bank or the opening bank.

Importance of Letters of Credit

To conduct international trade and business, the Letter of Credit is one of the essential documents.
Letters of Credit ensure the buyer that they will only pay once the seller has proof that the items have been shipped. The buyer does not have to make any unnecessary advanced payments.
Letters of Credit ensure that your business is ready to purchase more with companies outside the country.
A letter of credit help companies and individuals secure enough funding for their business.
A letter of Credit (LC) can be used to verify the credit status of a corporation or person.
If the buyer cannot pay for their purchases, the financial institution will help them by paying the amount.

Advantages of Letters of Credit

Since letters of credit are primarily used for international trade, growing the business in new markets overseas will become easier.
Letters of Credit allow your business to establish new connections with new companies globally.
A letter of credit is also highly customizable. The trading partners can include different terms, conditions, and requirements that will benefit them during the transaction.
The letter can also be customized with the same parties from one business deal to another.

Parties to Documentary Credit

Commercial/ trade parties – buyer/ seller, applicant/ beneficiary, etc.
Banks – The banks that issue LC, advising banks, LC is confirming bank, reimbursing bank, etc.
Related Parties – Shipping/ Air Lines, Insurance Companies, Forwarders, etc.

Types of a Letter of Credit

The letters of credit can be divided into the following categories:

Sight Credit

Under this Letter of Credit, documents are payable at the sight/ upon presentation of the correct documentation. For example, a businessman can present a bill of exchange to a lender along with a sight letter of credit and take the necessary funds immediately. A sight letter of credit is more immediate than other forms of letters of credit.

Acceptance Credit/ Time Credit

The Bills of Exchange that are drawn and payable after a period are called usance bills. Under acceptance credit, these usance bills are accepted upon presentation and eventually honored on their respective due dates.

Revocable Letter of Credit

As the name suggests, the issuing bank can revoke a letter of credit without the beneficiary's agreement.

Irrevocable Letter of Credit

Suppose an applicant applies for a duty credit scrip/ discharge of EO against a confirmed irrevocable letter of credit (or bill of exchange that is unconditionally co-accepted/ avalised/ guaranteed by a bank). In that case, this is confirmed and certified by the exporter’s bank in a relevant Bank Certificate of Export and Realization. Payment of export proceeds will be considered to have been realized. For Status Holders, an irrevocable letter of credit will suffice.

Confirmed Letter of Credit

A confirmed LC is a type of letter of credit in which the advising bank, at the request of the issuing bank, adds confirmation that payment will be made. The confirming bank’s liability is similar to the issuing bank. The confirming bank has to honor the payment if tendered by the beneficiary.

Back-to-Back Letter of Credit

In a back-to-back LC, a 2nd LC is opened by the original beneficiary in favor of the 2nd beneficiary against the security of the original LC. In general, a back-to-back LC is open for the suppliers.

Transferable Letter of Credit

If the beneficiary can transfer an LC in whole or part to a second beneficiary (usually a supplier to the seller), then the LC is transferable. The 2nd beneficiary, however, cannot transfer the LC further.

Restricted Letter of Credit

A restricted LC is one wherein it designates a specific bank to pay, accept or negotiate the LC.

Revolving Letter of Credit

In a revolving LC, the applicant can use the LC facility again based on drawings and payments made against the LCs.

Restricted Letter of Credit

A restricted LC is one wherein it designates a specific bank to pay, accept or negotiate the LC.

Precautions to be Taken

The bank that grants the Letter of Credit has to be a regular banker of the opener and should also be known to the beneficiary.

The Overseas Letter of Credit should always be advised through an Indian Bank; preferably, it should be confirmed.
The individual has to check the bank charges, whether to open the account or the beneficiaries account. Generally, the buyer and the seller must pay the bank charges in the respective countries, including the LC confirmation charges. The Letter of Credit has to mention the expenses that are on account of the applicant and which are on account of the beneficiary.
The individual has to check if the freight is prepaid or to pay according to the contract.

Import Export Code

The Import Export Code is a primary document necessary for commencing Import-export activities. The IE code is to be obtained for exporting or importing goods or services.IEC has numerous benefits for the growth of the business. Indeed, you cannot ignore the necessity of IE code registration, as it is mandatory. You can apply for an Import Export code through IndiaFilings and obtain it within 6 to 7 days.