[ecis2016.org] Letters of Credit is a letter issued by a bank, which guarantees the payments by a buyer to a seller. Here’s all you need to know.
Letters of Credit (LC) are payment mechanisms used in international trade in order to provide an exporter with an economic guarantee from a creditworthy bank. If the buyer and seller are unfamiliar with each other in international trade transactions, letters of credit minimise risk. Your company can only pay for goods after the supplier provides proof that they have been shipped using a letter of credit.
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What is a Letter of Credit?
A Letters of Credit is a vital document issued by a bank, which guarantees the payments by a buyer to a seller as per the specified conditions, thus ensuring the complete and timely payment to a seller. In case, the buyer fails to make the payment, the bank will cover the full or remaining amount, on behalf of the buyer.
Types of Letters of Credit
Direct payment is a method in which the issuing bank makes payments to the beneficiary. A standby letter of credit, on the other hand, is a secondary payment method in which the beneficiary is paid only when the holder cannot.
In this type of letter, a customer can make any number of withdrawals he or she desires within a certain time limit.
This letter guarantees that issuing banks will honour drafts made at certain foreign banks for recipients going abroad.
A letter of credit that is confirmed is guaranteed by a bank other than the one that issued the letter of credit. Normally, the seller’s bank is the confirming bank. Upon default by the holder and the issuing bank, the confirming bank ensures payment under the letter of credit. In international transactions, the issuing bank typically requests this arrangement.
Revocable and Irrevocable
It refers to letter of credit that can be revoked by the issuing bank without prior notice to the beneficiary. The terms and conditions can be cancelled or amended by the issuing bank. On the other hand, in a irrevocable Letter of Credit, the terms and conditions cannot be cancelled or amended. Therefore, the opening bank is required to adhere to the commitments given in the letter of credit.
How does an LC work?
Since the LC is used as a negotiable instrument, the issuing bank directly pays the beneficiary or another bank (nominated by the beneficiary). Banks collect a fee for their services, dependent on the size of the LC.
Letters of Credit: Importance
International trade is characterised by factors such as distance, different laws in various countries, and the lack of personal contact. Hence, letters of credit are regarded as a reliable payment mechanism. In international transactions, letters of credit are governed by the ‘International Chamber of Commerce Uniform Customs and Practices for Documentary Credits.’
What are the benefits of a letter of credit for the purchaser?
Generally, a letter of credit supports a beneficiary or seller in an exchange agreement, where the bank makes sure the beneficiary or seller receives the agreed-upon amount from the purchaser or issuing bank.
What is the cost of a letter of credit?
For the issuance of a letter of credit, the bank charges a fee. Fees for a letter of credit vary depending on several factors, such as the amount of risk and the type of letter of credit.
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