A guide to Letter of Credit – Its Features, Advantages & Disadvantages

Akansha Gupta

24 May, 2024

Buyers and sellers in international commerce are placed some distance away and are entirely uninformed of one other’s financial condition and integrity. The exporter is often hesitant to ship products against a sale contract because he or she is concerned that the importer may fail to accept the documents or make any default and while paying for them. To ensure payment, the importer usually obtains an undertaking, such as a letter of credit from his bank in favour of the exporter, stating that payment would be paid contingent on the receipt of certain shipping documents. The LC states that, in accordance with the specifications and conditions stated therein, the issuing bank would honour bills drawn under the LC up to a specific amount (typically the contract amount) covering a defined shipment of goods during the given period. There are also provisions for letters of credit under the Uniform Customs and Practice for Documentary Credit.

A letter of credit is an guarantee from a bank that a buyer’s payment to a seller will be paid on time and in full. If the buyer is unable to make a payment on the purchase, the bank must reimburse the whole or remaining amount of the transaction. Because of the nature of worldwide business, including issues like as distance, varying regulations in each country, and the difficulties in physically knowing each partner, the usage of letters of credit has become an extremely essential component of international trade.

A letter of credit is a valuable financial instrument in commercial operations. Letters of credit are used to ease payments and transactions in both the local and foreign markets. A bank or financial institution operates as a third party between the buyer and seller, guaranteeing the delivery of payments upon fulfilment of specified obligations.

Meaning of Letter of Credit

A letter of credit is a document issued by a bank or financial institution on behalf of the buyer that guarantees payment to the seller. Before issuing the LC, the bank must have certain documents in its possession. This letter serves as an assurance to the seller that payment would be paid, even though the buyer does not. The seller’s risk of non-payment is transferred to the bank. In most cases, another bank serves as an advisor to the seller throughout the process. The issuing bank gives the advisory bank permission to pay the seller.

For centuries, the commercial LC has been used to ease payment in both local and international commerce, such as import and export LC. In fact, as the global economy develops, its use will rise. Under the (UCP 600) Uniform Customs and Practice for Documentary Credits, the International Chamber of Commerce regulates all international letters of credit.

A letter of credit is a valuable instrument for ensuring seamless commercial operations. However, it is in the parties’ best interests to be completely aware of the complexities, benefits, and drawbacks of the LC.

Example of LC

Citibank provides letters of credit to purchasers in Latin America, Africa, Eastern Europe, Asia, and the Middle East who are unable to secure foreign credit on their own. Letters of credit from Citibank assist exporters in mitigating both the importer’s nation risk and the issuing bank’s commercial credit risk. Letters of credit are usually issued within 2 working days, with payment guaranteed by the confirming Citibank office. This benefit is especially significant when a client is located in an economically volatile area.

Features of Letter of Credit

Since letters of credit have been in use for centuries and there is a common regulatory code for letters of credit, some LC characteristics are conventional and exist uniformly in all letters of credit:-

• Negotiability: A LC is often regarded as a negotiable instrument that may be freely transferred like money between multiple parties. The LC mandates the issuing bank to pay the money not only to the beneficiary, but also to any other bank that he designates. However, a letter of credit is only considered negotiable if it includes an absolute guarantee to pay on demand or at a specific period.

• Revocability: A letter of credit may be revocable or irreversible. A revocable LC can be revoked or modified at any moment by the issuing bank without notice. The advising bank would not confirm the LC in this case. A revocable LC, on the other hand, is exceptionally rare. The most frequent type is an irrevocable LC, which cannot be amended or cancelled without the consent of all parties concerned.

• Transfer and Assignment: The recipient of the LC has the option to transfer or assign the LC as many times as they like. The LC will continue to function.

• Sight and Time Drafts: The LC requires payment to be paid in one of two ways: sight or time. When the LC is submitted, a sight draft must be paid, and a time draft must be paid after a certain amount of time. In both situations, the bank will check the LC to ensure that it is legitimate.

Parties involved in a Letter of Credit – LC

The key parties involved in a LC are explained further below. We can categorise the primary eight parties involved in a LC.

• Applicant of Letter of Credit (LC) –

Applicant is among the primary parties in a LC. Who is a Letter of Credit applicant?

An individual who opens the LC is known as the applicant. Typically, the Applicant who opens the LC is the buyer of the products. A letter of credit is opened per his instructions, and the appropriate payment is made to obtain an LC with his bank. The applicant arranges for a LC to be opened with his bank in accordance with the purchase order’s terms and conditions and business contract between the buyer and seller. As a result, Applicant is one of the main parties engaged in a Letter of credit.

• LC Issuing Bank –

One of the other major parties involved in an LC is the issuing bank. What is an Issuing Bank in the context of a Letter of Credit?

The bank that opens the LC is known as the issuing bank. The issuing bank creates a LC, which commits to paying the amount upon receipt of documents from the supplier of goods (beneficiary under LC).

• Beneficiary party –

One of the relevant parties in a letter of credit is the beneficiary. The beneficiary of the LC receives the benefit under the LC. Beneficiary is the party who gets the payment under the LC. The LC is opened in favour of the Beneficiary party. The beneficiary of a letter of credit delivers all needed documents to his or her bank according to the terms and conditions of the LC.

• Advising bank –

Another entity participating in LC is the advising bank. As part of the LC, the advising bank is responsible for communicating with the relevant parties under the LC as well as other needed authorities. The advising bank is the entity that provides documents to the opening bank under the LC.

• Confirming bank –

One of the other parties participating in a Letter of Credit is the confirming bank. The bank that affirms as a party to the LC confirms and guarantees to take on the obligation of payment or negotiating acceptance under the credit.

• Negotiating bank –

One of the primary parties engaged in LC negotiations is the negotiating bank.

Negotiating Bank, who negotiates documents submitted to the bank by the LC’s beneficiary. To minimise inconsistencies, the negotiating bank checks the documentation and confirms the terms and conditions of the LC on behalf of the beneficiary.

• Reimbursing bank –

One of the parties engaged in an LC is the reimbursing bank. The party authorised to honour the reimbursement claim of negotiation/payment/acceptance is the reimbursing bank.

• Second beneficiary –

One of the other parties participating in the LC is the second beneficiary.

In the absence of the first beneficiary or original beneficiary, the credits belonging to the original beneficiary are transferrable in accordance with the requirements.

Advantages and Disadvantages of Letter of Credit

For new importers and exporters, LC is a complicated commodity. Before deciding on a letter of credit (LC), it is essential to weigh the benefits and drawbacks. An LC is very customisable and facilitates new trade partnerships by lowering credit risk; nevertheless, it can increase the expense of doing business through bank fees and procedures. Let us look at its advantages and disadvantages in more detail:-

Advantages of Letter of Credit

A letter of credit has several advantages when it comes to completing an international commercial transaction. Some of the most important are listed below:

• Safely expand business internationally

A letter of credit allows trade partners to conduct business with unknown partners or in freshly established trade partnerships. It assists them in rapidly extending their business into new geographies.

• Highly customizable

A letter of credit can be completely customised. Both trade partners can include terms and conditions that meet their needs and come up with a mutual list of provisions. It can also be tailored from one transaction to the next involving the same trade partners.

• Seller receives money on fulfilling terms

A letter of credit separates the issuing bank from the commitments of the trade partners and any disputes/ controversy that may arise as a result of those obligations. The bank just needs to verify that the documentation supplied by the beneficiary meet the terms and conditions of the LC before paying the entire amount.

• Works as a credit certificate for buyer

The creditworthiness of the importer or buyer is transferred to the issuing bank via a letter of credit. When supported by a bigger and more established organisation, like a bank, the importer can do numerous transactions at the same time.

• Seller is free of credit risk

A letter of credit protects the seller or exporter in the event that the customer or importer goes bankrupt. Since the importer’s creditworthiness has been shifted to the issuing bank, it is the bank’s responsibility to pay the amount specified in the LC. As a result, a LC protects the exporter from the importer’s business risk.

• Quick to execute for creditworthy party

A letter of credit can be issued quickly. According to the initial terms and conditions, the seller or exporter is required to produce proof of material kind and amount, as well as transportation documentation, to support his assertion that the products have been sent. The advising bank will check the paperwork and pay the entire amount.

• Payment assured in dispute transactions

In the event of a disagreement between trade partners, the exporter has the option of withdrawing the funds as stipulated in the LC and resolving the matter later in court. The courts define the beneficiary’s claim to the whole sum as “pay now, litigate later.”

The importer cannot withhold or refuse payment to the exporter based on concerns about the quality of the products since the bank just needs to see papers that meet the letter of credit’s shipping terms and conditions.

• Timely payments leads to better cash flow planning

A letter of credit ensures that the quantity and timing of an exporter’s cash flows are both predictable. He can prepare ahead of time for his financial needs, lowering his risk.

• Pre-shipment financing available to sellers

The exporter can obtain pre-shipment finance in exchange for a letter of credit. This assists him in filling any financial shortages that may exist.

Disadvantages of Letter of Credit

Letters of credit, like any other financial instrument, have drawbacks, which are outlined below:

• Additional cost – bank fee

The expense of doing business is increased by a letter of credit. Banks charge a fee for this service, which might rise dramatically if the parties wish to include certain extra features.

• Time – consuming formalities

A letter of credit may involve extra documentation and formality. This may increase the expense of conducting business.

• Possibility of misuse – fraud risk

A letter of credit has complicated regulating requirements, and some unscrupulous buyers or sellers may take advantage of it.

The LC exposes the importer to a significant risk of fraud. The bank will pay the exporter based on the shipping documentation rather than the actual quality of the products. If the quality differs from what was agreed upon, a dispute may arise.

• Currency risk

A letter of credit is also subject to currency risk. The LC will include an agreed-upon currency. At least one of the parties will be using a different currency, putting them at risk from currency fluctuation. It may also work in your advantage.

• Time bound

A letter of credit contains an expiration date, thus the exporter has a time restriction during which he must deliver the products by whatever means. This haste might sometimes result in a mess.

• Risk of default by issuing bank

A letter of credit effectively transfers the importer’s creditworthiness to the issuing bank. As a result, even if the originating bank defaults, the exporter faces a payment risk. Though the exporter can avoid it if the advising bank guarantees payment, the cost of the LC will rise as a result.

Conclusion

Read our article:All you need to know about Rupee Drawing Arrangement