What is a Letter of Credit?
A Credit Letter or a Letter of Credit (LC) is a bank-issued guarantee document promising payment on behalf of the buyer to the seller. Typically issued against a pledge of security and after charging a fee to the tune of a specific percentage of the amount of the LC, the LC puts the onus of either full or partial payment coverage on the bank in case the buyer is unable to make the payment.
The three parties to the LC are:
Why is a Letter of Credit necessary?
International trade is marked by volatility triggered by external and internal factors. Additionally, long distances, different laws and regulations across countries, and lack of face-to-face contact raise concerns surrounding direct fund transfer between parties. The Letter of Credit then becomes a reliable instrument to conduct business by limiting fraudulent activities and putting both parties at ease from a payment standpoint.
How does an LC work?
A Letter of Credit entails the seller or the beneficiary or a bank nominated by the seller on behalf of the buyer to cover the payment in case of default. The LC is a negotiable instrument and is also transferrable, meaning the seller can allow a corporate entity or any third party the right to draw on his behalf.
Types of LC
Commercial LC: It is the most commonly opted-for LC, wherein the bank directly pays on behalf of the beneficiary.
Standby LC: The standby LC acts as a secondary payment instrument, and the bank only steps in to pay when the buyer fails to meet the payment criteria.
Revolving LC: This time-bound LC allows multiple withdrawals, subject to a specific limit and within a specified period.
Traveller’s LC: The traveller’s LC is a useful mode of accessing funds when travelling abroad. Domestic banks issue traveller’s LCs in the name of the traveller. Thereafter, when the traveller goes to an international country, he can get funds by submitting the LC at certain banks. The international banks accept the LC and pay the traveller the funds requested. Thereafter, the international bank sends the traveller’s LC to the issuing bank which honors it and reimburses the international bank for the funds advanced to the traveller.
Revocable and Irrevocable LC: One can amend or cancel a revocable LC by the issuing bank. Also, they can do this with or without any notice to the beneficiary. An irrevocable LC is comparatively more concrete and cannot be amended or cancelled, thereby binding the issuing bank to the commitments of the credit document.
Example of an LC: If a buyer wants to import raw materials from abroad to be used in his manufacturing unit in India, he can approach any Bank to issue an LC. This Letter of Credit document can help finance his import needs. The Bank then becomes the buyer’s issuing bank and guarantees payment on the buyer’s behalf.
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