Basics of Letter of Credit(LC)/Documentary Credit
What is Letter of Credit? How does it work? What are different Types of LC? Is there any law governing LC? What is Documentary Credit? Importance of LC in International Trade.
These are the questions ringing in the mind of people starting new business or people dealing with finance in any organization. In this blog our focus is to bring a solution for all these questions.
Letter of Credit(LC)- Back-bone of International Trade
Exports and Imports are very crucial for an open economy. Maintaining Balance of Trade and sufficient foreign exchange balance is vital for an economy. Export is the base of both of these crucial balances.
Foreign Credit Risk is involved in exports.
Foreign Credit Risk is the risk that abroad buyer may default on his payment obligation when payment becomes due. Foreign Credit Risk is higher than Domestic credit risk due to following factors:
- When goods travel from one country to another and it reaches outside the country of seller, any attempt to regain possession of goods will be significantly more difficult for the seller.
- If abroad buyer defaults in making payment after goods is delivered, It is more difficult to pursue the buyer for payment because the buyer and all his assets will probably outside the country of seller. Hence seller have to rely on the interference of courts or tribunals of foreign country to enforce payment.
- In case of default by foreign buyer, to regain possession of goods or to recover payment is more expensive than domestic.
Hence to minimize the Foreign Credit Risk, Letter is Credit becomes the life blood of international trade. However Letter of Credit is also used in Domestic trade. But it is very crucial in international trade due to higher credit risk.
What is Letter of Credit(LC)?
Letter of Credit is the written assurance of payment given by the foreign bank on compliance of specific conditions as mentioned in document of assurance given. Letter of Credit is also known as Documentary Credit. Letter of Credit is not a cheque or BG but a conditional undertaking where payment will be made only on compliance of specific conditions like documents which needs to be presented along with seller’s claim of payment. Generally these documents are Bill of lading, Quality and quantity certificate, Certificate of Origin, Insurance papers etc.
Before making payment, buyer’s bank will perform strict check like all required documents are received or not, Consignee name, Discharge port etc. Any qualification will result is dishonor of payment claim of seller. This is important to note that bank does not check goods physically, it just check that documents are per LC conditions. If documents are found in line with LC conditions, bank will release the payment to seller.
How Does Letter of Credit (LC) works?
For example if Indian Seller enters into any agreement with foreign buyer for sale of shoes then:
Step1: Indian Seller enters into an agreement with Foreign Buyer
Step2: Foreign buyer requests his bank to issue LC in favor of India seller.
(Foreign bank receives its LC charges from foreign buyer)
Step3: Foreign bank will issue LC and same will be sent to bank of Indian
seller in India.
Step4: Indian bank will verify authenticity of LC and after proper validation
Delivers the LC to Seller.
Step5: Indian Seller will dispatch the good to Foreign Seller.
Step6: Indian Seller will submit his claim for payment to foreign bank
through his Indian bank along with Documents as mentioned in
conditions of LC.
Step7: Foreign bank will strictly check compliance of LC conditions.
Step8: If Foreign bank is satisfied with compliance of LC conditions then FB
will release payment to Indian Seller.
Indian Seller (Exporter) should ensure that he has received a clean and validated Letter of Credit (LC) before possession or ownership of goods is transferred to abroad buyer. After receiving LC, Payment is secured for Seller. Chances of default by Foreign Bank is paltry than compared to any overseas buyer. Hence Foreign Credit Risk is minimized and more exporters will be motivated to export. Further Foreign buyer will also be secured that payment will not be released before receipts of proper documents as mentioned in LC conditions.
Law Governing Letter of Credit(LC):
A report of banks shows that more than 49% of LC claims are rejected by banks on account of non-compliance of LC conditions. Presently there is no law governing LC. Hence International Chamber of Commerce(ICC) has come out with universally accepted principles for dealing with Letter of Credit. These principles are also known as Uniform Custom Practices (UCP) for documentary credits. These principles are followed by all international banks while honouring seller’s claim.
Key Points of UCP issued by ICC
- LC and Sales Contract are independent of each other. Although Sales contract gives birth to LC but conditions mentioned in LC will prevail without any reference to the sales contract. Banks are neither concerned with sales contract nor with physical performance of sales contract. They only concerned about conditions mentioned in LC.
- LC must be irrevocable. Buyer must not in position to amend T&C of LC without concurrence from beneficiary.
- Banks deals with documents only not with physical goods. Bank will reply on documents like quality certificate for quality of goods and banks are not bothered about actual quality of goods.
- A valid claim must be presented before issuing bank prior to LC expiry date. The Expiry date is for presentation of claim and not for payment hence payment may be released by bank even after expiry date of LC.
Types of Letter of Credit:
- Revocable or Irrevocable LC:
A revocable LC is that which can be amended or cancelled by issuer at any time for any reason. Whereas an Irrevocable LC is that which cannot be changed or cancelled unless everyone involved agrees. Revocable LC are not in practice being unable to provide any security.
- Transferable LC:
Transferable LC specifically states that it is “Transferable”. Such LCs can be transferred to Second beneficiary on the request of first beneficiary but not to third beneficiary by second beneficiary.
- Confirmed and Unconfirmed LC:
When exporter request that LC to be issued by a designated bank but buyer is not having any relationship with such bank then buyer issue LC from his bank which in turn will request such designated bank to confirm the LC. LC so confirmed is called Confirmed LC and LC not so confirmed is called unconfirmed LC.
- Revolving LC:
When delivery of goods is at different intervals and payment has to be made upon each delivery, buyer may ask his bank to issue revolving LC where seller can claim payment at different intervals and upto a limit mentioned in LC. And buyer need not institute LC every time when delivery is scheduled.
- Red Clause LC:
Red Clause LC facilitate advance payment to seller before delivery of goods. Basically advance payment is made to finance the manufacture or purchase of goods to be delivered under LC. Advance is normally paid against a written undertaking from the seller to deliver the transportation documents before the LC expires.
- Standby LC:
In case of Standby LC the onus of payment is on buyer and if buyer defaults then seller can claim payment under Standby LC. This LC is like a bank guarantee.
- Back to back LC:
When a bank issues LC and second bank issues second LC on the basis of LC received from first bank and so on. This type of arrangement is called back to back LC. This arrangement is generally used by intermediaries or traders who buys goods from one party and sells the same to another with or without further processing.
- Other LC on the basis of payment availability:
- LC available on Acceptance:
LC where payment will be made only on acceptance of claim by issuing bank.
- LC available at sight:
LC where payment will be made on presentation of claim within 1 or 2 days.
- LC with deferred payment:
LC where payment will be made on a certain future date like 100 days from shipment of goods.
- LC available for Negotiation:
LC where seller can negotiate with any bank for discounting the LC before maturity to get paid. For example there is payment term of one month after shipment and seller can get the payment after one month of shipment by presenting a claim to the issuing bank. (eg. $200000/-)
In a negotiable LC, On first day after after shipment, seller can approach any bank with documents as mentioned in LC for discounting LC. Banks offer discounted payment at offered rate of interest (eg. 12% p.a.) even on first date after shipment. Seller can choose best offer and get paid (eg. $198020/- i.e Present value of 200000 after one month with interest rate of 1% per month) on first day after shipment. On the due date the discounting bank will present LC claim to the issuing bank and get paid.
Seller will choose to discount LC only if discounting rate (interest rate) offered by bank is less than Return on investment (ROI) of seller.