Get the best shipping quotes
Get the most updated container prices from main carriers
ORIGIN OF SHIPMENT

DESTINATION OF SHIPMENT

SELECT CONTAINER

Quote within hours

Letter of credit

Letters of Credit have the following basic components:

  • Applicant — The party applying for the issuance of the letter of credit, usually the buyer / importer.
  • The Issuing Bank — The bank that issues the letter of credit and takes the  responsibility to make payment to the beneficiary, usually the seller/exporter. Sometimes referred to as the opening bank.
  • Advising bank — The bank that will advise the beneficiary about the credit that is opened his favour.
  • Beneficiary — The party in whose favour the letter of credit is issued, usually the seller/exporter, and who will receive payment if all the conditions and terms of the credit are met.
  • Amount — The sum of money, usually expressed as a maximum amount, of the letter of credit, defined in a specific currency.
  • Terms — The requirements, including documents that must be met for the collection of the credit.
  • Expiry — The final date for the beneficiary to present against the credit.

An irrevocable and confirmed letter of credit gives the strongest guarantee in a situation when the Seller is not sure about the credit-worthiness of the buyer’s bank. A letter of credit is not an absolute guarantee of payment rather a payment mechanism which aims at reducing the risk of not getting paid. Common discrepancies in a letter of credit arise due to incorrectly stated name of the beneficiary and late shipment date. To avoid any problem of discrepancy, the terms and conditions of credit need to be thoroughly checked at the initial stage in the light of agreed Sale Contract & the governing rules of UCP 600.

On presentation of the documents by the buyer to the Issuing bank, if any discrepancy is noted, the buyer will be notified as soon as possible to decide whether to accept the documents despite the discrepancies. If the documents are accepted by the buyer, the issuing bank will then notify the seller’s bank that the letter of credit will be honoured despite the discrepancies. On the other hand, if the documents are rejected, then the issuing bank will issue a notice of rejection to the seller’s bank within five banking days from the date of receipt of documents by the issuing bank (UCP 600-Article 14b).

Implementation of a Letter of Credit

Step-by-step process for implementation of a Letter of Credit, is explained below in brief:

  1. Buyer and seller agree to conduct business & conclude Sale Contract. The seller wants a letter of credit to guarantee payment.
  2. Buyer applies to his bank for a letter of credit to be opened in favor of the seller.
  3. Buyer’s bank (Issuing Bank) approves the credit risk of the buyer, issues and forwards the credit to its correspondent bank (advising or confirming bank). The correspondent bank is usually located in the same geographical location as the seller (beneficiary).
  4. Advising bank will authenticate the credit and forward the original credit to the seller (beneficiary).
  5. Seller (beneficiary) ships the goods, then verifies and develops the documentary requirements to support the letter of credit. Documentary requirements may vary greatly depending on the perceived risk involved in dealing with a foreign buyer/ company.
  6. Seller presents the required documents to the advising or confirming bank to be processed for payment.
  7. Advising or confirming bank examines the documents for compliance with the terms and conditions of the letter of credit.
  8. If the documents are correct, the advising or confirming bank will claim the funds by: Debiting the account of the issuing bank. Waiting until the issuing bank remits, after receiving the documents. Reimburse on another bank as required in the credit.
  9. Advising or confirming bank will forward the documents to the issuing bank.
  10. Issuing bank will examine the documents for compliance. If they are in order, the issuing bank will debit the buyer’s account.
  11. Issuing bank then forwards the documents to the buyer.

Different types of letter of credit contracts

There are five commonly used types of letter of credit. Each type has different features with respect to providing degree of security and difference in the cost of credit implementation. The most common types are: irrevocable, revocable, unconfirmed, confirmed and transferable. Other special types include: standby revolving and back-to-back. Below you can find some examples:

  • Contact Number 1: To initiate business deal, the exporter starts negotiation with the importer and finalizes the sales / purchase contract first and then they choose the letter of credit as the method of payment.
  • Contract Number 2: As per this contract, the importer applies to his bank (Issuing Bank) to have the letters of credit issued in favour of the exporter. Since the bank is undertaking responsibility to pay the exporter, it demands some collateral security in the form of mortgage on property or the equivalent amount in cash or any other arrangement as the bank deems suitable. It is the discretion of the bank to determine the value of security which may or may not be the equivalent amount of letter of credit.
  • Contract Number 3: This represents contractual undertaking given by the issuing bank to pay to the exporter. But the undertaking is conditional. The bank effects payment only when the beneficiary complies fully with the requirements of the letter of credit. Complying presentation by the beneficiary is thoroughly checked by the bank in accordance with the terms and conditions of the credit. If found O.K, then payment is done. If not payment is rejected as per instruction of the importer.
  • Contract Number 4: This represents the contract between the Issuing Bank and the Correspondent/Advising Bank which is normally located in the same geographical location of the exporter. On the basis of this contract, the issuing bank authorizes the Advising bank to verify the authenticity of the letter of credit and to take necessary action to facilitate credit transactions. The Advising bank plays a significant role in evaluating the credit worthiness of importer’s bank and the importer which safeguards the interest of the exporter to get duly paid. Otherwise the exporter would need to deal with the issuing bank directly for receipt of letter of credit and its compliance which might create lot of hazards & uncertainity for him towards the implementation process of the credit.
  • Contact Number 5: It is a service contract between the exporter’s bank and the exporter. The exporter bank may perform different functions, depending on its acceptance of the instructions given in the letter of credit by the issuing bank. For example the exporter’s bank may, in the case of a letter of credit drawn at sight, be able to pay the exporter immediately on submission of complying documents and claim reimbursement from the issuing bank. These banking arrangements do not create any hazard for the exporter to get payment in time, as long as the letter of credit instructions provide appropriate mechanisms to reimburse payment to the exporter.

Description of commonly used letters of credit

  • Revocable Letters of Credit: The term “revocable” means that the letter of credit can be modified or cancelled by the buyer or his bank at any time without prior notice to the seller. It offers no guarantee of payment. Revocable letters of credit are rarely acceptable by sellers or used in international trade due to its inherent insecurity.
  • Irrevocable Letters of Credit: Under this type of credit the buyer’s bank makes an irrevocable commitment to pay the seller, on his complying presentation of documents as per terms and conditions of the letter of credit, and this cannot be changed or cancelled by the bank without permission of the exporter. It offers a guarantee for payment. Therefore, irrevocable letters of credit are widely used in international trade because of assurance of security it offers . They are more expensive since the Issuing bank is guaranteeing the credit.
  • Confirmed Letters of Credit: This term means that the credit is not only backed by the issuing bank, but that payment is also guaranteed by the confirming bank (which may be the advising/notifying bank). That means the confirming bank is adding its guarantee to pay the seller in case the issuing bank fails to make payment. If a seller is unfamiliar with the buyer’s bank (or even the buyer) which issues the letter of credit, or if he is trading in a high risk area, he may then insist on an Irrevocable confirmed letter of credit. A confirmation on a letter of credit adds costs because of additional liability taken by the confirming bank.
  • Unconfirmed Letters of Credit: This means that the issuing bank is the only party responsible for payment to the supplier. The seller’s bank does not offer its guarantee of payment and is obliged to pay only after the payment from the issuing bank is received. In case of any difficulties, the exporter has to deal with the issuing bank for payment. The most desirable type of credit is the “Irrevocable Confirmed Letter of Credit”, but this type of credit is costly & not always available.

Description of Special types of letters of credit

  • Revolving Letters of Credit: A revolving letter of credit covers multiple or continuous shipments of merchandise. It is a commitment on the part of the issuing bank to make the L/C available in the original amount whenever it has been used or drawn, usually under the same terms and without the issuance of another L/C. Revolving L/Cs enable sellers to rely on ongoing sources of short-term financing. This credit can avoid the fixed costs of entering each time into a new short-term financing transaction. The number of times the L/C can be utilized and the period of validity is specified in the L/C. A revolving letter of credit can be either cumulative or noncumulative. Cumulative means that the unused sums in the L/C can be added to the next installment, whereas noncumulative means that the partial amounts not used in time expire.
  • Back-to-Back Letters of Credit: Back-to-back letters of credit can be used by trading companies which arrange transactions for the sale of goods between two other parties, or by processing companies. They enable the trading company to use a first L/C, issued in his favour by the buyer, as collateral for his issuance of a second L/C in favour of the supplier. Thus a new L/C is opened on the basis of an already existing one.
  • Transferable Letters of Credit: Transferable letters of credit are an alternative to back-to-back L/Cs as a method of facilitating transactions arranged by a trading company. The first beneficiary (the trading company) instructs the advising bank to advise the letter of credit (i.e. to transfer all or part of the proceeds of the L/C) to the second beneficiary (the ultimate exporter).
  • Standby letters of credit: A standby letter of credit is an assurance from a bank that a buyer is able to pay a seller. The seller doesn’t expect to draw on the letter of credit to get paid.