In International trade, the buyer and the seller who are located in different countries, may not know each other and hence many times the problem of Buyer’s Creditworthiness hampers the trade between the buyer and the seller. The main objectives of the buyer and the seller in any international trade and contradictory in terms of Buyer will always try to delay the payment while the seller would like to receive funds at the earliest.

To mitigate this problem, Seller always request Buyer to arrange for a Letter of Credit to be issued by Buyer’s Bank. Upon issuance of Letter of Credit, the Buyer’s bank replaces its own Creditworthiness to that of the Buyer, it undertakes to reimburse the Seller for the value of the Letter of Credit “Irrevocably” provided two underline conditions are fulfilled by the Seller:

1. All the documents stated in the LC are presented;

2. All the terms and conditions of the LC are complied with.

The beauty of the LC is that if above two conditions are fulfilled, Issuing Bank will effect payment to the Beneficiary, irrespective of Applicant reimburses the Issuing Bank or not. Thus, a Letter of Credit is an undertaking issued by a bank in favor of a Beneficiary (Seller), which substitutes the bank’s creditworthiness for that of the Applicant (Buyer).

Why Letter?

It is named a Letter because initially the LCs were issued manually in a Letter format address by Issuing Bank to Beneficiary confirming its conditional undertaking to reimburse the Beneficiary, the amount of the LC provided above 2 basic conditions are fulfilled.

Parties involved in LC transaction:

1. The Applicant is the party that arranges for the letter of credit to be issued.

2. The Beneficiary is the party named in the letter of credit in whose favor the letter of credit is issued.

3. The Issuing or Opening Bank is the applicant’s bank that issues or opens the letter of credit in favor of the beneficiary and substitutes its creditworthiness for that of the applicant.

4. An Advising Bank may be named in the letter of credit to advise the beneficiary that the letter of credit was issued. The role of the Advising Bank is limited to establish apparent authenticity of the credit, which it advises.

5. The Paying Bank is the bank nominated in the letter of credit that makes payment to the beneficiary, after determining that documents conform, and upon receipt of funds from the issuing bank or another intermediary bank nominated by the issuing bank.

6. The Confirming Bank is the bank, which, under instruction from the issuing bank, substitutes its creditworthiness for that of the issuing bank. It ultimately assumes the issuing bank’s commitment to pay.

Letter of Credit Process:

Commercial Letter of Credit Flow

Applicant approaches Issuing/ Opening Bank with LC application form duly filled and requests Issuing Bank to issue a Letter of Credit in favour of Beneficiary.

1. Issuing Bank issues a Letter of Credit as per the application submitted by an Applicant and sends it to the Advising Bank, which is located in Beneficiary’s country, to formally advise the LC to the beneficiary.

2. Advising Bank advises the LC to the Beneficiary.

3. Once Beneficiary receives the LC and if it suits his/ her requirements, he/ she prepares the goods and hands over them to the carrier for dispatching to the Applicant.

4. He/ She then hands over the documents along with the Transport Document as per LC to the Negotiating Bank to be forwarded to the Issuing Bank.

5. Issuing Bank reimburses the Negotiating Bank with the amount of the LC post Negotiating Bank’s confirmation that they have negotiated the documents in strict conformity of the LC terms. Negotiating Bank makes the payment to the Beneficiary.

6. Simultaneously, the Negotiating Bank forwards the documents to the Issuing Bank to be released to the Applicant to claim the goods from the carrier.

7. Applicant reimburses the Issuing Bank for the amount, which it had paid to the Negotiating Bank.

8. Issuing Bank releases all documents along with the titled Transport Documents to the Applicant.

Settlements Under a Letter of Credit

All commercial letters of credit must clearly indicate whether they are payable by sight payment, by deferred payment, by acceptance, or by negotiation. These are noted as formal demands under the terms of the commercial letter of credit.
In a sight payment, the commercial letter of credit is payable when the beneficiary presents the complying documents and if the presentation takes place on or before the expiration of the commercial letter of credit.

In a deferred payment, the commercial letter of credit is payable on a specified future date. The beneficiary may present the complying documents at an earlier date, but the commercial letter of credit is payable only on the specified future date.

An acceptance is a time draft drawn on, and accepted by, a banking institution, which promises to honor the draft at a specified future date. The act of acceptance is without recourse as it is a commitment to pay the face amount of the accepted draft.

Under negotiation, the negotiating bank, a third party negotiator, expedites payment to the beneficiary upon the beneficiary’s presentation of the complying documents to the negotiating bank. The bank pays the beneficiary, normally at a discount of the face amount of the value of the documents, and then presents the complying documents, including a sight or time draft, to the issuing bank to receive full payment at sight or at a specified future date.

Types of Letter of Credit

Irrevocable

An irrevocable letter of credit can neither be amended nor cancelled without the agreement of all parties to the credit. Under UCP500 all letters of credit are deemed to be irrevocable unless otherwise stated. Here, the importer's bank gives a binding undertaking to the supplier provided all the terms and conditions of the credit are fulfilled.

Unconfirmed

The advising bank forwards an unconfirmed letter of credit directly to the exporter without adding its own undertaking to make payment or accept responsibility for payment at a future date, but confirming its authenticity.

Confirmed

A confirmed letter of credit is one in which the advising bank, on the instructions of the issuing bank, has added a confirmation that payment will be made as long as compliant documents are presented. This commitment holds even if the issuing bank or the buyer fails to make payment. The added security to the exporter of confirmation needs to be considered in the context of the standing of the issuing bank and the current political and economic state of the importer's country. A bank will make an additional charge for confirming a letter of credit.  In many cases, the confirming bank is located in Beneficiary’s country.
Confirmation costs will vary according to the country involved, but for many countries considered a high risk will be between 2%-8%. There also may be countries issuing letters of credit, which banks do not wish to confirm - they may already have enough exposure in that market or not wish to expose themselves to that particular risk at all.

Standby Letters of Credit

A standby letter of credit is used as support where an alternative, less secure, method of payment has been agreed. They are also used in the United States of America in place of bank guarantees. Should the exporter fail to receive payment from the importer he may claim under the standby letter of credit. Certain documents are likely to be required to obtain payment including: the standby letter of credit itself; a sight draft for the amount due; a copy of the unpaid invoice; proof of dispatch and a signed declaration from the beneficiary stating that payment has not been received by the due date and therefore reimbursement is claimed by letter of credit. The International Chamber of Commerce publishes rules for operating standby letters of credit - ISP98 International Standby Practices.

Revolving Letter of Credit

The revolving credit is used for regular shipments of the same commodity to the same importer. It can revolve in relation to time or value. If the credit is time revolving once utilised it is re-instated for further regular shipments until the credit is fully drawn. If the credit revolves in relation to value once utilised and paid the value can be reinstated for further drawings. The credit must state that it is a revolving letter of credit and it may revolve either automatically or subject to certain provisions. Revolving letters of credit are useful to avoid the need for repetitious arrangements for opening or amending letters of credit.

Transferable Letter of Credit

A transferable letter of credit is one in which the exporter has the right to request the paying, or negotiating bank to make either part, or all, of the credit value available to one or more third parties. This type of credit is useful for those acting as middlemen especially where there is a need to finance purchases from third party suppliers.

Back-to-Back Letter of Credit

A back-to-back letter of credit can be used as an alternative to the transferable letter of credit. Rather than transferring the original letter of credit to the supplier, once the letter of credit is received by the exporter from the opening bank, that letter of credit is used as security to establish a second letter of credit drawn on the exporter in favour of his importer. Many banks are reluctant to issue back-to-back letters of credit due to the level of risk to which they are exposed, whereas a transferable credit will not expose them to higher risk than under the original credit.

Advantages of Letter of Credit:

1. The beneficiary is assured of payment as long as it complies with the terms and conditions of the letter of credit. The letter of credit identifies which documents must be presented and the data content of those documents. The credit risk is transferred from the applicant to the issuing bank.

2. The beneficiary can enjoy the advantage of mitigating the issuing bank’s country risk by requiring that a bank in its own country confirm the letter of credit. That bank then takes on the country and commercial risk of the issuing bank and protects the beneficiary.

3. The beneficiary minimizes collection time as the letter of credit accelerates payment of the receivables.

4. The beneficiary’s foreign exchange risk is eliminated with a letter of credit issued in the currency of the beneficiary’s country.

Risks involved in Letter of Credit.

1. Since all the parties involved in Letter of Credit deal with the documents and not with the goods, the risk of Beneficiary not shipping goods as mentioned in the LC is still persists.

2. The Letter of Credit as a payment method is costlier than other methods of payment such as Open Account or Collection

3. The Beneficiary’s documents must comply with the terms and conditions of the Letter of Credit for Issuing Bank to make the payment.

4. The Beneficiary is exposed to the Commercial risk on Issuing Bank, Political risk on the Issuing Bank’s country and Foreign Exchange Risk in case of Usance Letter of Credits.