What is a Letter of Credit and How does it work?
Here's how it works:
- The buyer (importer) and seller (exporter) agree to use an LC as a method of payment.
- The buyer applies to their bank (issuing bank) for an LC, which specifies the amount of money, the beneficiary (seller), and the terms and conditions of the LC.
- The issuing bank sends the LC to a correspondent bank in the seller's country (advising bank), which informs the seller that an LC has been issued in their favor.
- The seller then ships the goods to the buyer and provides documentation (such as a bill of lading, commercial invoice, and insurance certificate) to the advising bank to show that the goods have been shipped.
- The advising bank checks the documentation against the terms and conditions of the LC and, if everything is in order, forwards the documents to the issuing bank.
- The issuing bank checks the documents and, if they are in compliance with the terms and conditions of the LC, pays the seller the agreed amount of money.
- By using an LC, both the buyer and the seller are protected. The buyer is assured that the goods will be shipped before payment is made, and the seller is assured of payment as long as they meet the terms and conditions of the LC.
What are 4 types of Letters of Credit?
- Revocable Letter of Credit: A revocable LC can be modified or canceled by the issuing bank at any time without notice to the beneficiary (seller). As a result, it offers little security to the seller.
- Irrevocable Letter of Credit: An irrevocable LC cannot be modified or canceled without the consent of all parties involved. It offers a higher level of security to the seller than a revocable LC.
- Confirmed Letter of Credit: A confirmed LC is guaranteed not only by the issuing bank but also by a second bank (the confirming bank). The confirming bank adds its guarantee to the LC, providing additional security to the seller.
- Standby Letter of Credit: A standby LC is a backup form of payment that is typically used when other forms of payment have failed. It is often used as a form of financial guarantee for a project or contract, with the funds being released only if certain conditions are met.
What are Letter of Credit examples?
- International trade: LCs are commonly used in international trade to ensure that payment is made for goods or services provided. For example, a company in the United States might use an LC to pay a supplier in China for a shipment of goods.
- Construction projects: LCs are often used in construction projects to guarantee payment for work completed. For example, a contractor might require an LC from the client to ensure that payment will be made once the project is completed.
- Government contracts: LCs are frequently used in government contracts to ensure that contractors fulfill their obligations. For example, a government might require an LC from a contractor to ensure that the contractor completes a project on time and within budget.
- Shipping and logistics: LCs are sometimes used in the shipping and logistics industry to ensure that payment is made for freight services. For example, a freight forwarding company might use an LC to ensure that payment is made for shipping goods from one country to another.
Who opens a Letter of credit?
Who pays charges for a Letter of Credit?
- Issuance fee: The issuing bank charges a fee for issuing the LC.
- Amendment fee: If the terms of the LC need to be amended, such as changing the amount or shipping date, an amendment fee may be charged.
- Advising fee: The advising bank in the seller's country may charge a fee for advising the seller that the LC has been issued.
- Confirmation fee: If a confirmed LC is used, the confirming bank charges a fee for adding their guarantee to the LC.
- Negotiation fee: If the seller requests that the advising bank pay them before the documents are presented to the issuing bank, a negotiation fee may be charged.
What is the process of a LC payment?
- Shipment of goods: The seller ships the goods to the buyer, along with the required shipping and commercial documents as specified in the LC.
- Presentation of documents: The seller presents the shipping and commercial documents, such as a bill of lading and invoice, to the bank that advised or confirmed the LC, typically through the seller's bank.
- Examination of documents: The bank examines the documents to ensure that they comply with the terms and conditions of the LC.
- Payment: If the documents are found to be in compliance with the LC, the bank will release payment to the seller, either directly or through the seller's bank.
- Delivery of documents: The bank then sends the shipping and commercial documents to the buyer, allowing them to take possession of the goods.
What is the cost of a Letter of credit?
- Issuance fee: The issuing bank may charge a fee for issuing the LC, which is typically a percentage of the LC amount.
- Advising fee: The advising bank in the seller's country may charge a fee for advising the seller that the LC has been issued.
- Confirmation fee: If a confirmed LC is used, the confirming bank charges a fee for adding their guarantee to the LC.
- Amendment fee: If the terms of the LC need to be amended, such as changing the amount or shipping date, an amendment fee may be charged.
- Interest charges: If the LC is a deferred payment LC, interest charges may apply for the period between the shipment and the payment due date.
What is a standby Letter of Credit?
A standby letter of credit (SBLC) is a financial instrument that is similar to a traditional letter of credit (LC) but is primarily used as a backup or guarantee in case the buyer is unable to fulfill their payment obligations. An SBLC is typically issued by a bank and provides assurance to the seller that they will receive payment if the buyer defaults on their payment obligation.
Unlike a traditional LC, an SBLC is not typically used as a means of payment for goods or services. Instead, it serves as a form of insurance or collateral, and the seller can use the SBLC to obtain funds from the issuing bank if the buyer fails to make payment. An SBLC may be used in a variety of situations, such as in construction contracts, real estate transactions, or other business deals where a guarantee of payment is needed.
An SBLC is often preferred by sellers over other types of guarantees, such as a bond or a guarantee from a third party, because it is typically easier to obtain and provides a higher level of security. However, the terms and conditions of an SBLC can be complex, and it is important for both the buyer and seller to fully understand the terms and conditions of the SBLC before entering into a transaction
Debalina Deb Roy
Experienced blog writer with a passion for storytelling and a knack for engaging readers. Adept at researching and creating captivating content across various topics, with a focus on providing valuable insights and a unique perspective. Proven track record of delivering high-quality articles that resonate with audiences.
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