Letter of Credit

Letter of Credit

Subject: Economy

Section: External Sector

New Delhi banned wheat exports on Saturday and only exports backed by letters of credit (LCs), or payment guarantees, issued before May 13 can proceed before the ban takes effect.

Letter of credit?

A letter of credit (L/C) is a type of “documentary credit” or a “non-fund based credit”. It is a document issued by a bank or financial institution at the request of a buyer whereby the bank or financial institution gives assurance  of payment to a seller if the terms and conditions specified in the document are fulfilled. This means that a Letter of Credit is a promise made by the Bank to pay to the exporter / seller on behalf of the importer / buyer. The seller receives the payment only when all the requirements specified in the L/C are met including the documents, delivery dates, product specification, etc.

Parties:

• Buyer / Importer: Also known as Opener, as he opens the credit
• Bank / Financial Institution: Also known as Issuer, as it opens the letter of credit
• Seller / Exporter: Also known as beneficiary as credit is opened in favour of him.

Types:

• Irrevocable Letter of Credit-It cannot be modified or cancelled without the agreement of all the three parties.
• Revocable Letter of Credit-It may be modified or even cancelled by the issuing bank at any time and without notice to the beneficiary. Such L/Cs are rare nowadays as they give maximum flexibility to the buyers but involve risk to the seller.
• Confirmed Irrevocable Letter of Credit-In a confirmed Irrevocable L/C, another bank (called Confirming Bank) is yet more party which obliges itself to honour the L/C in the same manner as issuing bank. Such L/C is used to back up the credit standing of the issuing bank and to mitigate the risk in foreign trade by replacing foreign bank risk by domestic bank risk.
• Unconfirmed Irrevocable Letter of Credit-In the Unconfirmed Irrevocable Letter of Credit, a seller’s domestic bank (called advisory bank)  acts as agent of the issuing bank but without assuming any responsibility towards the beneficiary. The role of advisory banks here is limited to taking care of the authenticity of the issuing bank and documentary credit.
• Revolving Letter of Credit- It is used in the case of regular business transactions between the buyer and the seller. The L/C is issued only once but remains valid for a stated period of time for a number of transactions without issuing another L/C. The Revolving L/C can be either revocable or irrevocable.

Bank Guarantee vs Letter of Credit: What’s the Difference?

Bank guarantees represent a more significant contractual obligation for banks than letters of credit do. A bank guarantee, like a letter of credit, guarantees a sum of money to a beneficiary. The bank only pays that amount if the opposing party does not fulfill the obligations outlined by the contract. The guarantee can be used to essentially insure a buyer or seller from loss or damage due to nonperformance by the other party in a contract.

A letter of credit acts as a promissory note from a financial institution—usually a bank or credit union. It guarantees a buyer’s payment to a seller or a borrower’s payment to a lender will be received on time and for the full amount. It also states that if the buyer can’t make a payment on the purchase, the bank will cover the full or remaining amount owed. The letter of credit ensures the payment will be made as long as the services are performed.

Bank guarantees are often used in real estate contracts and infrastructure projects, while letters of credit are primarily used in global transactions.