LETTER OF CREDIT: this blog article is a breakdown of What it is? Types and purpose of a letter of credit.
What is Letter of Credit?
A letter of credit provides sellers with reassurance or a guarantee that they will be paid for a significant transaction. In international or foreign transactions, letters of credit are especially common. They serve as an avenue for financial institutions or other authorized parties involved in the transaction to provide payment insurance confirming to seller that the buyer has a down payment.
Based of the nature of international transactions, which includes elements like distance, varying legal requirements in other nations, and the challenge of getting to know every participant personally, the use of letters of credit has grown to be a crucial component of international trade in order to safeguard buyers and sellers.
How Does a Letter of Credit Work:
A letter of credit could be required by buyers of large goods to guarantee the seller that payment would be made. In essence, the bank takes on the duty of guaranteeing the seller’s payment by issuing a letter of credit. Before the bank guarantees the seller’s payment, the buyer must demonstrate to the bank that they have sufficient assets or a sufficient line of credit.
Agreement between Buyer and Seller:
The buyer and seller agree to use a letter of credit as the method of payment for the transaction.
Issuance of the Letter of Credit:
The buyer applies for a letter of credit from their bank (the issuing bank). The bank evaluates the buyer’s creditworthiness and, if approved, issues the letter of credit.
Terms and Conditions:
The letter of credit includes specific terms and conditions that must be met for the seller to receive payment. These conditions usually involve presenting certain documents, such as a bill of lading, commercial invoice, certificate of origin, etc., proving that the seller has fulfilled their obligations under the sales contract.
Document Presentation and Shipment:
Following the items’ shipment, the seller gives the necessary paperwork to the bank specified in the credit letter (the negotiating bank). The conditions outlined in the credit letter must be followed by these papers.
Document Review:
The bank reviews the documentation to make sure it complies with the terms and conditions of the credit letter. The bank will forward the documentation to the issuing bank if everything checks out.
Payment to Seller:
In accordance with the conditions of the credit letter, the issuing bank pays the seller after verifying the documentation.
There are various different types of letter of credit but this post will only describe three(3) of it.
TYPES OF LETTER OF CREDIT{LOC}
1. Standby Letter Of Credit(SLOC).
2. Commercial Letter Of credit(CLOC).
3. Revocable Letter Of Credit(RLOC).
1. Standby Letter Of Credit (SLOC)
As the name portrait standby letter of credit is A financial instrument that a bank issues on behalf of a client Standby Letter of Credit (SLOC). In the event that the client (applicant) neglects to perform contractual responsibilities, such as making a payment or meeting deadlines, it acts as a guarantee of payment to a third party (beneficiary). The issuing bank will have to bare any loss or responsibilities caused by her clients for not meeting up. There are also some attributes as how the standby letter of credit works.
-
ISSUANCE: The client (applicant) requests the bank to issue an SLOC in favor of the beneficiary. The bank evaluates the client’s creditworthiness and agrees to issue the SLOC if the client meets its requirements. The bank charges fees for issuing the SLOC, typically based on a percentage of the SLOC amount and the duration of validity.
-
TERMS AND CONDITIONS: The terms and conditions under which the beneficiary will receive payment from the bank are specified in the SLOC. The underlying contract or agreement between the client and the beneficiary is typically reflected in these terms. They might contain information on the amount covered, the expiration date, the drawing circumstances, and any necessary paperwork.
- PAYMENT: Upon receipt of a compliant demand from the beneficiary, the bank is obligated to honor the SLOC by making payment up to the specified amount. The bank then looks to recover the amount paid from the client, along with any applicable fees and charges.
international trade, construction projects, and other commercial transactions where parties may require assurance of payment or performance. They provide a level of security to both the buyer and seller, reducing the risk of non-payment or non-performance.
Looking for help on making international payments
2. Commercial Letter of Credit
Commercial letter of credit is one of the documents applicants provide for international trade transactions. It’s a guarantee issued by a bank on behalf of a buyer (importer) to pay a specified amount of money to a seller (exporter) upon presentation of certain documents, typically related to the shipment of goods. Here’s how it generally works. It measures are are done thoroughly through some sections:
- Agreement: right before any transaction is kick started an agreement should be done The buyer and seller agree to use a letter of credit as the method of payment for the goods being traded
- Term’s and Conditions: The CLOC outlines the terms and conditions of the transaction, including the amount of money, documents required for payment, expiry date, shipping terms, etc. These terms must be precisely followed for payment to be made.
- Presentation of Documents: The seller presents these documents to their bank (advising bank), which verifies if they comply with the terms and conditions of the LC.
- Payment: Upon verification of the documents, the advising bank forwards them to the issuing bank. If the documents are in order, the issuing bank is obligated to honor the LC by making payment to the seller or accepting drafts drawn by the seller.
- Shipment: The seller ships the goods to the buyer and gathers the necessary documents specified in the LC, such as the bill of lading, commercial invoice, packing list, certificate of origin.
Commercial Letters of Credit offer protection to both the vendor and the customer. As long as the seller abides by the terms of the LC, payment is guaranteed, and the buyer can rest easy knowing that payment will only be made upon presentation of the necessary paperwork. It lowers the danger of non-payment or non-delivery, making it a popular instrument in international trade, especially when working with unknown or far-off business partners.
3. Revocable Letter of Credit.
A revocable letter of credit is a letter issued by a bank on behalf of a buyer (importer) to the seller (exporter) guaranteeing payment for goods or services once certain conditions are met. Unlike an irrevocable letter of credit, which cannot be changed or canceled without the consent of all parties involved, a revocable letter of credit can be altered or revoked by the issuing bank without the consent of the beneficiary (seller).
Here are it features it uses to carry out trades:
Flexibility: The revocable nature of this letter of credit provides flexibility to the issuing bank, allowing them to modify or cancel the credit at any time without prior notice to the beneficiary.
Risk: Because the terms of a revocable letter of credit can be changed or revoked by the issuing bank, it poses more risk for the beneficiary compared to an irrevocable letter of credit, where payment is more assured.
Limited Use: Revocable letters of credit are less common in international trade compared to irrevocable ones due to the uncertainty and risk they present to the seller.
Usage: Despite being less common, revocable letters of credit might still be used in certain situations, such as when the buyer and seller have a longstanding relationship and trust each other, or when the buyer’s creditworthiness is unquestionable.
Considerations: Sellers who accept a revocable letter of credit should be aware of the risks involved, such as the possibility of non-payment if the issuing bank decides to revoke or modify the credit terms. It’s crucial for sellers to carefully assess the reliability and reputation of the issuing bank and the buyer before agreeing to such payment terms.
Summarizing a revocable letter of credit offers flexibility to the issuing bank, it also carries more risk for the beneficiary, making it less favored in international trade transactions compared to irrevocable letters of credit.
Leave a Reply