Letter of Credit (LC) | Documentary Credit (DC)

What is Letter of Credit?

A Letter of Credit (LC), also known as a Documentary Credit, is a financial document issued by a bank, which guarantees that seller (exporter) will receive the payment of goods or services by a buyer (importer). An LC serves as a means of payment and provides assurance to both the buyer and seller in a transaction.

When a buyer and seller agree to use an LC, the buyer's bank issues the LC on behalf of the buyer. The seller's bank is responsible for verifying that the shipping documents comply with the terms and conditions of the LC before making payment to the seller.

The LC acts as a binding contract between the buyer and seller and specifies the terms and conditions of the transaction, including the amount of payment, the goods or services to be delivered, and the shipping and payment deadlines. The LC also specifies the documents required to be submitted by the seller to the bank to receive payment.

The use of an LC provides a level of security for both the buyer and seller, as it ensures that payment is made only when the agreed-upon terms and conditions have been met. This reduces the risk of non-payment and helps to build trust between the parties involved in the transaction.

LCs are widely used in international trade, particularly in transactions where there is a lack of trust or familiarity between the buyer and seller, or where the risk of non-payment is high. They are particularly important in industries where large amounts of money are involved or where goods are shipped long distances.

 

Here is a step-by-step guide on how a letter of credit works: 

1. The buyer and seller agree on the terms of the sale, including the price, quantity, and quality of the goods to be purchased.

2. The buyer applies to his or her bank for a letter of credit, which guarantees payment to the seller.

3. The issuing bank examines the application and the buyer's creditworthiness before deciding to issue the letter of credit.

4. The issuing bank issues the letter of credit and sends it to the seller's bank, also known as the advising bank.

5. The seller receives the letter of credit from the advising bank and reviews it to ensure that the terms and conditions are acceptable.

6. The seller then ships the goods to the buyer and obtains the necessary shipping documents, such as the bill of lading, commercial invoice, and packing list.

7. The seller presents the shipping documents to the advising bank for examination, and the bank verifies that the documents are prepared as per the conditions of the letter of credit.

8. If the documents are in order, the advising bank forwards them to the issuing bank for payment. The issuing bank then pays the seller the agreed-upon amount.

9. The issuing bank sends the shipping documents to the buyer, who uses them to take possession of the goods from the shipping company.

10. In summary, a letter of credit is a financial document that provides a guarantee of payment to the seller, if the terms and conditions of LC are met. The letter of credit serves as a contract between the buyer and seller, and the banks involved in the transaction act as intermediaries to ensure that the transaction is completed smoothly and securely.

 

Types of Letter of Credit:

1. Commercial Letter of Credit: This is the most common type of letter of credit, used in international trade to facilitate payment between buyer and seller.

2. Standby Letter of Credit: This is a type of letter of credit used to provide a guarantee of payment or performance, in case the buyer is unable to fulfil their obligations under a contract. Standby letters of credit are often used in construction and other large-scale projects.

3. Revolving Letter of Credit: This is a letter of credit that can be used for multiple transactions, up to a specified limit. It is often used in long-term contracts, where the buyer and seller have an ongoing business relationship.

4. Transferable Letter of Credit: This is a letter of credit that can be transferred by the original beneficiary to a third party. It is often used when the original beneficiary does not have the resources or expertise to complete the transaction.

5. Red Clause Letter of Credit: This is a type of letter of credit that allows the beneficiary to draw an advance payment from the issuing bank, before the goods are shipped. The red clause refers to the clause in the letter of credit that allows for the advance payment.

6. Green Clause Letter of Credit: This is a type of letter of credit that includes an additional clause that allows for the payment of storage and other costs incurred by the seller before the shipment  of the goods.

7. Revocable Letter of Credit: This is a letter of credit that can be cancelled or modified by the issuing bank at any time, without the consent of the beneficiary. It is rarely used in international trade, as it provides a bit security for the seller.

8. Irrevocable Letter of Credit: This is the most common type of letter of credit, and it cannot be cancelled or modified until or unless all parties (involved) agreed. It provides a high level of security for the seller, as long as the terms and conditions of the letter of credit are met.