It is a guarantee in the form of a letter, issued by a buyer’s bank. Suppose you want to buy or sell some goods from or to a foreign country. It is very much possible that you don’t know the seller or buyer. And also the laws regulating the trade may be different. Therefore, both the seller and the buyer need some kind of guarantee to seamlessly perform the trade. Here Letter of Credit comes into action.
Types of Letter of Credit
1. Irrevocable LC. This LC cannot be cancelled or modified without consent of the beneficiary (Seller). This LC reflects absolute liability of the Bank (issuer) to the other party.
2. Revocable LC. This LC type can be cancelled or modified by the Bank (issuer) at the customer’s instructions without prior agreement of the beneficiary (Seller). The Bank will not have any liabilities to the beneficiary after revocation of the LC.
3. Stand-by LC. This LC is closer to the bank guarantee and gives more flexible collaboration opportunity to Seller and Buyer. The Bank will honour the LC when the Buyer fails to fulfill payment liabilities to Seller.
4. Confirmed LC. In addition to the Bank guarantee of the LC issuer, this LC type is confirmed by the Seller’s bank or any other bank. Irrespective to the payment by the Bank issuing the LC (issuer), the Bank confirming the LC is liable for performance of obligations.
5. Unconfirmed LC. Only the Bank issuing the LC will be liable for payment of this LC.
6. Transferable LC. This LC enables the Seller to assign part of the letter of credit to other party(ies). This LC is especially beneficial in those cases when the Seller is not a sole manufacturer of the goods and purchases some parts from other parties, as it eliminates the necessity of opening several LC’s for other parties.
7. Back-to-Back LC. This LC type considers issuing the second LC on the basis of the first letter of credit. LC is opened in favor of intermediary as per the Buyer’s instructions and on the basis of this LC and instructions of the intermediary a new LC is opened in favor of Seller of the goods.
8. Payment at Sight LC. According to this LC, payment is made to the seller immediately (maximum within 7 days) after the required documents have been submitted.
9. Deferred Payment LC. According to this LC the payment to the seller is not made when the documents are submitted, but instead at a later period defined in the letter of credit. In most cases the payment in favor of Seller under this LC is made upon receipt of goods by the Buyer.
10. Red Clause LC. The seller can request an advance for an agreed amount of the LC before shipment of goods and submittal of required documents. This red clause is so termed because it is usually printed in red on the document to draw attention to “advance payment” term of the credit.
Steps Involved In Letter of Credit
The steps involved is very much as follows –
Step 1 – First a contract is signed between the buyer and the seller.
Step 2 – The buyer comes to his bank, and the bank issues a Letter of Credit, on behalf of the buyer, to the seller.
Step 3 – After getting the Letter of Credit, seller knows that he will be paid surely. So he consigns the goods to a Carrier, in exchange of a Bill of Lading (Carrier provides it to the Seller
Step 4 – Seller takes the Bill of Lading and provide it to his bank (i.e., seller’s bank), who eventually transfers it to buyer’s bank, who then provides it to the buyer.
Step 5 – Buyer takes the Bill of Lading, and gives it to the Carrier. The Carrier then getting his own Bill of Lading, delivers the goods to the buyer.
Step 6 – Carrier then asks his payment from the Seller, by providing his Bill of Lading, that he has actually delivered the goods
Step 7 – Seller then asks his bank (i.e., sellers bank) for payment, who eventually asks the buyers bank. The buyers bank settles the payment.