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In modern business practice, specially International Trade, a Letter of Credit (LC) also known as a Documentary Credit, is a written commitment by a bank issued after a request by an importer (foreign buyer) that payment will be made to the beneficiary (exporter) provided that the terms and conditions stated in the LC been met, as evidenced by the presentation of specified documents.
A letter of credit is a method of payment that is an important part of international trade. They are particularly useful where the buyer and seller may not know each other personally and are separated by distance, and also laws are differing in each country with different trading customs. It is generally considered that Letters of Credit provides security to both the buyer and the seller, both the buyer and seller rely upon the security of banks and the banking system to ensure that payment is received and goods are provided. In a Letter of Credit transaction the goods are consigned to the order of the issuing bank, meaning that the bank will not release control of the goods until the buyer has either paid or undertaken to pay the bank for the documents.
In the event that the buyer is unable to make payment on the purchase, the seller may make a demand for payment on the bank. The bank will examine the beneficiary’s demand and if it complies with the terms of the letter of credit, will honor the demand.
Because a letter of credit is typically a negotiable instrument, the issuing bank pays the beneficiary or any bank nominated by the beneficiary. If a letter of credit is transferrable, the beneficiary may assign another entity, such as a corporate parent or a third party, the right to draw.
Banks typically require a pledge of securities or cash as collateral for issuing a Letter of Credit. Banks also collect a fee for service, typically a percentage of the size of the Letter of Credit. The International Chamber of Commerce Uniform Customs and Practice for Documentary Credits oversees Letters of Credit used in international transactions.
Types of Letters of Credit :
A commercial letter of credit is a direct payment method in which the issuing bank makes the payments to the beneficiary. On contrary, a standby letter of credit is a secondary payment method in which the bank pays the beneficiary only when the holder cannot.
A revolving letter of credit lets the customer make any number of draws within a certain limit during a specific time period. A traveler’s letter of credit guarantees the issuing banks will honor drafts made at certain foreign banks.
A confirmed letter of credit involves a bank other than the issuing bank guaranteeing the letter of credit. The second bank is the confirming bank, typically the seller’s bank. The confirming bank ensures payment under the letter of credit if the holder and the issuing bank default. The issuing bank in international transactions typically requests this arrangement.