In international trade, there are various financial instruments used to facilitate transactions and reduce risk for all parties involved. One such instrument is the Letter of Credit (LC). This article aims to provide a comprehensive guide on what LC stands for, its meaning, and how it works.
What is an LC?
An LC is a legal document issued by a bank at the request of an importer (applicant) to guarantee payment to an exporter (beneficiary) for goods or services. It is a type of payment mechanism that protects both parties from the risk of non-payment or default.
How does an LC work?
When the importer (applicant) and the exporter (beneficiary) agree to use an LC as a payment method, the importer will request the issuing bank to issue an LC in favor of the exporter.
The issuing bank will then send the LC to the advising bank in the exporter’s country, who will notify the exporter of the LC’s details.
The exporter will then ship the goods to the importer and present the required documents (bill of lading, inspection certificate, insurance certificate, etc.) to the advising bank to receive payment.
The advising bank will then forward the documents to the issuing bank, who will check if the documents comply with the terms of the LC. If the documents are in order, the issuing bank will release payment to the exporter.
Types of LC
There are different types of LC that cater to specific needs and situations. The following are the most common types of LC:
1. Revocable LC
A revocable LC can be amended or cancelled by the issuing bank without the consent of the beneficiary.
2. Irrevocable LC
An irrevocable LC cannot be amended or cancelled without the consent of all parties involved. It provides a greater level of security for both the importer and the exporter.
3. Confirmed LC
A confirmed LC is a type of LC where the advising bank adds its confirmation to the LC, thereby providing an additional layer of security to the beneficiary.
4. Unconfirmed LC
An unconfirmed LC is a type of LC where the advising bank does not add its confirmation to the LC.
5. Transferable LC
A transferable LC allows the beneficiary to transfer all or part of the credit to another party.
6. Non-transferable LC
A non-transferable LC does not allow the beneficiary to transfer any part of the credit to another party.
7. Standby LC
A standby LC is a type of LC used as a backup or guarantee for the payment in case of default by the importer.
Parties Involved in an LC
Several parties are involved in an LC transaction, including:
The applicant is the importer or buyer who requests the issuing bank to issue an LC in favor of the exporter. The applicant bears the cost of the LC and is responsible for ensuring that all terms and conditions of the LC are complied with.
The beneficiary is the exporter or seller who receives the LC from the issuing bank and is entitled to receive payment upon presentation of the required documents.
3. Issuing Bank
The issuing bank is the bank that issues the LC at the request of the applicant and assumes the obligation to pay the beneficiary if all terms and conditions of the LC are met.
4. Advising Bank
The advising bank is the bank in the beneficiary’s country that receives the LC from the issuing bank and advises the beneficiary of the LC’s details. The advising bank also reviews the documents presented by the beneficiary and forwards them to the issuing bank for payment.
Advantages of using LCs
The use of LCs in international trade has several advantages, including:
1. Reduced Risk
LCs reduce the risk of non-payment or default by providing a guarantee of payment to the exporter upon presentation of the required documents.
2. Increased Trust
LCs increase the level of trust between the importer and the exporter by providing a secure payment mechanism that protects both parties.
3. Compliance with Regulations
LCs ensure compliance with import and export regulations by requiring the presentation of the necessary documents, such as a bill of lading, inspection certificate, and insurance certificate.
LCs can be tailored to meet the specific needs of the importer and the exporter, such as the type of LC, credit amount, and expiry date.
Disadvantages of using LCs
While LCs have several advantages, they also have some disadvantages, including:
LCs can be expensive, with fees charged by the issuing bank, advising bank, and any other parties involved in the transaction.
LCs can be time-consuming, with several documents required to be presented and reviewed before payment can be made.
3. Errors and Discrepancies
Errors or discrepancies in the documents presented can lead to delays in payment or even rejection of the documents.
LC vs. Bank Guarantee
While both LCs and bank guarantees provide a level of security for international transactions, there are some differences between the two. LCs are primarily used for payment transactions, while bank guarantees are used for non-payment transactions, such as performance guarantees.
Common LC Terminology
To fully understand LCs, it is essential to be familiar with some common terminology used in LC transactions, such as:
1. Credit Amount
The credit amount is the maximum amount of money that the issuing bank is obligated to pay the beneficiary.
2. Expiry Date
The expiry date is the date by which the documents must be presented to the issuing bank for payment.
3. Documents Required
The documents required are the documents that the beneficiary must present to the advising bank to receive payment, such as a bill of lading, inspection certificate, and insurance certificate.
Incoterms are the international commercial terms that define the responsibilities of the importer and the exporter in an international transaction, such as the cost of transportation and the transfer of risk.
5. Bill of Lading
The bill of lading is a document issued by the carrier that acknowledges receipt of the goods and specifies the terms of transportation.
6. Inspection Certificate
The inspection certificate is a document issued by an independent inspector that verifies the quality and quantity of the goods being shipped.
7. Insurance Certificate
The insurance certificate is a document issued by the insurer that provides coverage for the goods during transportation.
FAQs on Letter of Credit
Yes, LCs can be cancelled by the issuing bank or the applicant before the expiry date, provided that all parties involved agree to the cancellation.
The processing time for an LC can vary, depending on the complexity of the transaction and the number of parties involved. However, it typically takes several days to process an LC.
If the documents presented by the beneficiary are incorrect or incomplete, the issuing bank may reject the documents or request corrections, which can result in delays in payment.
An LC is used primarily for payment transactions, while a standby LC is used as a form of performance guarantee, such as in a construction project.
LC fees are typically calculated as a percentage of the credit amount and can vary depending on the issuing bank, the type of LC, and the complexity of the transaction.
In conclusion, LCs are a widely used payment mechanism in international trade that provides security and protection to both the importer and the exporter.
By understanding the parties involved, the advantages and disadvantages of using LCs, and the common terminology used in LC transactions, importers and exporters can ensure that their transactions are conducted smoothly and efficiently.