What is a Letter of Credit?

A Letter of Credit is a document provided by a credit-worthy bank to give assurance of payment to a seller of goods as long as the seller presents it with the correct documentation. 

Mostly these letters are utilized in international trade where they are regulated by the rules of the International Chamber of Commerce in the form of Uniform Customs and Practice for Documentary Credits (UCP).

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Who is Involved in a Letter of Credit Transaction?

The letter of credit is constituted by three parties:

• Beneficiary - The beneficiary (generally a seller) who receives payment, 
• Applicant - The applicant (buyer of the goods) originates the letter of credit, and 
• Issuing Bank - The institution which issues the letter of credit. 
• Advising Bank - Bank that receives the letter of credit and will make payment on the letter to the Beneficiary. Also known as the Confirming Bank, Nominated Bank, or Prime Bank.

What is the Process of Using a Letter Credit

1. The Beneficiary (Seller) and Applicant (Buyer) enter into a sales agreement for the goods in question.
2. The Applicant (Buyer) approaches a financial institution (the Issuing Bank) about generating a letter of credit. 
   • The buyer generally has a bank account at the institution. 
   • The buyer specifies what is required for the bank to pay the letter of credit (generally receiving ownership documents - such as a Bill of Lading - for specific goods).
3. The Applicant sends the letter of credit to the Beneficiary's financial institution (the Advising Bank).
4. The Advising Bank will provide an Advising Letter of Credit to the Beneficiary. 
   • This allows the Beneficiary to receive payment upon presentation of shipment verification and Ownership Documents (such as a Bill of Lading).
5. The Beneficiary ships goods to the Applicant (Buyer) and receives Ownership Documents 
   • These documents allow the holder to take possession of the goods upon arrival.
6. The Beneficiary turns the Ownership Documents over to the Advising Bank.
7. The Advising Bank sends the documents to the Issuing Bank.
8. The Issuing Bank provides the Documents to the Applicant Seller and makes payment on the letter of credit to the Advising Bank.
9. The Advising Bank then makes payment on the Advising Letter of Credit to the Beneficiary. 

What are the Types of Letter of credit? 

There are various categories of these letters. Examples of these categories include the following:

• Import/export: A single letter of credit can be either an import or export letter depending on the perspective of the user ( who can be either an importer or exporter)
• Revocable / Irrevocable: This determines if the buyer and the issuing bank can control the letter of credit without the seller's permission. In a revocable letter, changes or termination are channeled through the issuing bank by the applicant with the beneficiary's approval and authentication. However, this category is becoming irrelevant since UCP 600 considers all letters or credit as irrevocable.
• Confirmed/Unconfirmed: A letter of credit (LC) is confirmed when the Advising bank guarantees to honor a presentation put forth as a request by the issuing bank. If unconfirmed, the advising bank will only make payments on the documents once that payment is received from the Issuing Bank.
• Restricted/Unrestricted: In the case of a restricted LC, an advising bank can buy a bill of exchange from the seller. If a confirmation bank is not mentioned, an exporter can present the bill of exchange to any bank for payment on an unrestricted LC.
• Deferred/Usance: This is a credit that is assigned after a stipulated period accepted by the buyer and seller and not immediately after the presentation. The seller gives the buyer the authority to pay after he takes and sells the goods involved.

The following are some of the unique terms of the letter of credit that relate to the payment conditions in the underlying reference documents.

• At Sight: This is a credit that is paid as soon as possible by the Advising bank after it is done inspecting the seller's documents.
• Acceptance - If a letter of credit is against acceptance, the issuing bank will release the ownership documents to the Buyer upon receipt of a promise (Acceptance) to pay. It is an alternative to Cash Against Documents.
• Red Clause: This is a situation where the seller can deposit the prepaid money in the bank before he sends the products.
• Back to Back: This is issued for the purpose of promoting intermediary trade.
• Standby Letter of Credit: This is a letter of credit with the objective of providing a source of payment in the case of non-performance of a contract. It is used as a failsafe against an unfulfilled obligation.