What is a LETTER OF CREDIT ?
A letter of credit, or “credit letter,” (in short LC or LOC) is a letter from a bank guaranteeing that a buyer’s payment to a seller will be received on time and for the correct amount. In the event that the buyer is unable to make a payment on the purchase, the bank will be required to cover the full or remaining amount of the purchase. It may be offered as a facility.
Due to the nature of international dealings, including factors such as distance, differing laws in each country, and difficulty in knowing each party personally, the use of letters of credit has become a very important aspect of international trade.
A letter of credit is a document sent from a bank or financial institute that guarantees that a seller will receive a buyer’s payment on time and for the full amount.
Letters of credit are often used within the international trade industry.
There are many different letters of credit including one called a revolving letter of credit.
Banks collect a fee for issuing a letter of credit.
How does it works?
Buyers of major purchases may need a letter of credit to assure the seller that the payment will be made. A bank issues a letter of credit to guarantee the payment to the seller, essentially taking responsibility that the seller will be paid. A buyer must prove to the bank that they have enough assets or sufficient line of credit to pay before the bank will guarantee the payment to the seller.
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 transferable, the beneficiary may assign another entity, such as a corporate parent or a third party, the right to draw.
The International Chamber of Commerce Uniform Customs and Practice for Documentary Credits oversees letters of credit used in international transactions.
REMARK:
-> Banks typically require a pledge of securities or cash as collateral for issuing a letter of credit.
-> LC’s can be revocable or irrevocable, confirmed, unconfirmed, transferable, non-transferable, revolving, back-to-back. Please contact us for these details.
What is the cost to issue a Letter of credit?
Banks will usually charge fee for a letter of credit, which can be a percentage of the total credit they are backing. The cost of a letter of credit will vary by bank and size of the letter of credit. For example, they may charge 4% of the amount they are guaranteeing. Good and clear negotiation with the bank is very important before signing contracts with a seller. Many deals collapse because of “no funds available for the cost”!.
There are 4 types of letter of credits.
Commercial Letter of Credit
This is a direct payment method in which the issuing bank makes the payments to the beneficiary. In contrast, a standby letter of credit is a secondary payment method in which the bank pays the beneficiary only when the holder cannot.
Revolving Letter of Credit
This kind of letter allows a customer to make any number of draws within a certain limit during a specific time period.
Traveler’s Letter of Credit
For those going abroad, this letter will guarantee that issuing banks will honor drafts made at certain foreign banks.
Confirmed Letter of Credit
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.
Procedure.
Often in international trade, a letter of credit is used to signify that a payment will be made to the seller on time, and in full, as guaranteed by a bank or financial institution. Before sending a letter of credit, the bank will charge a fee, typically a percentage of the letter of credit, in addition to requiring collateral from the buyer. Among the various forms of letters of credit are a revolving letter of credit, a commercial letter of credit, and a confirmed letter of credit.
IMPORTANT:
Many intermediates contact us asking for a LC, and their client must have a LC from a top-rated bank. Well, this is the answer:
Top-rated banks will ONLY issue a LC to their OWN CLIENTS. It’s not their business to issue a LC to non-clients.
LC’s will be issued from banks which are specialized in this market. These banks are well-known and there will never be a problem for the receiving bank to accept the LC.
MSFinAdvice has direct contact with specialized banks issuing the LC, DLC (Documentary Letter of Credit) for the clients and MSFinAdvice has the authority to do the DD and verification of the contracts. Once MSFinAdvice gives the green light to the client, a mandatory contact with the receiving bank has to be set up to make sure the procedure between the banks is agreed and confirmed. Then the file goes to the issuing bank, who will issue the agreements and after acceptance of the client, the bank will invoice the cost of the LC/DLC, DIRECT to the client. MSFinAdvice will coordinate the MT’s (799 and 760).
Example.
Consider an exporter in an unstable economic climate, where credit may be more difficult to obtain. The Bank of America would offer this buyer a letter of credit, available within two business days, in which the purchase would be guaranteed by a Bank of America branch. Because the bank and the exporter have an existing relationship, the bank is knowledgeable of the buyer’s creditworthiness, assets, and financial status.
Is a Letter of Credit TRANSFERABLE?
Yes, an LC is transferable and allows the first beneficiary to transfer some or all of the credit to another party, which creates a secondary beneficiary. The party that initially accepts the transferable letter of credit from the bank is referred to as the first, or primary beneficiary.
A transferable letter of credit is often used in business deals to ensure payment to the supplier or manufacturer. A transferable letter of credit is an alternative option to advance payments.
A transferable letter of credit permits an initial beneficiary to transfer some or all of the credit they are due to another party.
The parties involved in a transferable letter of credit are the applicant (the buyer), the first beneficiary (the middleman), and the second beneficiary (the seller).
What is a Sight letter of credit ?
A sight letter of credit refers to a document that verifies the payment of goods or services, payable once it is presented along with the necessary documents. An organization that offers a sight letter of credit commits itself to paying the agreed amount of funds provided the provisions of the letter of credit are met.
