Sellers get assurances or guarantees in the form of letters of credit that they will be paid for a major transaction. They’re especially prevalent in international or foreign currency markets. Consider them a kind of payment insurance provided by a financial institution or similar transaction-accredited entity. Travelers’ credits were the earliest letters of credit, which were widely used in the 18th century. Commercial letters of credit, standby letters of credit, revocable letters of credit, irrevocable letters of credit, revolving letters of credit, and red clause letters of credit are the most prevalent current letters of credit, however there are numerous more.
Letters of Credit Mean
A letter of credit (LC) is a bank service that ensures payment of the amount specified in the letter of credit to the Seller in accordance with the Buyer’s instructions in exchange for the shipment of goods, fulfillment of the letter of credit’s other conditions, and submission of relevant documents.
Thus, the Bank (issuer) will secure the transfer of money to the Seller’s account upon transfer of ownership of the products delivered by the Seller to the Buyer and submission of the document verifying the fulfillment of the LC’s other requirements.
Performance of LC
- Buyer and Seller address the Bank for LC issue;
- A special account is opened with the Bank for payments;
- Buyer transfers the amount indicated in the contract to this account in the Bank;
- Buyer submits a document confirming the transfer of ownership over delivered goods and then the Bank transfers the funds from the special account to the Seller’s account;
- If the required documents are not submitted within the time period indicated in the contract, the Bank returns the funds from the special account to the Buyer’s account.
Advantages of LC
Advantages of LC for the Buyer:
- Elimination of the Buyer’s risk of losing money
- Payments are made only after the Seller has fulfilled his contractual duties –
- Ownership of shipping items is transferred to the Buyer within the time frame specified in the LC and according to other parameters.
Advantages of LC for the Seller:
- Payment guarantee that is not reliant on the Buyer (subject to the fulfillment of contractual obligations)
- The ability to make a payment before turning over the items to the buyer
- The ability to carry out complicated business transactions
The many forms of LC
The names of LC kinds are also supplied in English because to their widespread use in international cooperation.
Irrevocable LC – Without the beneficiary’s approval, this LC cannot be cancelled or amended (Seller). This LC shows the Bank’s (issuer’s) absolute obligation to the other party.
Revocable LC – Without the beneficiary’s permission, the Bank (issuer) may cancel or modify this LC type at the customer’s request (Seller). After the LC is revoked, the Bank will have no obligations to the recipient.
Stand-by LC – This LC is similar to a bank guarantee and allows Seller and Buyer to collaborate more freely. When the Buyer fails to meet his or her payment obligations to the Seller, the Bank will honor the LC.
Confirmed LC – This LC type is validated by the Seller’s bank or any other bank, in addition to the LC issuer’s bank guarantee. Regardless of whether the Bank issuing the LC (issuer) pays, the Bank confirming the LC is responsible for fulfilling its commitments.
Unconfirmed LC – Only the bank that issued the LC is responsible for its payment.
Transferable LC – The Seller might allocate a portion of the letter of credit to another party using this LC (ies). This LC is particularly useful when the Seller is not the only maker of the items and must acquire components from other parties, since it removes the need to create several LCs for different parties.
Back-to-Back LC – This LC type contemplates providing a second letter of credit based on the first. According to the Buyer’s instructions, an LC is opened in favor of the intermediary, and a second LC is established in favor of the Seller of the items based on this LC and the intermediary’s instructions.
Payment at Sight LC – Payment is given to the vendor promptly (maximum within 7 days) when the appropriate paperwork are provided, according to this LC.
Deferred Payment LC – Payment to the seller is not paid when the papers are provided under this LC, but rather at a later date specified in the letter of credit. The payment in favor of the Seller under this LC is usually paid after the Buyer receives the goods.
Red Clause LC – Before shipping items and submitting relevant documentation, the seller might get an advance for an agreed-upon sum of the LC. This red clause gets its name from the fact that it’s frequently displayed in red on the paper to emphasize the credit’s “advance payment” requirement.