, letter of credit , parties involved in lc transaction , letter of credit process , commercial letter of credit flow , advantages of letter of credit , risks involved

1. Letter Of Credit

2. Definition
 A document issued by a financial institution on behalf
of a buyer stating the amount of credit the buyer has
available, and that the institution will honor drafts up
to that amount written by the buyer. It gives the
buyer the prestige and financial backing of the
issuing institution and satisfies the requirements of
the seller in completing the transaction. The
accepting institution has a prior agreement as to how
the buyer will pay for the drafts as they are
presented.
 A commitment, usually by a bank on behalf of a
client, to pay a beneficiary a stated amount of money
under specified conditions.

3. Parties involved in LC transaction
 The Applicant is the party that arranges for the
letter of credit to be issued.
 The Beneficiary is the party named in the letter of
credit in whose favor the letter of credit is issued.
 The Issuing or Opening Bank is the applicant’s
bank that issues or opens the letter of credit in favor
of the beneficiary and substitutes its creditworthiness
for that of the applicant.

4. Parties involved in LC transaction (Contd..)
 An Advising Bank may be named in the letter of
credit to advise the beneficiary that the letter of
credit was issued. The role of the Advising Bank is
limited to establish apparent authenticity of the
credit, which it advises.
 The Paying Bank is the bank nominated in the
letter of credit that makes payment to the
beneficiary, after determining that documents
conform, and upon receipt of funds from the issuing
bank or another intermediary bank nominated by the
issuing bank.
 The Confirming Bank is the bank, which, under
instruction from the issuing bank, substitutes its
creditworthiness for that of the issuing bank. It
ultimately assumes the issuing bank’s commitment to
pay.

5. Letter of Credit Process

6. Commercial Letter of Credit Flow
1. Applicant approaches Issuing/ Opening Bank with
LC application form duly filled and requests Issuing
Bank to issue a Letter of Credit in favor of
Beneficiary.
2. Issuing Bank issues a Letter of Credit as per the
application submitted by an Applicant and sends it
to the Advising Bank, which is located in
Beneficiary’s country, to formally advise the LC to
the beneficiary.
3. Advising Bank advises the LC to the Beneficiary.
4. Once Beneficiary receives the LC and if it suits his/
her requirements, he/ she prepares the goods and
hands over them to the carrier for dispatching to
the Applicant.
5. He/ She then hands over the documents along with
the Transport Document as per LC to the
Negotiating Bank to be forwarded to the Issuing
Bank.

7. Commercial Letter of Credit Flow (Contd..)
6. Issuing Bank reimburses the Negotiating Bank with
the amount of the LC post Negotiating Bank’s
confirmation that they have negotiated the
documents in strict conformity of the LC terms.
Negotiating Bank makes the payment to the
Beneficiary.
7. Simultaneously, the Negotiating Bank forwards the
documents to the Issuing Bank to be released to the
Applicant to claim the goods from the carrier.
8. Applicant reimburses the Issuing Bank for the
amount, which it had paid to the Negotiating Bank.
9. Issuing Bank releases all documents along with the
titled Transport Documents to the Applicant.

8. Types of Letters of Credit

9. 1. Irrevocable LC. This LC cannot be cancelled or modified without
consent of the beneficiary (Seller). This LC reflects absolute liability
of the Bank (issuer) to the other party.
2. Revocable LC. This LC type can be cancelled or modified by the
Bank (issuer) at the customer's instructions without prior agreement
of the beneficiary (Seller). The Bank will not have any liabilities to
the beneficiary after revocation of the LC.
3. Stand-by LC. This LC is closer to the bank guarantee and gives
more flexible collaboration opportunity to Seller and Buyer. The
Bank will honor the LC when the Buyer fails to fulfill payment
liabilities to Seller.

10. 4. Confirmed LC. In addition to the Bank guarantee of the LC issuer,
this LC type is confirmed by the Seller's bank or any other bank.
Irrespective to the payment by the Bank issuing the LC (issuer), the
Bank confirming the LC is liable for performance of obligations.
5. Unconfirmed LC. Only the Bank issuing the LC will be liable for
payment of this LC.
6. Transferable LC. This LC enables the Seller to assign part of the
letter of credit to other party(ies). This LC is especially beneficial in
those cases when the Seller is not a sole manufacturer of the goods
and purchases some parts from other parties, as it eliminates the
necessity of opening several LC's for other parties.
7. Back-to-Back LC. This LC type considers issuing the second LC on
the basis of the first letter of credit. LC is opened in favor of
intermediary as per the Buyer's instructions and on the basis of this
LC and instructions of the intermediary a new LC is opened in favor
of Seller of the goods.

11. 8. Payment at Sight LC. According to this LC, payment is made to
the seller immediately (maximum within 7 days) after the required
documents have been submitted.
9. Deferred Payment LC. According to this LC the payment to the
seller is not made when the documents are submitted, but instead
at a later period defined in the letter of credit. In most cases the
payment in favor of Seller under this LC is made upon receipt of
goods by the Buyer.
10. Red Clause LC. The seller can request an advance for an agreed
amount of the LC before shipment of goods and submittal of
required documents. This red clause is so termed because it is
usually printed in red on the document to draw attention to
"advance payment" term of the credit.
11. Green clause letter of credit. This is a normal documentary
letter of credit, which provides a secured form of credit in that
exporters can draw an agreed percentage of the value of the goods
to be shipped against presentation of warehouse receipts as
collateral.

12. Settlements Under a Letter of Credit
 All commercial letters of credit must clearly indicate
whether they are payable by sight payment, by
deferred payment, by acceptance, or by negotiation.
These are noted as formal demands under the terms
of the commercial letter of credit.

13. Settlements Under a Letter of Credit (Contd..)
 In a sight payment, the commercial letter of credit
is payable when the beneficiary presents the
complying documents and if the presentation takes
place on or before the expiration of the commercial
letter of credit.
 In a deferred payment, the commercial letter of
credit is payable on a specified future date. The
beneficiary may present the complying documents at
an earlier date, but the commercial letter of credit is
payable only on the specified future date.

14. Settlements Under a Letter of Credit (Contd..)
 An acceptance is a time draft drawn on, and
accepted by, a banking institution, which promises to
honor the draft at a specified future date. The act of
acceptance is without recourse as it is a commitment
to pay the face amount of the accepted draft.
 Under negotiation, the negotiating bank, a third
party negotiator, expedites payment to the
beneficiary upon the beneficiary’s presentation of the
complying documents to the negotiating bank. The
bank pays the beneficiary, normally at a discount of
the face amount of the value of the documents, and
then presents the complying documents, including a
sight or time draft, to the issuing bank to receive full
payment at sight or at a specified future date.

15. Advantages of Letter of Credit (Exporter)
 Credit risk eliminated
 Reduces exchange rate and political risk
 No Need for Credit Check
 Requirements to pay are well-known
 Pre shipment risk avoided
 Facilitates financing
 Immediate payment

16. Advantages of Letter of Credit (Importer)
 Expert Examination of Documents
 Sources of Supply expand
 Financing
 No cash tied up
 Payment only after compliance
 To ship by a certain date requires an on-board
bill of lading
 No risk in import

17. Risks involved
1. Since all the parties involved in Letter of Credit deal
with the documents and not with the goods, the risk
of Beneficiary not shipping goods as mentioned in the
LC is still persists.
2. The Letter of Credit as a payment method is costlier
than other methods of payment such as Open
Account or Collection
3. The Beneficiary’s documents must comply with the
terms and conditions of the Letter of Credit for
Issuing Bank to make the payment.
4. The Beneficiary is exposed to the Commercial risk on
Issuing Bank, Political risk on the Issuing Bank’s
country and Foreign Exchange Risk in case of Usance
Letter of Credits.