Letter of credit

From Wikipedia, the free encyclopedia A standard, commercial letter of credit (LC[1]) is a document issued mostly by a financial institution, used primarily in trade finance, which usually provides an irrevocable payment undertaking. The letter of credit can also be payment for a transaction, meaning that redeeming the letter of credit pays an exporter. Letters of credit are used primarily in international trade transactions of significant value, for deals between a supplier in one country and a customer in another. In such cases, the International Chamber of Commerce Uniform Customs and Practice for Documentary Credits applies (UCP 600 being the latest version).[2] They are also used in the land development process to ensure that approved public facilities (streets, sidewalks, storm water ponds, etc.) will be built. The parties to a letter of credit are usually a beneficiary who is to receive the money, the issuing bank of whom the applicant is a client, and the advising bank of whom the beneficiary is a client. Almost all letters of credit are irrevocable, i.e., cannot be amended or canceled without prior agreement of the beneficiary, the issuing bank and the confirming bank, if any. In executing a transaction, letters of credit incorporate functions common to giros and Traveler's cheques. Typically, the documents a beneficiary has to present in order to receive payment include a commercial invoice, bill of lading, and documents proving the shipment was insured against loss or damage in transit. Definition L/C. A binding document that a buyer can request from his bank in order to guarantee that the payment for goods will be transferred to the seller. Basically, a letter of credit gives the seller reassurance that he will receive the payment for the goods. In order for the payment to occur, the seller has to present the bank with the necessary shipping documents confirming the shipment of goods within a given time frame. It is often used in international trade to eliminate risks such as unfamiliarity with the foreign country, customs, or political instability.

Types of letter of credit

There are five commonly used types of letter of credit. Each has different features and some are more secure than others. The most common types are: Irrevocable revocable unconfirmed confirmed transferable

Other types include: standby revolving back-to-back Sometimes a letter of credit may combine two types, such as 'confirmed' and 'irrevocable'. Irrevocable and revocable letters of credit A revocable letter of credit can be changed or cancelled by the bank that issued it at any time and for any reason. An irrevocable letter of credit cannot be changed or cancelled unless everyone involved agrees. Irrevocable letters of credit provide more security than revocable ones. Confirmed and unconfirmed letters of credit When a buyer arranges a letter of credit they usually do so with their own bank, known as the issuing bank. The seller will usually want a bank in their country to check that the letter of credit is valid. For extra security, the seller may require the letter of credit to be 'confirmed' by the bank that checks it. By confirming the letter of credit, the second bank agrees to guarantee payment even if the issuing bank fails to make it. So a confirmed letter of credit provides more security than an unconfirmed one. Transferable letters of credit A transferable letter of credit can be passed from one 'beneficiary' (person receiving payment) to others. They're commonly used when intermediaries are involved in a transaction. Standby letters of credit A standby letter of credit is an assurance from a bank that a buyer is able to pay a seller. The seller doesn't expect to have to draw on the letter of credit to get paid. Revolving letters of credit A single revolving letter of credit can cover several transactions between the same buyer and seller. Back-to-back letters of credit Back-to-back letters of credit may be used when an intermediary is involved but a transferable letter of credit is unsuitable.

Uniform customs and practice for documentary credit To standardise terms and procedures and avoid misunderstandings, a set of international rules for letters of credit have been developed by the International Chamber of Commerce (ICC). Most commercial letters of credit are governed by these rules, which are referred to as Uniform Customs and Practice for Documentary Credits (UCP). The current version of the rules is UCP 600, which came into effect on 1 July 2007. The UCP standards give definitions of important terms that are used in letters of credit. When referring to letters of credit, banks and others involved in international trade will generally use the UCP definitions of key terms and phrases. UCP also sets out general documentary requirements and standard practices for handling letters of credit. The ICC publishes a number of guides on UCP 600. You can find available publications about UCP 600 on the ICC Bookshop website - Opens in a new window. Using UCP 600 letters of credit Because UCP 600 standards are internationally recognised it's always best to use letters of credit that are covered by them. If you're an importer you may well find that sellers require you to use UCP letters of credit. If a letter of credit is subject to UCP it will state this somewhere on it. It might include a statement like 'This letter of credit is subject to the latest version of Uniform Customs and Practice for Documentary Credits published and updated by the International Chamber of Commerce'. Be aware that in some instances the definitions and procedures set out in the UCP standards may differ from the laws of a particular country. Irrevocable An irrevocable letter of credit can neither be amended nor cancelled without the agreement of all parties to the credit. Under UCP500 all letters of credit are deemed to be irrevocable unless otherwise stated. Here, the importer's bank gives a binding undertaking to the supplier provided all the terms and conditions of the credit are fulfilled. Unconfirmed The advising bank forwards an unconfirmed letter of credit directly to the exporter without adding its own undertaking to make payment or accept responsibility for payment at a future date, but confirming its authenticity.

Confirmed A confirmed letter of credit is one in which the advising bank, on the instructions of the issuing bank, has added a confirmation that payment will be made as long as compliant documents are presented. This commitment holds even if the issuing bank or the buyer fails to make payment. The added security to the exporter of confirmation needs to be considered in the context of the standing of the issuing bank and the current political and economic state of the importer's country. A bank will make an additional charge for confirming a letter of credit. In many cases, the confirming bank is located in Beneficiarys country. Confirmation costs will vary according to the country involved, but for many countries considered a high risk will be between 2%-8%. There also may be countries issuing letters of credit, which banks do not wish to confirm - they may already have enough exposure in that market or not wish to expose themselves to that particular risk at all. Standby Letters of Credit A standby letter of credit is used as support where an alternative, less secure, method of payment has been agreed. They are also used in the United States of America in place of bank guarantees. Should the exporter fail to receive payment from the importer he may claim under the standby letter of credit. Certain documents are likely to be required to obtain payment including: the standby letter of credit itself; a sight draft for the amount due; a copy of the unpaid invoice; proof of dispatch and a signed declaration from the beneficiary stating that payment has not been received by the due date and therefore reimbursement is claimed by letter of credit. The International Chamber of Commerce publishes rules for operating standby letters of credit - ISP98 International Standby Practices. Revolving Letter of Credit The revolving credit is used for regular shipments of the same commodity to the same importer. It can revolve in relation to time or value. If the credit is time revolving once utilised it is re-instated for further regular shipments until the credit is fully drawn. If the credit revolves in relation to value once utilised and paid the value can be reinstated for further drawings. The credit must state that it is a revolving letter of credit and it may revolve either automatically or subject to certain provisions. Revolving letters of credit are useful to avoid the need for repetitious arrangements for opening or amending letters of credit. Transferable Letter of Credit A transferable letter of credit is one in which the exporter has the right to request the paying, or negotiating bank to make either part, or all, of the credit value available to one or more third parties. This type of credit is useful for those acting as middlemen especially where there is a need to finance purchases from third party suppliers.

Back-to-Back Letter of Credit A back-to-back letter of credit can be used as an alternative to the transferable letter of credit. Rather than transferring the original letter of credit to the supplier, once the letter of credit is received by the exporter from the opening bank, that letter of credit is used as security to establish a second letter of credit drawn on the exporter in favour of his importer. Many banks are reluctant to issue back-to-back letters of credit due to the level of risk to which they are exposed, whereas a transferable credit will not expose them to higher risk than under the original credit.

What's the difference between a bank guarantee and a letter of credit?

A bank guarantee and a letter of credit are similar in many ways but they're two different things. Letters of credit ensure that a transaction proceeds as planned, while bank guarantees reduce the loss if the transaction doesn't go as planned. A letter of credit is an obligation taken on by a bank to make a payment once certain criteria are met. Once these terms are completed and confirmed, the bank will transfer the funds. This ensures the payment will be made as long as the services are performed. A bank guarantee, like a line of credit, guarantees a sum of money to a beneficiary. Unlike a line of credit, the sum is only paid if the opposing party does not fulfill the stipulated obligations under the contract. This can be used to essentially insure a buyer or seller from loss or damage due to nonperformance by the other party in a contract. For example a letter of credit could be used in the delivery of goods or the completion of a service. The seller may request that the buyer obtain a letter of credit before the transaction occurs. The buyer would purchase this letter of credit from a bank and forward it to the seller's bank. This letter would substitute the bank's credit for that of its client, ensuring correct and timely payment. A bank guarantee might be used when a buyer obtains goods from a seller then runs into cash flow difficulties and can't pay the seller. The bank guarantee would pay an agreed-upon sum to the seller. Similarly, if the supplier was unable to provide the goods, the bank would then pay the purchaser the agreed-upon sum. Essentially, the bank guarantee acts as a safety measure for the opposing party in the transaction. These financial instruments are often used in trade financing when suppliers, or vendors, are purchasing and selling goods to and from overseas customers with whom they don't have established business relationships. The instruments are designed to reduce the risk taken by each party.

Subject - Bank guarantee and a letter of credit

What's the difference between a bank guarantee and a letter of credit? (By Ahmed Imam) A bank guarantee and a letter of credit are similar in many ways but they're two different things. The main difference between the two credit security instruments is the position of the bank relative to the

buyer and seller of a good, service or basket of goods or services in the event of the buyer's default of payment. These financial instruments are often used in trade financing when suppliers, or vendors, are purchasing and selling goods to and from overseas customers with whom they don't have established business relationships. A bank guarantee is a guarantee made by a bank on behalf of a customer (usually an established corporate customer) should it fail to deliver the payment, essentially making the bank a co-signer for one of its customer's purchases. Should the bank accept that its customer has sufficient funds or credit to authorize the guarantee, it will approve it. A guarantee is a written contract stating that in the event of the borrower being unable or unwilling to pay the debt with a merchant, the bank will act as a guarantor and pay its client's debt to the merchant. The initial claim is still settled primarily against the bank's client, and not the bank itself. Should the client default, then the bank agrees in the bank guarantee to pay for its client's debts. This is a type of contingent guarantee. A bank guarantee is more risky for the merchant and less risky for the bank. But this is not the case with a letter of credit. While a letter of credit is a similar, the principal difference is that it is a potential claim against the bank, rather than a bank's client. For example, a seller may request that a buyer be provided with a letter of credit, which must be obtained from a bank and which substitutes the bank's credit for that of its client. In the event that the borrower defaults, the seller would go the buyer's bank for the payment. The seller's risk is mitigated because it is unlikely that the bank will be unable to pay the debt. A letter of credit is less risky for the merchant, but more risky for a bank. Banks accept full liability in both cases. With a bank guarantee, a client can default and the bank assumes the liability. With a line of credit, liability rests solely with the bank, which then collects the money from its client.