How do Letter of Credits Work?

Trade is an important component of a country’s economic well-being. An established relationship between the buyers and the sellers is the foundation for ensuring flourishing trade. About 80% of the international business works on the ‘buy now, pay later’ principle. In this scenario, what reduces credit risk and provides some form of security as far as goods and payments are concerned is a Letter of Credit.

What is a Letter of Credit?

A Letter of Credit (or LC) is considered an important financial tool. The International Chamber of Commerce (ICC) defines Letter of Credit as ‘a legal assurance given by a third party, say a bank or a NBFC like Tata Capital, on behalf of the customer or importer (the buyer) to pay the exporter or beneficiary (the seller) a stipulated sum in the decided currency ’

Why is an LC needed?

Factors such as distance, variation in trade laws, and lack of any form of personal communication may prove to be a hindrance in case of international trade. What a Letter of Credit offers is a lawful and reliable means of payment to conduct a smooth trade. The Uniform Customs and Practice for Documentary Credits (UCP 600) of the ICC issues and formats the Letters of Credits for international transactions. A Letter of Credit process also involves a small fee collected by the issuing bank for service, usually as a percentage of the LC amount involved.

Types of Letters of Credit

1. Commercial LC: a standard LC, also known as a documentary credit, involving a direct payment by the bank to the seller
2. Standby LC: Quite similar to a bank guarantee, the method of payment is secondary, i.e. the bank makes the promised payment to the beneficiary only when the buyer cannot
3. Export/Import LC: The same Letter of Credit functions both as an Import LC as well as an Export LC, based on who is using it
4. Confirmed LC: To avoid the risk of payment failures from the first bank, a second bank or the confirming bank guarantees reimbursement to the seller
5. Unconfirmed LC: It is assured by only one bank, i.e. the issuing bank, and does not involve a second bank
6. Transferable LC: When a beneficiary itself acts as an intermediate pathway to the actual dealer, the transferable LC allows it to reassign the entire or a percentage of the payment to a second supplier in the sequence
7. Un-transferable LC: As the name suggests, it does not allow the recipient to further transfer the money to any other beneficiary
8. Traveler’s LC: If you are visiting a foreign country, the issuing bank will help you with the drafts you make at a foreign bank
9. Revolving LC: Instead of issuing separate LC for each of multiple transactions required to be made, a single LC, called Revolving LC covers all of it. It can be further subdivided into Value-Based and Time Based (Cumulative or Non-cumulative)
10. Revocable LC: An LC that can be altered by the bank or the buyer without notifying the beneficiary. Usually avoided as the seller is not protected against potential risks

Advantages of an LC

Some of the major advantages of availing a Letter of Credit are as follows:

Extremely Customizable

An LC can be customized as per the requirements of both parties to arrive at mutually acceptable terms and conditions. It can even be modified for different transactions with the same trader.

Expand Business Overseas

It helps you with transactions with new trade partners in new geographies, thereby, consolidating your business internationally.

Low Credit Risk for Beneficiary

In case of a payment failure, say in the event of bankruptcy, the issuing bank is obliged to meet the costs on behalf of the buyer, thereby protecting the seller from running into a loss.

Better Cash Flows

Letter of credit entitles a seller to gain pre-shipment finances with which he can complete all dues if any. Besides, with timely payments, the exporter can also plan his financial goals well in advance.

Today, a Letter of Credit is accepted in 175 countries. It undoubtedly provides better transaction clarity. With risk and trust as two major determining factors in trade, LCs come handy to better trade relationships, providing comfort, both the buyer as well as the seller. To know how to navigate overseas operations smoothly, check for Tata Capital’s Letter of Credit solutions.