Letter of Credit- A Basic Understanding

Introduction- In this article will try to understand the concepts and mechanism of international trade involving Letter of credit. Since the concept can be very lengthy and wide we will try to understand it moderately. We will discuss about the governance, Documents involved, the overall mechanism, and a little bit of in-depth mechanism of the international trade involving letter of credit.

Governance- The international trade is governed by the International Chamber of Commerce which has prescribed set of rules and regulations which are followed internationally. Uniform Customs and Practices for Documentary Credit version 600(UCP 600), Uniform Rules for Collection version 522(URC 522), International Standard Banking Practices are the guidelines which are followed worldwide for uniform treatment of transactions. We will discuss about all of these as we progress into the discussion.

Documents- There are various documents involved in the processing of the international trade transactions. Some of the documents are-

1. Bill of Lading/ Air way bill

2. Invoice

3. Packing list

4. Certificate of origin

5. Letter of credit

6. FIRC(Foreign Inward remittance certificate)/BRC(Bank realization certificate)

7. Insurance Policy

We will discuss about these documents as we progress.

Situations- Now let’s start discussion about how an international trade transaction happen and why there is need of letter of credit. The globalization has made the whole globe as a common market thus presently, it is very common for a business to trade with the person of another country. There can be three situations in any trade transactions.

1. Seller is a giant and buyer is just a normal business person.

2. Buyer is giant and seller is just a normal business person.

3. Both are normal business person not having any big international repute.

• In the first case, where seller is giant and buyer is just a normal person, usually there should not be any problem as the conditions of the seller will dominate over buyer’s. The buyer will be happily able to send advance to the seller as the seller is giant and has international repute. The buyer is assured that seller will send the goods.
• In the second case as well, there should not be any problem as the buyer is giant and the conditions of buyer will dominate, which, the seller will happily follow as the buyer has international repute and he will send the goods in advance to the buyer without worrying about the payment of the goods.
• The problem arises in the third case when none of buyer and seller has international repute and both of buyer and seller don’t know each other. The buyer will want the goods to be sent first so that the payment can be made after receiving of goods whereas the seller will want buyer to send the payment first so that the seller can send goods only after receiving the payment. Both the parties want their interest to be secured.

The Problem of third case is solved by the letter of credit. First of all we should understand that all the international trade transactions are routed through banks. Mostly everything is done via banks. Thus it is obvious that there will be at least four parties in the transaction. The importer, the exporter, the bank of importer and finally the bank of exporter.  What actually happens is the exporter requests the importer to issue a letter of credit in favour of him. But what exactly is letter of credit? In simple words, Letter of credit is a written undertaking by bank that upon presentation of document specified in letter of credit, within the time specified by the letter of credit, the bank will honour the payment to the exporter. Each and every word of above definition is very important.

The process– First of all a sale contract takes place between exporter and importer. The exporter then, request the buyer to issue a letter of credit in favour of him. The importer applies in his bank to issue a letter of credit. Since it is the importer’s bank who issues the LC, it is called the issuing bank. Since it is made in favour of exporter, he is called the beneficiary. The issuing bank (importer’s bank) sends the LC to exporter’s bank. This sending is done through SWIFT (Society for worldwide inter-bank financial telecommunication. This society manages the international financial messages. Messages are sent in a predefined format.) After the LC is received by the exporter’s bank, it is advised (informed) to the exporter. After exporter receives the LC, he ships the documents either through sea or air. In case of sea, the captain of ship issues the bill of lading to the exporter and in case of air, the air way bill is issued. It is important to understand that the bill of lading is the title deed of goods which means whoever has the bill of lading, is the owner of goods and he will have to show it to the custom port to release the goods. Hence after the goods are shipped, the exporter, along with other documents mentioned in LC like Invoice, Packing list, Marine Cargo Insurance Policy, Certificate Of Origin (certificate issued by chamber of commerce certifying the country of origin. It is necessary for preferential rate of custom duty) submits it to his bank. Exporter’s bank then, sends the documents through post to the issuing bank who first of all, scrutinizes the documents thoroughly as per International Standard Banking practices (ISBP) which talks about the documentation. If documents are as per LC, it communicates it to the importer. But if documents are not as per LC and mistakes have been found in documents as per ISBP, It sends a refusal advice to the exporter’s bank stating that since documents are not as per LC, the issuing bank has no liability to honour the payment and payment will be made only if the buyer makes the payment.

Now, the importer needs bill of lading to release the goods but there can be two situations, whether documents are against payment or against acceptance. It may happen that as per documents , due date of payment is after 90 days but importer needs the goods immediately and has no funds to pay. In that case, documents against acceptance method is chosen in which the issuing bank(who now has bill of lading) releases the bill of lading on the condition that the importer will give an acceptance to bank that it will honour the payment on due date. After acceptance, the documents are released to the importer.

On due date, if the documents are correct and complete, the issuing bank makes payment to the beneficiary’s bank. What is important to note is that in case of LC, the exporter doesn’t follow up from importer to make payment. All he has to do is submit documents to issuing bank and bank honours the payment. Thus, interest of both parties are secured in this method. Since in LC, banks have nothing to do with goods it only deals in documents, LC is also called documentary credit.

The difference between LC and bank guarantee is that in case of LC, you do not have to wait for the default of party to honour your payment through bank. All you have to do is submit the documents mentioned in LC within time and bank will honour the payment.

Conclusion-There are many more aspects in an international trade like bill discounting, bill sent for collection, types of LC, international settlements, confirmation of LC etc. But like I said we will discuss it moderately with little bit of in depth discussion, I think the discussion is sufficient to understand the basics of international trade involving LC. Since this is my first article please excuse me for any mistakes I have done. Thank you.