Letter of Credit How does it works

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Letter of Credit

The “letter of credit” is issued by a bank inviting one of its branches or another bank to remit on one or more occasions and under certain conditions a sum of money to a person named or at his or her order, for a specified amount of which he guarantees payment.

It is a banking technique widely used in international trade. Thus an exporter of a commodity will agree with the importer of the same commodity, that he will make the shipment when he is in possession of a letter of credit subscribed by a bank his profit or for the benefit of his bank an amount equal to the value of the merchandise and shipping costs.

For its part the importer require the completion of the transaction takes place only against his banker, the banker of the sender, invoice, a certificate of origin of lading (transportation Maritime) or the air waybill (LTA) mentioning the actual shipment, the latter document, possibly accompanied by a statement made at embarkation establishing that the goods comply with the order.

The transaction is resolved in two stages, first, between the importer’s and the exporter’s bank, and then between the importer’s bank and the importer’s bank Paid.

The transaction may be supplemented by credit extended by the importer’s banker to the latter, so that, particularly where the voyage takes some time, the goods may be resold before their arrival at their destination. In this case, the importer’s bank is endorsed with the ship’s papers and becomes the owner of the goods during the sea voyage and is reimbursed by the purchasers for the sums advanced by it as and when The final deliveries or deliveries.

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Letter of credit another definition:

The definition of the letter of credit is a financial document issued by an issuing bank at the request of a buyer (the applicant) in favor of a seller (the beneficiary). 
It is an undertaking by the importer’s bank to guarantee the exporter the payment of the goods against the delivery of a goods transport ticket. 
It is better known as Credit Documentary (L / C) or Credoc
The documentary credit is the inverse operation of the documentary delivery, namely that the request is made by the buyer.

The Letter of Credit is administered by the Uniform Rules and Uses of the International Chamber of Commerce.

The documentary credit presents two types of risks: 

  • Documentary risk: the difference between the entries on the documents and the goods actually shipped 
  • The risk of unpaid payments

How LETTER OF CREDIT  works

The actors of the letter of credit (Process of Letter of Credit)

  • The buyer (the importer) who initiated the letter of credit 
  • The buyer’s bank that issues the credoc documents 
  • The seller’s bank that receives the credoc and checks the documents for compliance 
  • The seller (the exporter ) Who receives and receives the documentary credit
Letter of credit
Letter of credit process

The letter of credit can be used in two different ways: 

  • Directly: In this case, only one bank intervenes. The buyer’s bank carries out the issuance and implementation of the letter of credit. It notifies the buyer directly. 
  • Indirectly: The buyer requests the intervention of his bank in the implementation of the documentary credit. In this case, two banks intervene, the bank (notifier) of the seller and the bank (issuer) of the buyer.
letter of credit process
letter of credit process

The operating plan for the letter of credit

Conduct of transactions to secure business transactions with a letter of credit.

N ° 1: Acceptance of the commercial contract. The buyer (the importer) and the seller (the exporter) agree on the terms of the contract. 
N ° 2: The buyer requests from his bank the letter of credit (the issuing bank) in favor of the seller. 
N ° 3: Request for notification and confirmation of the letter of credit. The issuing bank undertakes, upon presentation of the documents, to pay to the notifying bank in case of unpaid payment. 
N ° 4: Notification of the letter of credit to the seller

Utilization of the letter of credit in case of unpaid

In the case of non-payment of the invoice, the seller can use the letter of credit to be paid. 
To do this, he will have to provide his bank with all the necessary documents.

N ° 1: Unpaid statement: the buyer did not pay his invoice in time despite the delivery. 
N ° 2: The seller transmits to his bank the documents (proof of delinquency, the copy of the packing slip, a copy of the invoice, good realization of the commercial contract) to start the procedure. 
No 3: The notifying bank delivers the documents to the issuing bank to request payment. 
N ° 4: After checking the conformity of the documents, the issuing bank deducts the invoice amount from the importer’s account. 
N ° 5: The issuing bank sends the funds to the notifying bank. 
N ° 6: With the funds transmitted, the notifying bank credits the seller’s account.

Different Types of Letter of Credit

There are numerous types of documentary credit: 

  • The irrevocable letter of credit cannot be modified or canceled without the agreement of all parties concerned. It may be notified or confirmed by the bank.
  • A revocable letter of credit may be amended or canceled by the bank. Payment can be guaranteed under certain conditions. 
  • The letter of credit is transferable if the beneficiary can make the credit available to another or several beneficiaries

Difference between documentary credit and standby letter of credit

The standby letter of credit is not a payment instrument, unlike the documentary credit. 
It is a bank guarantee in order to guarantee the correct execution of a contract. It shall only be carried out in the event of default by the principal in the performance of his contractual obligations. 
Standby letters of credit are adapted for bid, performance, performance and prepayment guarantees.

The advantages of export credit insurance compared to the letter of credit

The export credit insurance offers two important advantages over the use of the letter of credit. 

  • The costs are considerably less. 
  • The operation is much less restrictive.

“Credit insurance: a better solution compared to the letter of credit!”

Moreover, credit insurance offers many other advantages: 

  • Allows companies to develop their sales with confidence sales without credit problems. 
  • provides protection against unpaid payments on all contracts.
  • Improves the efficiency of a company’s internal credit department by speeding up credit limit requests and monitoring buyers. 
  • Allows exporters to secure all transactions abroad. 
  • Increases the borrowing capacity of the company by securing the receivables.

The Advantages of the letter of credit:

The key advantage of letter of credits is to assure the seller in collection of the merchandise and the buyer the receipt of the same. Though there are many additional advantages:

  • Allows a stay of payment to the buyer, securing the payment to the seller.
  • The seller can even get ahead the collection of the stock with respect to the term negotiated with the buyer.
  • Maximum legal protection
  • It increases the option of business for the seller, since it removes the country risk that exists in international trade.

The disadvantages of the letter of credit

  • Can only cover a single transaction for a single buyer and can be tedious in time. 
  • It’s expensive! Both in terms of absolute cost friends also and in terms of use of the line of credit. 
  • The complaint process is laborious and time-consuming.

Downloads:

  • letter of credit sample in .pdf format
  • letter of credit in .ppt format

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