LETTER OF CREDIT OR DOCUMENTARY CREDIT

DEFINITION

An LC is a financial document provided by a third-party (with no direct interest in the

transaction), mostly a bank or a financial institution, that guarantees the payment of
funds for goods and services to the seller once the seller submits the required
documents. In some ways, the buyer also enjoys protection under a letter of credit:
Buyers might prefer to pay a bank with a big legal department rather than send the
money directly to an unknown seller.

Parties to the letter of credit

1. Applicant (The opener): The party who requests the letter of credit. The applicant
is often an importer or buyer who uses the letter of credit to make a purchase.
2. Beneficiary: The party who receives payment. This is usually a seller or exporter
who has requested that the applicant use a letter of credit (because the beneficiary
wants more security).
3. Issuing bank (The issuer): The bank that creates or issues the letter of credit at the
applicant’s request. It is typically a bank where the applicant (importer) already does
business (in the applicant’s home country, where the applicant has an account or a
line of credit).
4. Negotiating bank (notifying bank/confirming bank/ advising bank): The bank
that works with the beneficiary. This bank is often located in the beneficiary’s home
country, and it may be a bank where the beneficiary (exporter) is already a customer.
The beneficiary submits documents to the negotiating bank, and the negotiating
bank acts as a liaison between the beneficiary and the other banks involved.
5. Confirming bank (second bank): A bank that “guarantees” payment to the
beneficiary as long as the requirements in the letter of credit are satisfied. The
issuing bank already guarantees payment, but the beneficiary (exporter) may prefer
a guarantee from a bank in their home country (with which they are more familiar).
This may be the same bank as the negotiating bank.
6. Advising bank (notifying bank): The bank that receives the letter of credit from
the issuing bank and notifies the beneficiary that the letter is available.
7. Intermediary: A company that connects buyers and sellers, and which sometimes
uses letters of credit to facilitate transactions.
8. Freight forwarder: A company that assists with international shipping. Freight
forwarders often provide the documents exporters need to provide in order to get
paid.
9. Shipper: The company that transports goods from place to place.
10. Legal counsel: A firm that advises applicants and beneficiaries on how to use letters
of credit.
Process

 A manufacturer receives an order from a new customer overseas. The manufacturer

has no way of knowing if this customer can (or will) pay for the goods after
producing and shipping the products.
 To manage risk, the seller uses an agreement that requires the buyer to pay with a
letter of credit as soon as shipment is made.
 To move forward, the buyer needs to apply for a letter of credit at a bank in their
home country. The buyer may need to have funds on hand at that bank or get
approval for financing from the bank.
 The bank will only release funds to the seller after the seller proves that the
shipment happened. To do so, the seller typically provides documents showing how
goods were shipped (with details like the exact dates, destination, and contents).

The Money behind a Letter of Credit

A bank promises to pay on behalf of a customer, but where does the money come from?
The bank will only issue a letter of credit if the bank is confident that the buyer can pay.
Some buyers must pay the bank up front or allow the bank to freeze funds held at the
bank. Others might use a line of credit with the bank, effectively getting a loan from the
bank. Sellers must trust that the bank issuing the letter of credit is legitimate and that
the bank will pay as agreed. If sellers have any doubts, they can use a "confirmed" letter
of credit, which means that another (presumably more trustworthy) bank will
guarantee payment.

TYPES OF LETTER OF CREDIT

There are various types of letters of credit in trade transactions. Some of these are
classified by their purpose. The following are the different types of letters of credit:

1. COMMERCIAL LC

A standard LC also called as a documentary credit

2. EXPORT/IMPORT LC

The same LC becomes an export or import LC depending on who uses it. The exporter
will term it as an exporter letter of credit whereas an importer will term it as an
importer letter of credit.

3. TRANSFERABLE LC

A letter of credit that allows the transfer all or a part of the payment of money to any
third party. The beneficiary can further use the letter of credit to pay anyone.

4. UN-TRANSFERABLE LC

A letter of credit that doesn’t allow the transfer of money to any third parties. The
beneficiary is the only recipient of the money and cannot further use the letter of credit
to pay anyone.

5. REVOCABLE LC

An LC that issuing bank or the buyer can alter any time without any notification to the
seller/beneficiary

6. IRREVOCABLE LC

An LC that does not allow the issuing bank to make any changes without the approval of
all the parties

7. STANDBY LC

A letter of credit that assures the payment if the buyer does not pay. It is quite similar to
a bank guarantee.

8. CONFIRMED LC

Which the seller or exporter acquires the guarantee of payment from a confirming bank
(also called the second bank). This is primarily to avoid the risk of non-payment from
the first bank.
 9. UNCONFIRMED LC

A letter of credit that is assured only by the issuing bank and does not need a guarantee
from the second bank. Mostly the letters of credit are an unconfirmed letter of credit.

10. REVOLVING LC

When a single LC is issued for covering multiple transactions in place of issuing separate
LC for each transaction is called revolving LC.

11. BACK TO BACK LC

Back to back LC is an LC which commonly involves an intermediary in a transaction.

There are two letters of credit, the first issued by the bank of the buyer to the
intermediary and the second issued by the bank of an intermediary to the seller.

12. RED CLAUSE LC

A letter of credit that partially pays the beneficiary before the goods are shipped or the
services are performed. The advance is paid against the written confirmation from the
seller and the receipt.

13. GREEN CLAUSE LC

An LC that pays advance to the seller just not against the written undertaking and a
receipt, but also a proof of warehousing the goods. For more information click on Green
Clause LC

14. SIGHT LC

A letter of credit that demands payment on the submission of the required documents.
The bank reviews the documents and pays the beneficiary if the documents meet the
conditions of the letter.

15. DEFERRED PAYMENT LC

An LC that ensures payment after a certain period. The bank may review the documents
early but the payment to the beneficiary is made after the agreed-to time passes. It is
also known as Usance LC.

16. DIRECT PAY LC

A letter of credit where the issuing bank directly pays the beneficiary and then asks the
buyer to repay the amount. The beneficiary may not interact with the buyer.