A Letter of Credit commonly referred to as LC is a financial tool used for international trade. The term originates from the Italian word “Lettera di credito”, the French word “accreditation”, and the Latin word “accreditivus” which all relate to the concept of trust. When a buyer and a seller are located in different countries, there is often a level of uncertainty and distrust between the two parties. The buyer may worry about receiving the correct product, while the seller may worry about receiving payment. A Letter of Credit acts as a guarantee that helps to mitigate these concerns. The bank is involved in the transaction, ensuring that the seller will receive payment once they have fulfilled their obligation of delivering the goods to the buyer. In other words, the Letter of Credit acts as a bridge between the buyer and seller, helping to build credibility between the two parties and reducing the risk of financial loss.
Importance of the Letter of Credit in the Export Import business?
LC is an important aspect of the export-import business as it provides a level of security for both the buyer and the seller. In international trade, it can be difficult to build trust between parties who are located in different countries and may not know each other. By using an LC, both parties can be assured that the transaction will be completed in a secure and fair manner.
For the seller, an LC serves as a guarantee that they will receive payment for their goods once they have been shipped and confirmed as meeting the agreed-upon specifications. This helps to reduce the risk of not getting paid for their goods or having to take legal action to recover payment.
For the buyer, an LC acts as a form of security that they will only pay for the goods once they have received them and confirmed that they meet the agreed-upon specifications. This helps to reduce the risk of paying for goods that are not up to standards or being cheated.
How To Open A LC From Bangladesh
To open an LC, an importer needs to approach a bank that he/she has been a customer of. Banks play a crucial role in the process of LC. Banks are the intermediaries that issue LCs on behalf of the buyer (importer) and guarantee payment to the seller (exporter) when certain conditions are met. While issuing an LC, two banks are involved in the procedure. One is the LC issuing bank where the importer deposits the money, another is the advising bank which is also known as a confirming bank that assures and receives the payment from the issuing bank on behalf of the exporter. At the issuing bank, a concerned officer will assist the importer to fill up the necessary application. Since the LC can be opened on the basis of the purchase contract, a copy of the export or purchase contract and other documents are a must to open LC from the issuing bank.
The documents include –
- Business Trade license
- Business Bank Account
- Application for opening a Letter of Credit
- Purchase Contract
- Importer’s IRC certificate
- Indent / Performa invoice
- Membership certificate from the local chamber of commerce
- Income tax clearance
- VAT registration certificate
While opening an LC, the bank will ask the importer to keep the margin amount on the bank. The margin amount represents the total value of the imported goods that the issuing bank keeps as security. After the importer receives the product, the bank will release the money to the advisory bank. Then the exporter will collect the money from there. After depositing the margin amount, the bank will block the money and issue a letter of credit on behalf of the importer.
Types Of Letter Of Credit
Depending on the type of business, a Letter Of Credit also varies. The types are mentioned below –
- Revocable: This type of LC can be changed at any time by the buyer or through the issuing bank. In this case, there is no need to give notice to the beneficiary.
- Irrevocable: The Issuing Bank cannot make any changes to the Letter of Credit unless both parties agree.
- Standby: Standby LC guarantees payment to the seller in case of any mistake made by buyers or the issuing bank.
- Confirmed: When the Advising Bank guarantees payment to the seller.
- Unconfirmed: Confirmed only through the Issuing Bank where confirming the bank’s approval is not required at all.
- Revolving: Revolving LC is used to settle certain debts between importer and exporter.
- Back-to-back: Back-to-back LC is issued when the exporter does not have the required capital to ship the goods after opening the LC in favor of the exporter. Through a Back to Back LC, an exporter arranges the necessary funds for the purchase, processing, preparation, and packaging of the goods for export.
- Direct Pay: In this letter of credit, the issuing bank pays the beneficiary directly, not through the advisory bank.
- Deferred Payment: This LC allows for delayed payment. It is also known as Usance LC.
How Does Letter Of Credit Work?
When the importer and exporter agree on the terms of the trade, the importer opens an LC with the issuing bank. The issuing bank then sends a copy of the LC to the exporter’s advisory bank for verification. After the advisory bank checks the credibility of the LC, they send it to the exporter. The exporter rechecks the terms and conditions of the LC to ensure they match the agreement and starts the shipping process if everything is in order. In case of any discrepancy, the exporter may request the importer to amend the LC. Once the goods are shipped and the necessary documents are received by the importer, the issuing bank transfers the payment to the advisory bank, and finally, the exporter receives the payment.
Frequently Asked Question(FAQ)
Q. How long does it take to open LC?
A. To issue a letter of credit (LC), it will take only one or two days if you already have an LC facility with the bank. However, if you need to set up an LC facility, it will take anywhere from 15 days to a few months as the process involves a comprehensive credit appraisal of your company’s financials, promoters, and collaterals.
Q. What happens if LC is not paid?
A. If the buyer fails to make the payment as specified in the LC, it is considered a default, and the seller can take legal action against the buyer. Moreover, it will also damage the business relationship with the seller and may also cause the rejection of future LCs from the bank.
Q. What happens if LC is expired?
A. An expired LC means that the specified time period for the LC has passed and the buyer has not fulfilled their obligation as outlined in LC. If the LC expires and the buyer has provided any form of collateral (such as a bank guarantee), the seller may have the right to claim this collateral.
Q. Can importers cancel LC?
A. LC can be canceled if both the buyer and the seller agree to it, or if the buyer and the bank agree to it. The buyer may choose to cancel the LC if they are no longer interested in purchasing the goods or services specified in the LC, or if the terms of the LC have changed and they are no longer able to meet the obligations outlined in the LC.