Letter of credit

[Link]:- A letter issued by a bank to another bank (especially

one in a different country) to serve as a guarantee for payments made
to a specified person under specified conditions.
A letter of credit (LC), also known as a documentary credit or bankers
commercial credit, or letter of undertaking (LoU), is a payment
mechanism used in international trade to provide an
economic guarantee from a creditworthy bank to an exporter of
goods. Letters of credit are used extensively in the financing of
international trade, where the reliability of contracting parties cannot
be readily and easily determined. Its economic effect is to introduce a
bank as an underwriter, where it assumes the credit risk of the buyer
paying the seller for goods.
The letter of credit has been used in Europe since ancient
times. Letters of credit were traditionally governed by internationally
recognized rules and procedures rather than by national law.
The International Chamber of Commerce oversaw the preparation of
the first Uniform Customs and Practice for Documentary
Credits (UCP) in 1933, creating a voluntary framework for
commercial banks to apply to transactions worldwide.
In the late 19th century and early 20th century, travelers commonly
carried a circular letter of credit issued by a relationship bank, which
allowed the beneficiary to withdraw cash from other banks along their
journey. This type of letter of credit was eventually replaced
by traveler's checks, credit cards and automated teller machines.
Although letters of credit first existed only as paper documents, they
were regularly issued by telegraph in the late 19th century, and
by telex in the latter half of the 20th century.
Beginning in 1973 with the creation of SWIFT, banks began to
migrate to electronic data interchange as a means of controlling costs,
and in 1983 the UCP was amended to allow "tele transmission" of
letters of credit. By the 21st century, the vast majority of LCs were
issued in electronic form and entirely "paperless" LCs were becoming
more common.

[Link] of letter of credit

Companies and laypeople often do not have the capital they need to found
projects or make large purchases on their own. They have to turn to credit are
letters that banks issue to verify the credit a business or person has. They are
useful because they tell sellers that the bank will back the buyer in the event
the buyer can’t pay on his own.

Letter of credit advantages for the seller:-

 The seller has the obligation of buyer's bank's to pay for the
shipped goods;
 Reducing the production risk, if the buyer cancels or changes his
order
 The opportunity to get financing in the period between the
shipment of the goods and receipt of payment (especially, in
case of deferred payment).
 The seller is able to calculate the payment date for the goods.
 The buyer will not be able to refuse to pay due to a complaint
about the goods

Letter of credit advantages for the buyer:-

 The bank will pay the seller for the goods, on condition that the
latter presents to the bank the determined documents in line with
the terms of the letter of credit;
 The buyer can control the time period for shipping of the goods;
 By a letter of credit, the buyer demonstrates his solvency;
 In the case of issuing a letter of credit providing for delayed
payment, the seller grants a credit to the buyer.
  Providing a letter of credit allows the buyer to avoid or reduce
pre-payment.

The content of this article is intended to provide a general guide to the

subject matter. Specialist advice should be sought about your specific
circumstances.

I) Purpose: The primary purpose of a letter of credit is to

guarantee payment. Although the conditions of a letter of credit
may vary based on your situation and the banks regulations,
letters of credit instead of relying on your own. The seller knows
that if you don’t come through with funds, the bank will. This
promise to pay is vital for establishing new business relationships.
II) Payment and shipment confirmation: Financial
institutions often describe letters of credit as beneficial to the
seller, since they guarantee payment. However, letters of credit
also ensure that the bank will act on behalf of the buyer; they
keep payments from being made until the buyer can confirm
shipment. This helps the buyer avoid scams.
III) International trade: In general, people use letters of credit
for international trade. This is because people may be less familiar
with companies, sellers and banks the farther away they are. It
also is harder for effective communication to take place in
international trade, although technology greatly is improving
communication difficulties. Letters of credit also are useful for any
domestic transections where the buyer and seller have not
worked with each other previously.
IV) Seller trust: A letter of credit works on the basis that the seller
will trust the issuing bank to cover payments if the buyer cannot
do so. This means that a letter of credit may be harder to use if
the issuing bank has not been established long enough to have a
solid reputation.
 V) Types: There are different types of letters of credit. These
include confirmed, commercial, irrevocable, revocable and
standby. Each of these letters of credit has different terms, so one
may be more appropriate for you than another depending on your
situation. Your attorney or bank can advise you on which type
would suit your needs best.

Classification 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:

I) Commercial LC: A standard LC also called as a documentary credit.

II) 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.

III) Transferable LC: A letter of credit that allows a beneficiary to

further transfer all or a part of the payment to another supplier in the
chain or any other beneficiary.

IV) 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.

V) Revocable LC: An LC that issuing bank or the buyer can after any
time without any notification to the seller/beneficiary. Such types of
letters are not provided any protection.
VI) Irrevocable LC: An LC does not allow the issuing bank to make any
changes without the approval of all parties.

VII) Standby LC: A letter of credit that assures the payment if the buyer
does not pay.

VIII) Confirmed LC: Which the seller or exporter acquires the guarantee
of payment from a confirming bank.

IX) Unconfirmed LC: A letter of credit that is assured only by the

issuing bank and does not need are an unconfirmed letter of credit

X) Revolving LC: When a single LC is issued for covering multiple

transections in place of issuing separate LC for each transaction is
called revolving LC.

XI) Back to back LC: Back to back LC is an LC which commonly involves

an intermediary in a transaction.

XII) Red clause LC: A letter of credit that partially pays the beneficiary
before the goods are shipped or the services are performed.

XIII) 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.

XIV) Sight LC: A letter of credit that demands payment on the submission
of the required documents.

XV) Deferred payment LC: An LC that ensures payment after a

certain period.

XVI) 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 LC which are used in specially in
BANGLADESH?
Standby Letter of credit is a promissory note issued by a bank which
undertakes to pay one party to a contract to the beneficiary when the other
party has failed, or is alleged to have failed to perform the contract. A standby
letter of credit is often payable simply on the beneficiary's presentation of a
written demand. The demand usually requires the presentation of documents
that evidence a default in the underlying transaction between the letter of
credit beneficiary and typically a third party that arranges for the issuance of
the letter of credit-the letter of credit applicant.
The standby L/C is a bank guarantee of payment which is close to the
documentary Letter of credit (L/C) except that it is only a guarantee of
payment and not a means of payment. It is used only in the event of non-
payment by the buyer. In this case, the seller sends the documents to the bank
to be paid immediately.
The Standby L/C is separate from and independent of the underlying contract.
The issuing bank will not investigate the underlying facts of the transaction e.g.
whether or not there was a default or contract breach. The bank only reviews
conditions that are evidenced by a document. The bank's commitment is
contingent upon the presentation of the stipulated documents in accordance
with the terms and conditions of the L/C. These documents related to
agreements and contracts are "for information only" to the issuer of Standby
Lc.

The issuer's undertaking to pay creates a primary obligation on it, which is

independent of the underlying contract. A standby letter of credit is therefore
similar to an on-demand bond but differs from a true guarantee.
Now a days, Standby L/C letter of credit and commercial L/C are two main
documentary credit types used in international trade transactions. Both
standby and commercial letter of credit are irrevocable and conditional
payment promises given by trusted financial institutions mostly by banks.
Standby L/C and Commercial L/C are governed by International System of
Practices 98 (ISP 98) and The Uniform Customs & Practice for Documentary
Credits (UCP 600), formulated by International Chamber of Commerce (ICC)
and ratified by United Nations Convention (1996) on Independent Guarantees
and Stand-by Letters of Credit. The UN convention is also a guideline for
member countries to adapt law for Standby L/C in their respective jurisdiction
or make the standby
L/C compatible with local law.
The ISP, like the UCP for commercial letters of credit, simplifies, standardises,
and streamlines the drafting of standbys, and provides clear and widely-
accepted answers to common problems. It is issued as a documentary credit
with or without confirmation. However, it may be sent directly to the supplier
without going through his bank.
ISP98 reflects generally accepted practice, custom, and usage of standby
letters of credit. The International Chamber of Commerce refers to ISP 98 as "a
distillation of practices from a wide range of standby users-bankers,
merchants, rating agencies, corporate treasurers, credit managers,
government officials and banking regulators. Like the UCP for commercial
credits, ISP98 is destined to become the standard for the use of standbys in
international transactions."
ISP98 was published by the ICC and endorsed by the UN after consultation with
the International trading community with motive to harmonise trade practices,
help define roles and responsibilities of all parties to the instrument and
enforce independence principle. These rules supplement the Governing Law
applicable to a Standby to the extent not prohibited by that Law.
As a contract of international trade and facilitates exchanges, a Standby L/C
does not have to be formatted alike a documentary credit. In some occasions,
Standby L/C is used as secondary payment option which means it acts as a
guarantee and will be utilised in case another primary payment mechanism
does not work. Commercial L/C, on the other hand, is primary payment
method in international sales. Also, Standby L/C ensures that suppliers will be
paid by the bank just after a complying presentation is made under a
commercial letter of credit.
Over the years, Standby L/C has evolved into an all-purpose instrument. Such
Standby letters of credit can also be employed to play the role of a Direct Pay
tool through the power of which the beneficiary can simply draw funds needed
to comply with the requirements of the executed agreement between the two
parties.
Standby L/C allows the seller to accept a simple mode of payment such as bank
transfer with security of the bank guarantee in the background. Its cost is
relatively low compared to documentary credit.
The ISP98 is also intended to be standard practice used in arbitration as well as
judicial proceedings similar to the expert-based letter of credit arbitration
system developed by the International Centre for Letter of Credit Arbitration
(ICLOCA) Rules or general commercial ICC arbitration or with alternative
methods of dispute resolution.
Standby L/C is practiced in international trade supporting payment guarantee
of a documentary L/C and international trade against contract. Apart from this,
standby L/C is also instrumental to other categories of transaction and
guarantee. These are (1) "Bid Bond/Tender Bond Standby" that supports an
obligation of the applicant to execute a contract if the applicant is awarded a
bid. (2) "Counter Standby" supports the issuance of a separate standby or
other undertaking by the beneficiary of the counter standby. (3) "Financial
Standby" supports an obligation to pay money, including any instrument
evidencing an obligation to repay borrowed money. (4) "Direct Pay Standby"
supports payment due of an underlying payment obligation typically in
connection with a financial standby without regards to a default. (5) "Insurance
Standby" supports an insurance or reinsurance obligation of the applicant. (6)
"Commercial Standby" supports the obligations of an applicant to pay for
goods or services in the event of non-payment by other methods.
ISP98 became effective on January 01, 1999. It is currently being used and
promoted by major banks that issue standby letters of credit, and is expected
to become the world standard within the next few years. Bangladesh has no
initiative to introduce Standby L/C. Banks in Bangladesh are still not willing to
accept UCP 600 for commercial letter of credit and overseas suppliers are not
comfortable with 'standard and old-fashioned' format of L/C.
There are many financial institutions and global corporations not willing to
accept documentary L/C from banks in Bangladesh unless there is confirmation
from third party or guaranteed by insurance. The non-acceptance of L/C is
making our export and import transactions expensive over our competitors in
the global market. Standby L/C can be an alternate and cheaper option in
international trade.
How does LC work?
First, a buyer (importer) and seller (exporter) decide to do business together.
They agree on a price, quantity, and other terms, and they specify how and
when the goods will be shipped to the buyer. As part of the contract, we
assume that the seller requires the buyer to use a letter of credit (LOC).
Why does the seller demand a letter of credit? The seller wants more
confidence that the buyer will pay. Perhaps this buyer and seller have never
worked together, or the order might be large enough to cause severe financial
hardship if something goes wrong. For example, if the seller spends money to
produce and ship goods, the seller wants to recoup those costs. The buyer
might not pay for several reasons (the buyer’s assets could be seized for some
reason, the buyer might go bankrupt, and so on).
The sales agreement is not part of a letter of credit. The sales agreement is
between the buyer and the seller only, and the LOC relies on information in the
agreement, but the LOC is a separate document issued by a bank.
Continue to 1 of 3 below.

I) Issuing the LOC

To obtain the LOC, the buyer contacts her bank. That bank operates in the
buyer’s home country, and is most likely a bank that the buyer currently does
business with. The buyer provides information required for the bank to issue
the LOC, including:
1. How much is the payment?
2. What is the name and address of the seller (known as the beneficiary)?
 3. When will the seller ship goods?
4. How will the seller ship the product?
Details matter: It’s essential that the bank gets all of the details correct. The
LOC is a legally binding document, and these documents are interpreted
exactly as written. Again, the LOC is separate from the sales agreement, and
it’s based on documents—not actions performed—so you can't assume that
everything will work out if there’s an error in the LOC. Even a seemingly minor
item, like a typographical error, can cause problems. If the document isn’t
perfect, it needs to be corrected before anybody moves forward.
Funding: When the bank issues the LOC, the bank makes a promise, and the
bank is responsible for sending money. That’s what makes a letter of credit so
safe for sellers—the fact that the bank takes responsibility for payment.
Because of that, the bank needs to be confident that the buyer can fund the
payment. Before the bank issues the LOC, the buyer may have to deposit funds
with the bank, or the bank might arrange financing for the buyer as part of the
LOC.
Banks and intermediaries: After issuing the LOC, the bank sends it to the
seller’s bank. That bank is typically located in the seller’s country and is likely a
bank that the seller already has a relationship with. There may be several
banks in between acting as intermediaries, but those are left out for simplicity.
Seller review: The seller’s bank reviews the LOC and forwards it to the seller. At
that point, the seller must review the LOC to ensure that it matches what she
agreed to do and that she is capable of meeting the requirements of the LOC.
She should also decide if she is comfortable trusting the issuing bank and any
other banks involved.
If everything is acceptable, the seller can move to the next step: produce and
ship goods.

II)
Sending Goods and Documents
To receive payment with a LOC, the seller must satisfy the requirements
specified in the LOC. Among other things, that usually means:
1. Shipping the goods by a certain date
2. Possibly having the goods inspected before shipment
3. Using the shipping method specified in the LOC
4. Shipping to and from ports specified in the LOC
5. Gathering documents listed in the LOC (specific shipping documents, for
example)
6. Submitting documents to the bank by a specific date
Seller confidence: The seller knows that she will get paid as long as she meets
the requirements of the LOC (and assuming the banks involved remain solvent
and follow through on their obligations). It doesn’t matter if her customer goes
bankrupt or decides not to pay—the bank is on the hook for payment. The end
customer’s financial situation is the bank’s problem, not the seller’s problem.
Delivery not required: Depending on the details of the LOC, it doesn’t even
matter if the goods ever make it to the customer. A storm may damage or
destroy products during shipment, but the seller might not be responsible for
that loss if they just had to ship goods. Documentary requirements: The
primary challenge for the seller is meeting the requirements of the LOC. Again,
banks only care about the details written into the LOC and the documents you
submit to satisfy the LOC. If anything is off, the seller won’t get paid.
For example, if you ship one day late, it’s a major problem. You might throw in
some extra product for free (and your customer might even agree that this
makes up for the late shipment), but banks won’t pay unless the LOC is
amended to account for the later shipping date. It takes extra money and time
to revise a LOC.

III) Payment and Shipment Arrive

Once documents arrive at the seller’s bank, the bank verifies that the
documents meet the requirements of the LOC. Again, the bank takes
everything literally: If anything doesn't match—even the spelling or
abbreviation of a company name—the bank can refuse payment. Banks take
several business days to conduct this review. If the documents are in good
order, the seller’s bank forwards the documents to the buyer’s bank. The
buyer’s bank performs the same review of documents against the LOC. If
everything checks out, the buyer’s bank sends payment to the seller’s bank.
Next, the buyer’s bank forwards the documents to the buyer, who uses those
documents to take possession of the goods when they arrive. When does the
seller get paid? The timing of payment depends on the type of LOC used .
Diagram of the working process of LC

Buyer on the request of seller, obtains

LC from a issuing bank

↓
Exporter submits the export
document to the exporter bank.

↓
Bank forwards this document to the
issuing bank.

↓
LC issuing bank checks the
authenticity of the document and
communicate their acceptance of bill
under LC.

↓
The exporter bank issues LC advise
to exporter.

↓
The exporter, in need of funds,
request discounting of the bill which
backed by the LC.
 ↓

Exporters bank discount the bill and

make net payment to the exporter
after the deduction of discount.

↓
Exporter gets the money uses it to
process the order and makes delivery
of goods as per the terms.