In the business world, trust is one of the most important aspects. There is a basic rule of authentication and trustworthiness in the trading business considering international trade. Therefore, the letter of credit acts as the certificate of authentication and maintains the company's trustworthy reputation. When there is an ongoing trade within countries, a letter of credit is issued to make sure the buyer receives the full payment of the product to the seller. The bank that issues this letter of credit attains a percentage of the payment amount as a service charge. Hence, it provides the benefit of paying the full payment of the product if the buyer is unable to pay.
Did you know?
The usual cost of the letter of credit is 0.75% of the total purchase cost. In some cases, the cost of the letter of credit comes close to 1.5%
Why is a Letter of Credit Important in International Trades?
Letter of Credit
A letter of credit is a certification to maintain the authentication and proper relationship between buyers and sellers. The letter of credit is a certificate of authentication and a pact. This pact determines the full payment of the product or an item purchased by the buyer. Basically, this letter of credit is issued by the bank taking full responsibility for the payment of the item. If the buyer cannot fulfil the payment or provide the amount required by the seller, the bank is liable to pay the total price to the seller. On behalf of signing this letter of credit, the bank charges a fee based on the percentage of the number of payments of the seller.
Based on the nature of payment and the condition of the payment, there are six distinct categories of the letter of credit. They are:
1. Credit on sight.
2. Time credit.
3. Revocable credit.
4. A standby letter of credit.
5. Irrevocable credit.
6. Transferable credit.
Many processes are involved in the letter of credit that is beneficial for both the buyer and the seller. Several processes involved in the letter of credit are:
1. The applicant approaches an issuer bank to issue a letter of credit.
2. An advising bank receives the letter of credit and checks the authenticity of the LC.
3. Advising bank explains all of the conditions of the LC sample to the beneficiary.
4. After accepting all the conditions by the seller, the product will be shipped.
5. The applicant will prove that they have received the product by providing the bill of lading.
6. The nominating bank will make the payment for the product on behalf of the buyer.
7. The issuer bank confirms the bill of lading and receiving the goods from the applicant.
8. Once all the process is authenticated, the applicant will pay for the goods paid back to the nominating bank.
Importance of Letters of Credit
The letter of credit states that these are the letters of certification that provide full authentication. It states that a particular buyer will fulfil the seller's payment in a fixed time and a total amount. Moreover, it is also a protecting certification that forces the bank that issued this letter of credit to make the full payment on behalf of the buyer when the buyer cannot fulfil the payment to the seller. This letter of credit has great importance in international trade dealings. As the selling and buying operation is considered between countries, the buyer's trustworthiness and authenticity are very important. Therefore, a letter of credit is issued by a bank or any other financial institute to mark up the quality of the buyer and safeguard the amount invested in this transaction. Based on this mode of payment, their letter of credit is categorised into several groups.
Parties to a Letter of Credits
The letter of credit is one of the important aspects of the dealing business. A letter of credit acts as a letter of certification and authentication between the buyer and the seller. Therefore, many entities are involved in issuing a letter of credit. Several parties involved in the letter of credit are:
An applicant is a buyer or the purchaser making the transaction in this operation of selling and buying. Therefore, the applicant must apply for a letter of credit. While issuing the letter of credit, the person or individual who is the purchaser of any product or an item is considered the applicant in the documentation.
Beneficiaries are the individual who is making the transaction for selling out the product, i.e., the seller will receive the full payment made by the buyer. A mutual understanding of the conditions of the letter of credit is required where both the applicant and the beneficiary need to be involved.
3. Advising bank
An advising bank is an advisory body that provides support and solution to the seller while issuing the letter of credit. The basic working principle of an advising bank is to make the seller aware of the several terms and conditions, support it while setting up the requirements in the letter of credit and make sure about the credit sensibility.
4. Issuing bank
An issuer bank is a bank that takes full responsibility for determining conditions laid out on the letter of credit. The basic issuing of the letter of credit is in the hands of the issuing bank, and it takes the protocol of fulfilling the payment, i.e., paying the full amount to the seller in the condition where the buyer is unable to make the payment on time.
Types of a Letter of Credits
A letter of credit is a safeguard to protect the relationship between the buyer and the seller. A letter of credit is quite important in every buying and selling operation condition. Therefore, based on the occasion of payment and the nature of payment, the letter of credit is divided into several categories. These are some of the letters of credits type:
1. Sight Credit
According to this LC payment terms, the payment is made at the point of the presentation, i.e., as soon as the authentication of the document is confirmed, the payment is required to be made. It is one of the fastest modes of payment among the other letter of credit types.
2. Acceptance Credit/Time Credit
The payment is made on a fixed date under the acceptance credit or the time credit. The date is mutually decided between the buyer and the seller during the presentation of the letter of credit. Considering one of these categories of letter of credit example, if the seller provides a 30 days' time for the payment, the buyer needs to fulfil their payment before the end of the 30th day.
3. Revocable and Irrevocable Credit
Revocable and irrevocable credit is a crucial letter of credit that the bank issues. Under the revocable credit, the bank is under the provision of amending or cancelling the letter of credit due to the basis of several conditions. However, before cancelling their certification, the bank allows a prior notice to the issuer. And one the other hand, an irrevocable credit is a bounded category of letters of credit over the bank, which cannot be amended or cancelled under any condition. Hence, the bank has a confined set of rules under which it must make the payment, no matter how adverse the conditional or situation becomes.
4. Confirmed Credit
This category of LC means a confirmation issued by another bank over the letter of the credit instead of the confirmation issued by the issuing bank. The irrevocable letter of credit is one of the categories of confirmed credit that another banker confirms. Under the issuing of a confirmed letter of credit, it is required to submit the documentation of the letter to the confirming bank. Hence, this submission is fulfilled by the beneficiary's bank.
In this modern generation, the transaction and the buying/selling operation have spread their arm worldwide. Nowadays, India is trading internationally with a different number of countries. While transacting internationally, a need for trust and faith arise. This is the point where the letter of credit is of most importance, which plays as the certificate of authentication for the buyer and maintains the relationship between the purchaser and the seller. The basic feature of the letter of credit is that the bank issuing the LC takes responsibility for the full payment of the product under the condition that the buyer is unable to pay the amount.