Letter of Credit and Financing of Foreign Trade

A letter of credit is an undertaking by a bank to pay or to arrange to pay for specified merchandise provided that certain stipulated conditions are met by beneficiary. The International Chamber of commerce has defined a banker’s documentary credit as an arrangement, however named or described, whereby a bank (the issuing bank), acting at the request and in accordance with the instructions of a customer (the applicant to the credit) take payment to or to the order of third party ( the beneficiary), or is to pay, accept or negotiate bills of exchange (drafts) drawn by the beneficiary, or authorized such payments to be made or such drafts to be paid, accepted or negotiated, by another bank , against stipulated documents and compliance with stipulated terms and conditions.

The letter of credit arrangement offers advantages to both the seller and buyer. As far as the seller is concerned, a letter of credit ensures him payment for the goods he sells provided, of course, he follows the instructions. Though the buyer has the responsibility of arranging for the letter of credit, it may enable him to obtain more liberal discounts and a lower price from the seller. Further, the buyer is assured that the shipment will be made by the date specified in the letter of credit, or else the credit will expire.

Parties to the Letter of Credit:

The Opener: The opener is the buyer (the importer). The letter of credit is opened at the initiative and request of the buyer.

The Issuer: The issuer, also called opening or issuing is the bank in the importer’s country issuing the letter of credit at the request of the importer.

The beneficiary: The beneficiary is the party in whose favor the credit is issued: that is, the beneficiary is the seller or exporter.

The three parties mentioned above are regarded as the fundamental parties to a letter of credit. However, the following parties concerned with a letter of credit transaction.

The Confirming Bank: The confirming bank is a bank in the exporter’s country which guarantees the credit at the request of the issuing bank. The confirming bank undertakes all the obligations of the issuing bank as primary party to the credit, and even if the issuing bank fails during the currency of the credit, the confirming bank is obliged to honor its commitment.

The Notifying bank: The notifying bank is the bank which, at the request of the issuing bank, notifies the beneficiary that the credit has been opened in his favor. If the letter of credit is confirmed bank advises the beneficiary accordingly.

The Paying bank: The paying bank on which the draft or bill of the exchange is to drawn under the commercial credit. The paying bank may be the issuing bank, the confirming bank or the notifying bank.

The Negotiating Bank: The negotiating bank is the bank which pays or accepts the drafts of the exporter. If no paying bank is specified in the credit, the beneficiary may go to any bank and present the draft and related documents under the credit; and if the bank agrees to negotiate the documents, it becomes the negotiating bank. By negotiating drafts, the negotiating bank becomes “an endorsee and bonafide holder” of the draft and has recourse on the drawer of the bill until it is accepted and paid by the drawee.

Kinds of Letters of Credit:

There are different kinds of letters of credit (L/C). The important classifications are mentioned below:

Clean Letter of credit: This kind of letter of credit may be negotiated against a clean draft. A clean draft is draft without any documents attached to it.

Documentary Letter of credit: Under the documentary letter of credit, the draft must be accompanied by the documents in the letter of credit.

Assignable Credit: Under this kind of L/C, the beneficiary may assign his rights to another beneficiary, either within a stated period or before the expiry date of the credit.

Non-Assignable Credit: As opposed to the assignable credit, the named beneficiary of a non-assignable L/C cannot transfer his rights to another party.

Cash credit: Under the cash credit, the exporter may draw a sight daft on the bank. The great advantage of this type of credit, therefore, is that the beneficiary will receive cash for his draft as soon as goods are ready for shipment and the relevant documents in proper order are represented to the bank.

Acceptance Credit: Under this arrangement, the bank merely “accepts” the drafts drawn by the exporter. After it has been accepted by the bank, the draft becomes a bank acceptance, which may be readily discounted or sold by the exporter to the accepting bank to other banks or to exchange dealers.

Revocable Credit: The revocable letter of credit may be revoked or cancelled at any tm without the consent of, and without notice to, the beneficiary. As the revocable L/C does not adequately protect the beneficiary, exports on the basis of this type of L/C are not common.

Irrevocable Credit: An irrevocable L/C is one which cannot be revoked amended or modified by the issuing bank without the express consent of all the parties concerned. An irrevocable credit is a definite undertaking on the part of the issuing bank and constitutes the engagement of that bank to the beneficiary of any bonafide holders of the drafts drawn under the credit, provided that the terms and conditions of the credit re complied with.

Confirmed Credit:
If the L/C is confirmed by a bank in the beneficiary’s country, it becomes a confirmed credit. In this case, the bank issuing the L/C sends it through its branch or correspondent bank located in the beneficiary’s country with the request to add its Confirmation to the credit. Confirmation constitutes a definite and legal undertaking on the part of the confirming bank that it will duly honor the payment or acceptance, as the case may be, on presentation of stipulated documents.

Back-to- back Credit: A back-to-back credit is essentially a secondary credit, opened by a bank on behalf of the beneficiary of an original credit, in favor of a domestic supplier. The original credit backs another credit and facilities the purchase of the goods from a local supplier by the beneficiary of the original L/C.

Revolving Credit: A revolving credit is designed to obviate the need for establishing new credit for each shipment when the transactions are more or less continuous. Under the revolving credit, provision may be made for making available the credit again as soon as the importer reimburses the issuing bank with the drafts already negotiated by the paying bank.

Red Clause Credit: The red clause L/C enables the beneficiary to draw a predetermined value of the L/C as soon as it is established. The ‘red clause’ is an authority to the negotiating bank to make advances to the beneficiary for the purpose of purchasing the relevant goods. The conditions on which such advances may be made are incorporated in the L/C.

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  • Sourojitroy

    Thanks for such a nice explanation and document.