Ideally any seller of goods/services would like to receive payment before the delivery of goods/services to a buyer. Similarly the buyer would also like to ensure that the goods/services bought are as per his specifications and deliveries are effected in time, before parting with the money. If the buyer and seller are at two different, far away
stations, both the factors can not be satisfied simultaneously. As a compromise, services of third party as an intermediary are utilised. This intermediary is usually a bank who issues a letter of assurance to a seller at the request of a buyer for payment of cost of goods / services sold on certain terms and conditions. Such an assurance letter is named as a "Letter of Credit". A letter of credit is a written instrument issued by a banker at the request of a buyer (applicant) in favour of the seller (beneficiary) undertaking to honour the documents or drafts drawn by the seller in accordance with the terms and conditions specified in the credit, within a specified time. Thus the credit is made available to the seller against delivery of certain specified documents. When the credit stipulates payment of money when the documents are presented to the paying bank, the L/C is called a Documents against Payment L/C (D/P/ L/C). If the credit stipulates the delivery of documents by the seller against acceptance and that the payment will be made on the due date, the L/C is called a usance L/C or D/A L/C.
- Following are the parties to a letter of credit :
Applicant : The buyer of the goods/services (borrower) - Opening Bank : The Bank/Branch which lends its name/credit.
Advising Bank : Opening bank's branch or another bank at beneficiary's place to whom the Letter of Credit is sent for onward transmission to the beneficiary - Seller/Beneficiary : The party to whom the credit is addressed (seller or supplier of the goods/services)
- Negotiating Bank : Opening bank's branch or another bank who negotiates the documents.
- Confirming Bank : The bank adding confirmation to the letter of credit.
The different types of letters of credits which banks generally issue are :
- Inland L/C : An L/C where all the parties to an L/C are located within the country.
- Foreign L/C : An L/C where either the opener or the beneficiary is located outside the country of issue and arising out of export or import of goods/services out of/into the country of issue.
- Revocable : A credit that can be cancelled or amended at any time without the prior knowledge of the beneficiary.
- Irrevocable : It is a definite undertaking of the issuing bank to honour documents strictly drawn as per terms and conditions of credit which cannot be amended or cancelled without the agreement of all the parties to the credit, in particular the beneficiary.
- Confirmed : Where credits carry the confirmation of the
advising bank. It constitutes a definite undertaking of
such confirming bank in addition to that of the opening bank. - Transferable : A transferable credit is a credit under which the beneficiary (first beneficiary) may request the bank authorized to pay, incur a deferred payment undertaking, accept or negotiate (the "Transferring Bank"), or in the case of a freely negotiable credit, the bank specifically authorized in the credit as transferring bank, to make the credit available in whole or in part to beneficiary(ies) second beneficiary/beneficiaries
- Acceptance : Where the payment is to be made on the maturity date calculated on/after in terms of the credit.
(viii) Revolving : Which provide that the amount of drawings made there under would be reinstated and made available to the beneficiary again and again for further drawings during the currency of credit, up to a certain sum