A documentary letter of credit is issued by a bank or a financial institution, giving assurance to the supplier (beneficiary) that they will receive payment up to the amount stated in the letter of credit, provided that a compliant presentation is made under the LC. It is a form of guarantee issued as a document by a bank to another, undertaking the liability to make a payment to the nominated bank of beneficiary in case of default by the party. It is a negotiable instrument and a very important document used in international trade. The payments are however made only if the obligated terms and conditions are precisely met.
The parties to a letter of credit are the supplier (beneficiary), an advising bank, of whom the beneficiary is usually a client, and the issuing bank, of whom the buyer (applicant) is a client.
This financial instrument is mostly used in international transactions, where the buyer and the supplier relationship is rather new and are operating in different countries.
The laws differ in various countries and also it is not possible to verify each party individually in such a case, thus making letter of credit a highly useful instrument. It being a negotiable instrument is allowed to freely pass to another party just like money.
Not just banks and financial institutions but also insurance companies issue letters of credit. The transactions of letters of credit is overseen by the International Chamber of Commerce.
A letter of credit is a very important financial instrument used to meet short term needs which allows its recipient to obtain the necessary credit for financing his project with hopes of generating enough return from it to settle the due amount in the given time frame.
A letter of credit specifically states which documents and information are required by the beneficiary upon presentation, including the date and place the letter of credit expires. By submitting a compliant presentation, the letter of credit provides the beneficiary the requisite guarantee assuring them to be paid if the required conditions for document delivery have been met.
The bank which writes or issues a letter of credit on behalf of the buyer (applicant) must now make sure the conditions for all documentation under the credit are duly met before paying the supplier.
Letters of credit are usually governed by the rules of the International Chamber of Commerce (ICC).The specific rules for letters of credit are known as the Uniform Customs and practice for documentary Credit (UCP). The version currently in effect is UCP600, since July 1st, 2007.
Letters of credit at sight requires the payment made upon presenting of the trade documents of the commodities being exported. Usance letter of credit refers to the time period, permitted by the custom, from the bill's date to its payment. The document covers all the details of the mode of payment. It is also applied to many goods purchased on credit also technically known as company's accounts payable. The goods and the bill are delivered immediately but the company gets a time of up to 30 days to make the payment.
Usance letter of credit permits payment set at a future date as according to the established contract of sale to the beneficiary. Similar to other types of debt instruments, usance letters of credit are open to advance settlement on the request of recipient and usually without attracting a penalty. The major benefit of a usance letter of credit to other debt instruments is the lower interest rate than most of them. However, this depends upon conditions and country of business.