What Is Letter Of Credit In Export Import Business?

What is LC in Export?

Think of an LC (Letter of Credit) as a bank's promise on behalf of the buyer (importer) to the seller (exporter).

If we were to put it plainly, a Letter of Credit is a legal document issued by a bank that guarantees the seller will receive payment from the buyer's bank if the seller fulfills all specified terms of the agreement.

Fundamental Principles of LC Based on Documents and Involvement of Various Parties

Knowing this part isn't enough—you must also know its fundamentals. Have a look!

1. Nature of documents: The entire LC process is based on documents, not the physical goods. This means that banks deal with documents proving shipment and compliance with the sales contract rather than inspecting the actual goods
2. Independence principle: The LC is independent of the sales or other contracts on which it may be based. Banks are not concerned with the terms of the sale, only with the terms of the LC and whether the presented documents comply with these terms
3. Good faith: All parties involved must act in good faith, ensuring that documents are genuine and not fraudulent, and that all engagements are carried out with honesty and integrity
4. Compliance: This is a critical principle where documents presented under the LC must strictly comply with its terms. The slightest discrepancy between the papers and the LC can lead to a refusal of payment
5. Equality: The LC protects all parties involved. It ensures that exporters receive payment for goods shipped, provided they comply with the LC terms, and it assures importers that they will not pay until their terms are met

Having said that, the following parties are involved in an LC:

1. The issuing bank: It guarantees payment to the seller
2. The advising bank (usually in the seller’s country): It advises the seller that the LC has been opened in their favor
3. The confirming banks, when involved: They add their guarantee to the LC issued by the issuing bank

Types of Letters of Credit

While people often ask about this, they must also understand that there are different types of LCs. We have explored the key types below.

1. Irrevocable LC

This standard form of LC cannot be amended or canceled without the consent of all parties involved. It provides a strong assurance of payment, making it a preferred choice for international transactions.

2. Revocable LC

Unlike the irrevocable LC, this type can be altered or nullified by the issuer without needing the beneficiary's consent. Due to its less secure nature, it's rarely used in international trade.

3. Confirmed LC

It offers an additional layer of security to the seller. Alongside the issuing bank's promise to pay, a confirming bank in the seller's country also guarantees payment under the LC.

4. Unconfirmed LC

In this case, only the issuing bank provides a guarantee of payment. The seller takes on the risk associated with the reliability of the foreign bank.

5. Sight LC

This LC requires the bank to pay the beneficiary immediately upon presenting and verifying the documents stipulated in the LC.

6. Usance (or Time) LC

It allows for a deferred payment, giving the buyer a set period after the document presentation to make the payment.

Comparison between LC at Sight and Usance LC

One of the most asked questions after this is what's the difference between Sight LC and Usance LC. So, before we give you an idea about more LC types, we've tabulated the differences between in-sight and Usance LCs. Have a look!

Special Letters of Credit and Their Applications (What is LC in Export?)

• Transferable LC

It is designed for use in transactions where the first beneficiary may need to transfer part or all of the LC to another party. It's ideal for intermediaries in a trade, such as trading houses.

• Revolving LC

It facilitates multiple shipments over a period, eliminating the need for separate LCs for each transaction. It's perfect for ongoing business relationships with regular deliveries.

• Standby LC

It acts more as a guarantee of payment in case the buyer fails to fulfill a contractual obligation rather than a direct payment mechanism. It's akin to a financial safety net for the seller.

• Red Clause LC

It contains a specific clause that allows the beneficiary to receive an advance on the payment before the shipment of goods. This feature is helpful for exporters who need funding to procure or produce the goods for sale.

List of Documents Needed for an LC

Now that you know this term and its different types, it's time to walk you through the documents needed to get a letter of credit.

• Commercial invoice: Details the sale transaction and pricing
• Bill of lading: A receipt for shipped goods and a carriage contract
• Insurance documents: Confirm that the shipment is insured against loss or damage
• Packing list: Provides details about the contents of the shipment.
• Certificate of origin: Verifies the country in which the goods were produced
• Inspection certificate: May be required to prove that goods were inspected and meet quality standards

Gathering documents for an LC can be a meticulous task. Let Pazago Portal streamline your document management, ensuring accuracy and saving you time for what truly matters - growing your business.

The Importance of a Letter of Credit (What is LC in Export?)

Exploring the importance of Letters of Credit (LC) in international trade is just as important as understanding it. Let's help you figure out the benefits so you know the importance of this document.

Benefits for Both Buyers and Sellers in International Trade

Understanding "what is LC in export" reveals the advantages of this document for both parties involved. Here are the details:

For Sellers/ Exporters

• Guaranteed payment: Upon fulfilling the agreed terms, sellers are assured of their payment, reducing the risk of non-payment
• Enhanced creditworthiness: Sellers can undertake more significant transactions with confidence, knowing the bank guarantees payment
• Improved working capital management: With payment assurances, exporters can better predict their cash flow, aiding in smoother operation management

For Buyers/ Importers

• Assured quality and timeliness: Payment is only made if the sellers meet the specific conditions of the LC, including quality and delivery timelines
• Financial flexibility: Buyers can negotiate better terms, such as longer payment periods, improving cash flow

Key Features and Characteristics of a Letter of Credit (What is LC in Export?)

Understanding what is LC in export and import is essential, as is understanding the main features of these letters. We've discussed the details below.

Negotiability, Revocability, Transfer, and Assignment

• Negotiability allows the beneficiary to endorse the LC to another party. It's a feature that makes the LC payable to the order of another entity upon endorsement
• Revocability refers to the ability to amend or cancel the LC without the beneficiary's consent. Irrevocable LCs, on the other hand, cannot be changed without all parties' agreement, offering more security to the beneficiary
• Transfer and Assignment features enable the rights under the LC to be transferred or assigned to another party. This is particularly useful for middlemen or agents who need to secure payment for goods they have ordered from suppliers

Sight & Time Drafts and Their Importance in Payment Terms (What is LC in Export?)

Sight Drafts and Time Drafts play pivotal roles in defining the payment terms under an LC:

• Sight drafts: Require the paying bank to pay the beneficiary immediately upon presenting and verifying the documents stipulated in the LC. They are used in Sight LCs, where payment is made as soon as the documents proving shipment and compliance with the LC terms are presented
• Time drafts (or usance drafts): They are used in conjunction with Usance LCs, allowing for deferred payment. The buyer is given a specified period after the presentation of documents to make the payment, enabling them to potentially sell the goods or use them before the payment is due

Process and Documentation (What is LC in Export?)

Now that you know a lot more than what is LC in export, it's time to tie up all the loose ends by explaining the full cycle of how an LC finally comes into existence. Tag along!

Step-by-Step Process from Issuance to Settlement of Payment

Sales Agreement

The journey begins with a sales contract between the importer and exporter, where terms, including using an LC, are agreed upon.

Application and Issuance

• The buyer applies for an LC at their bank (the issuing bank), providing a detailed list of conditions the seller must meet
• The issuing bank evaluates the application and, upon approval, issues the LC, sending it to the seller's bank (the advising or confirming bank)

Advising/Confirmation

• The advising bank verifies the authenticity of the LC and informs the seller that the LC has been issued in their favor
• If the LC is confirmed, the confirming bank also guarantees payment under the LC, adding an extra layer of security for the seller

Shipment of Goods

The seller ships the goods to the buyer and obtains the necessary shipping documents.

Document Presentation

The seller presents the required documents to their bank, which checks them against the LC terms. If compliant, the documents are forwarded to the buyer's bank.

Payment

The issuing bank examines the documents. If they meet the LC terms, the bank makes the payment to the seller's bank, which, in turn, pays the seller.

The buyer's bank releases the documents to the buyer, allowing them to take possession of the goods.

Settlement

The transaction concludes with the buyer reimbursing their bank for the payment made to the seller.

Contents of an LC at Sight and Essential Information Included (What is LC in Export?)

An LC at Sight is the most common type of LC that exporters use. Here's what it typically contains:

• Beneficiary details: Name and address of the seller
• Applicant details: Name and address of the buyer
• Description of goods: Detailed description, quantity, and pricing
• Documents required: List of documents to be presented for payment
• Terms and conditions: Specific terms under which the payment will be released
• Expiration date: The date by which all documents must be presented
• Payment details: Instruction that payment is to be made at sight upon document presentation

Important Considerations for Exporters (What is LC in Export)?

Now you know what is LC in export and its types and importance, it's natural that you are excited about the prospects of securing your trade through an LC. And just so you do it right, here's a list of considerations you must follow by heart.

• Confirm LC terms: You must review the LC terms to ensure you can meet all conditions and document requirements. Ambiguities or errors can result in non-payment
• Regulatory compliance: Both parties must ensure the LC and its terms comply with international trade regulations, including sanctions, embargoes, and anti-money laundering standards
• Document preparation: You should prepare for the meticulous collection and presentation of required documents, such as commercial invoices, shipping documents, and any certificates mandated in the LC

Also Read: Import and Export Services: Basic Guidelines and Procedures 

Fees, Charges, and Financial Aspects

Alongside understanding what is LC in export, you must also understand the financial implications of utilizing a Letter of Credit. Hence, we've created this section. Have a look at the details!

Outline of Various Fees Associated with an LC

• Issuance fee: Charged by the issuing bank to set up the LC, usually a percentage of the LC amount
• Advisory fee: Levied by the advising bank for notifying the beneficiary about the LC, which may vary depending on the bank and the complexity of the transaction
• Negotiation fee: Incurred when the beneficiary's bank checks the documents for compliance with the LC terms before payment
• Confirmation fee: Applied if the beneficiary requests the advising bank to add its confirmation to the LC, offering an additional layer of security
• Amendment fee: Charged for any changes to the LC terms after issuance, excluding cancellation or extension fees, which may be assessed separately
• Courier and communication fees: Cover the costs of sending documents and correspondence between the involved banks and parties

Worried about the costs associated with different types of LCs? With Pazago's extensive experience and network, including our partnerships with top financial institutions, enjoy competitive rates and transparent transactions, ensuring cost-effective international trade dealings.

Comparison of Bank Guarantee Versus Letter of Credit

Now that you know what is LC in export, it's only obvious that you might be confused about how it's different from a bank guarantee document. And to make sure you choose what's best for you, we've tabulated the features of both. Have a look. 

Frequently Asked Questions

Is an LC safe for both buyers and sellers?

Absolutely. For sellers, an LC offers the assurance that payment will be received as long as the terms and conditions outlined in the LC are met.

For buyers, it ensures that payment is only made once the goods have been shipped as per the agreement.

What costs are involved with an LC?

Several fees can be associated with an LC, including:

• Issuance fee: Charged by the issuing bank to set up the LC
• Advising fee: Charged by the advising bank to the seller for advising the LC
• Negotiation fee: If the bank negotiates the documents for payment, there might be a fee
• Confirmation fee: When a bank adds its confirmation to the LC, it charges a fee for this additional guarantee

Can an LC be canceled?

Yes, but it depends on the type of LC. Revocable LCs can be amended or canceled by the issuing bank without prior notice to the beneficiary. 

However, irrevocable LCs cannot be canceled or amended without the agreement of all parties involved, including the beneficiary.

Is an LC negotiable?

Yes, LCs can be negotiable, meaning the payment can be made to any beneficiary the holder designates. 

This feature is particularly useful for trading companies that might need to transfer an LC's benefits to their suppliers.

What responsibility does the buyer's bank have?

The buyer's bank, or the issuing bank, is responsible for paying the seller as long as the terms of the LC are met. Before releasing funds, the bank must examine all documents to ensure they comply with the LC terms.

Conclusion

You’ve covered enough grounds to finally understand what is LC in export! An LC is basically a promise from a bank that payment will be made to the exporter, as long as the exporter does what they agreed to in the deal. It's like having a financial safety net that makes sure exporters get paid and buyers get what they ordered. 

Although very beneficial for exporters, an LC protects all involved parties. But to benefit from an LC, traders must pay close attention to the type of LC too.

Feeling overwhelmed? Want to dive into the world of export-import but worried how complex documents like LC can get? If so, Pazago can help you. 

Our platform is designed to deliver a simplified trade experience, from managing all critical trade documents to securing competitive shipping rates. Transform your trade operations with Pazago today.