Take advantage of secure payment guarantees
How a Letter of Credit Works
A Letter of Credit is a secure method of payment between a buyer and a seller.The buyer transfers funds to the bank, the bank reserves them, and releases payment to the seller only after receiving documents that confirm shipment of goods or provision of services.
This ensures that:the seller is guaranteed to receive payment,the buyer pays only for obligations that have been duly fulfilled.
Benefits
Avoids the risk of losing funds
Guarantees the receipt of payment, goods, performance of services
Provides legal and documentary protection for the parties
1. Goods Supply Contract
2. Application for L/C issuance
3. L/C issuance
4. L/C advising to the beneficiary
5. Shipment of goods
6. Documents are received by the financing bank
7. Payment
8. Documents and loan repayment schedule
9. Documents are handed over to the applicant
10. Repayment of the principal according to the schedule
Parties - participants in the L/C
Applicant (Importer/Buyer) - a party opening the L/C.
- Beneficiary (Exporter/Seller) - a party in favour of whom the L/C is opened.
- Issuing bank - a bank opening the L/C (Applicant's bank).
- Advising bank - a bank that transfers the L/C terms and conditions to the beneficiary, as a rule, it is the beneficiary's bank.
- Confirming bank a bank adding its confirmation to the L/C issued by the issuing bank.
- Nominated bank - a bank, where the beneficiary must present the documents for payment. In other words, it is the bank that makes a payment to the beneficiary. As a rule, the nominated bank is the confirming bank, but it can also be another bank.
Irrevocable L/C - can be revoked by the Applicant only with the beneficiary's and the confirming bank's consent (if any).
Unconfirmed L/C - only the issuing bank is liable for payment to the beneficiary. In other words, the beneficiary is dependent on the issuing bank's creditworthiness.
Confirmed L/C - the issuing bank's obligation is confirmed by a third confirming bank. Before adding its confirmation to the L/C, the confirming bank must verify the issuing bank's creditworthiness, as the issuing bank's inability to fulfill its irrevocable commitment (due to change of political regime in the country, military operations, insolvency or other reasons) does not release the confirming bank from its irrevocable commitment to pay the beneficiary
L/C at sight
The beneficiary presents the documents to the nominated bank, which according to UCP 600 has the right to check them within 5 banking days. If there are no discrepancies in the documents, the nominated bank credits the amount of the documents to the beneficiary's account.
Deferred payment L/C
Letter of Credit can be opened with deferred payment, which is agreed between the buyer and the seller. Deferred payment is very favourable to the buyer, as it enables the buyer to have sufficient funds on the expected payment date through the resale of goods, their processing or through the sale of goods produced with the help of the equipment received under the L/C.
The beneficiary grants a payment deferral to the applicant, e.g. for 30 or 60 days from the date of shipment. The documents presented by the beneficiary (strictly complying with the L/C terms) must be accepted by the nominated bank, and the latter must confirm the future payment date in writing. The L/C documents can be discounted or negotiated by the beneficiary bank (also by the confirming or issuing bank), i.e. the amount of the documents can be paid to the seller/exporter before the due date under the LC. Discounting is most often used in deferred payment letters of credit to ensure that the seller receives payment immediately after the goods are shipped. If discounting is made by the confirming or nominated bank, the issuing bank will pay the amount within the timeframe specified in the L/C.
Transferable L/C
A letter of credit, the scheme of which is as follows: buyer-seller/intermediary (first beneficiary)-supplier (second beneficiary). That is, the buyer opens a letter of credit in favour of the intermediary, which is called "transferable" (initial/original letter of credit). The intermediary, in its turn, can transfer the letter of credit opened in its favour either in one amount to the second beneficiary or in several amounts to several second beneficiaries, but up to the amount of the initial L/C.
A transferable L/C may be transferred only on the terms and conditions indicated in the original L/C, except for: the L/C amount, the unit price, the L/С validity period, the document submission deadline, and the shipment period. Any or all of these items may be reduced or decreased.
Revolving L/C
This L/C is used when the buyer and the seller enter into a long-term contract under which the goods are shipped at certain intervals in fixed batches for a certain amount. To avoid unnecessary costs, the buyer in this case opens one "revolving L/C" instead of several L/Cs. The L/C can be revolved either automatically or upon notice of revolvement.
Moreover, a mixed form of payment can be used for L/C settlement, providing for both partial payment immediately after submission of shipping documents to the bank, and subsequent payments in installments or in one sum within the period specified in the L/C.
The L/C allows the use of a "red clause", i.e. a condition when a part of the L/C amount is paid to the seller as an advance payment. The use of "red clause" is convenient when the seller needs to receive funds to make an advance payment for transportation company services, customs procedures related to the goods shipment, certification or other expenses.