Letters of credit are used for the purpose of substituting a customer’s credit for that of the banks. This transaction provides the ability to facilitate a trade. Letters of credit are often used for international trading, where a seller lives in one country and the buyer lives in another. There are essentially two types of letters of credit – the commercial letters of credit and the standby letters of credit. The primary payment used for a transaction is the commercial letters of credit and the standby letters of credit are considered as the secondary payment option.
Commercial Letters of Credit
A commercial letter of credit has been used for hundreds of years as a way to facilitate payments for international trading. As the global economy is continuing to evolve, the letters of credit will continue to be used.
The governing agency of commercial letters of credit is the International Chamber of Commerce Uniform Customs. The provisions and definitions of the documents are binding for all parties that are involved in the transaction.
The document is a contract agreement between the bank that issues it and one of their customers. The letter of credit authorises the confirming bank to make the payment. A customer will request that the issuing bank open the letter of credit and the bank will commit to honour the drawings that are made through the credit. Typically, the provider of the service or goods will be the beneficiary. Simply put, the issuing bank is replacing their customer as the payer. Letters of credit act as a guarantee for suppliersand an international finance corporationcan routinely issue these.
Letter of Credit Elements
1. Issuing bank undertakes a payment on behalf of the applicant in order to pay the seller a set amount of money
2. If specified, documents that represent the goods that are supplied are presented within the specified time frame
3. Documents have to meet the terms and conditions as set out in the letter of credit document
4. The documents have to be presented in a place that is specified.
If the beneficiary provides the necessary documents as evidence as stated in the letters of credit, he/she is entitled to payment. Letters of credit are distinct and separate documents from the sales contract that it is based on. The parties will deal with documents and not with goods and the issuing bank cannot be held liable for the contract that has been set between the customer and the beneficiary. The obligation of the bank is to inspect the documents in order toensure that they meet the terms and conditions that were set for the credit. If the bank finds that the conditions have been met it will issue the payment as directed.
Characteristics of the Letter of Credit
Typically a letter of credit will be negotiable. The bank that issues the letter will be obligated to pay the beneficiary, as well as the bank that is nominated by the beneficiary. The instrument can be passed between parties in the same manner as money exchanging hands. In order for the letter to be negotiable there will need to be a clause that states there is an unconditional promise to make a payment on demand or within a specified time.
When creating a letter of credit the parties may choose to make it irrevocable or revocable. Revocable letters can be changed at any time for any reason, without notification from the issuing bank. This type of letter may not be confirmed.
If the letter is irrevocable it cannot be changed unless all parties agree. This type of letter is insurance for the beneficiary, stating that if the correct documents are presented payment will be made.