Letter of Credit: Meaning, Types and Risks In LC

By | December 10, 2021

A letter of credit is an instrument which is mainly used in national and international trade for sales and purchase of goods and services. So, let’s see what are the different types of letter of credit, risk associated with it and documents required to get a LC.

Letter of Credit: Meaning, Types and Risks In LC

Topics Discussed In This Article:

  • Meaning of Letter of Credit
  • Types of Letter of Credit
  • Documents Required In Letter of Credit Transactions
  • Risks in Letter of Credit Transactions

Now, let’s discuss each topics on letter of credit in detail. Let’s first understand the concept of LC.

Meaning of Letter of Credit

Letter of credit a financial tool under which buyer’s bank promises to the bank of seller or exporter that the bank will honor the invoice presented by the exporter on due date and make payment. It plays very important role in international trade.

Letter of credit is simply a written instrument issued by a bank at the request of buyer or importer, whereby bank promises to pay the exporter for goods and services, provided that the exporter presents all documents called for, exactly as stipulated in the letter of credit, and meet all other terms and conditions set out in the letter of credit.

Types Of Letter of Credit

1. Documentary Letter of Credit

In this type of letter of credit, various types of documents are required to be presented by the exporter to the importer. Generally the documents specified includes: commercial invoice, insurance policy, certificate of quality analysis, bill of lading, consular invoice, certificate of origin, packing list, bill of exchange etc. Importer’s bank make payment only when all the documents specified in the letter of credit is handed over by the exporter.

2. Revocable Letter of Credit

The letter of credit which can be easily withdrawn by the importer or importer’s bank at any time without any notice to the exporter is called revocable letter of credit. This type of letter of credit does not protect the interest of exporter.

3. Irrevocable Letter of Credit

The irrevocable letter of credit can not be withdrawn without the prior permission and intimation of the exporter. It is just opposite of revocable letter of credit. The exporter gives more preference to irrevocable letter of credit because it provides more safety to them.

4. Clean Letter of Credit

A clean letter of credit is a type of letter of credit which does not lay down any condition for making the payment. It also does not contain any terms and condition for acceptance of bill of exchange which is drawn by exporter upon the importer. It is clean in the sense that there is no condition for payment to be made.

5. Assignable Letter of Credit and Non- Assignable Letter of Credit

Assignable letter of credit is also known as transferrable letter of credit. It provides facility to the exporter to transfer and assign it to any other person. In the other hand, non assignable letter of credit can not be transferred and assigned by the exporter to another person. Only the beneficiary whose name is written on the letter of credit can get the payment.

6. Revolving Letter of Credit

When there is continuous business between exporter and importer then revolving letter of credit is used by them. Under this, credit is availed against one and same letter of credit is used for all subsequent export transactions. It eliminates the problem of issuing letter of credit again and again for the export transactions occurred between same parties.

7. Confirmed Letter of Credit

Under this, opening bank appoints a banker in the country of exporter in order to make the confirmation of credit. Exporter has the right to draw the bill of exchange on the confirming bank.

8. Back to Back Letter of Credit

An exporter at first purchase goods from manufacturer and then export it to the importer. Back to back letter of credit is issued in the favor of manufacture or supplier of goods on the request of exporter. Importer pay the money to the manufacturer or supplier rather to the exporter. Generally, merchant exporter uses such types of letter of credit to get goods for export on credit basis.

9. With or Without Resource Letter of Credit

The LC ( Letter of Credit ) which facilitates to the paying bank to hold the exporter who is responsible for recovery of payment if the importer is unable to reimburse it to the paying bank. In this case, exporter then will have to return or refund all the money he has received along with interest to the paying bank.

Documents Required In Letter of Credit Transactions

In order to receive payment, the beneficiary must present all the documents which are specified in the letter of credit by issuing bank. The required documents often includes :

– Bills of exchange

– Invoices

– Government documents such as embassy legalizations, licenses, inspection certificates, certificate of origin etc.

– Shipping and transport documents such as bill of lading, airways bill etc.

– Insurance policies or certificates.

Risks in Letter of Credit Transactions

As any monetary transactions, letter of credit transactions are also not risk free. Following are the types of risks associated with letter of credit transactions :

– Fraud risk can occurred if the payment obtained through the use of forged or falsified documents worthless or non-existent merchandise

– Regulatory risk can occurred if government actions prevent completion of the transaction

– Legal risk can occurred if any legal action prevent completion of the transaction

– Force mejeure risk can occurred if any external forces such as war or a natural disaster prevent the completion of transaction

– Due to failure of the collecting or issuing bank

– Insolvency of the buyer or beneficiary

Some Questions Answered

How Does A Letter of Credit Work?

When any trade transactions happen between international buyer and seller then a letter of credit is issued by a bank on the request of buyer in order to guarantee the seller that payment will be made on time if all necessary conditions fulfilled.

What is The Purpose of Letter of Credit

The purpose of letter of credit is to ensure successful business transactions between buyer and seller.

So, this much is for today’s discussion on letter of credit. If there is still anything not understood about letter of credit, please post your queries in the comment box below. Thank You !

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