LC: Full Form, Types, Advantages and Disadvantages

What is LC?

LC is defined as a financial document commonly utilised in international trade and commerce. It functions as an official commitment from a bank or other financial organisation on behalf of a buyer to pay a seller, a certain amount of money after a few requirements are satisfied. In a trade transaction, LC offers protection and security to both parties, particularly in situations when they may not have a formal business relationship and are in different countries.

Full Form of LC

LC stands for Letter of Credit. LC is defined as a financial document commonly utilised in international trade and commerce. It functions as an official commitment from a bank or other financial organisation on behalf of a buyer to pay a seller, a certain amount of money.

Elements of Letter of Credit (LC)

1. Beneficiary (Seller): The person to whom the Letter of Credit has been issued is the beneficiary.

2. Applicant (Buyer): The person who asks the bank to issue the Letter of Credit on their behalf.

3. Issuing Bank: The applicant’s bank, which is in charge of opening and issuing the Letter of Credit, is the issuing bank. Its responsibilities include confirming the applicant’s reliability, providing the LC, and making sure the terms and conditions match the instructions provided by the application.

4. Advising Bank: The bank that serves as the link between the beneficiary and the issuing bank is the advising bank, and it is situated in the beneficiary’s nation. It notifies the beneficiary of the LC’s existence and may, if necessary, confirm the LC.

5. Expiration Date: The last day for the beneficiary to deliver the necessary paperwork to the bank to receive payment is known as the LC’s expiration date.

6. Documents Needed: The LC outlines all the paperwork the recipient has to bring to the bank in order to get paid. Invoices, bills of shipment, certificates of origin, inspection documents and packing lists are examples of common paperwork.

7. Amount: Upon fulfilment of the terms and conditions of the LC, the beneficiary will receive the amount specified in the LC.

8. Currency: The LC specifies the currency that will be used for the transaction.

9. Location of Presentation: This is the address where the beneficiary has to show the bank, typically the advising bank, all the necessary paperwork.

Features of Letter of Credit (LC)

1. Payment Guarantee: An LC gives the seller a guarantee that they will be paid.

2. Third-Party Involvement: To facilitate and secure the transaction, at least three parties are involved in any LC, the buyer, the seller and a bank.

3. Costs and Fees: The issue and management of an LC can result in costs and fees for the buyer and seller, including issuance, negotiation and confirmation fees.

4. International Trade: To reduce the risks involved with cross-border transactions, legal system disparities and payment security issues, LCs are frequently used in international trade.

5. Legal Obligation: As long as the submitted documents comply to the terms and conditions stated in the LC, banks are required to fulfil the LCs, which are legally binding agreements.

6. Documentary Transaction: Invoices, bills of shipment, inspection documents and other relevant proof may be required in order for payment to be completed.

7. Terms and Conditions: The terms of the LC include the payment amount, the deadline for presenting papers, the shipment and delivery information and any additional particular requirements that have been agreed upon by the seller and the buyer.

Types of Letter of Credit (LC)

1. Irrevocable Letter of Credit: An irrevocable LC offers the seller the highest level of security and cannot be changed or revoked without the approval of all parties.

2. Revocable Letter of Credit: A LC that is revocable may be altered or terminated by the issuing bank without the seller’s approval.

3. Transferable Letter of Credit: A transferable letter of credit (LC) enables the original seller to assign all or a portion of the LC to another party.

4. Non-Transferable Letter of Credit: A LC that is not transferable prohibits the original recipients from assigning any portion of the LC to a different entity.

5. Red Clause Letter of Credit: An LC with a red clause contains a unique provision that permits the seller to receive payment in advance prior to the items being sent.

6. Green Clause Letter of Credit: A green clause letter of credit features a provision that allows both an advance payment and after the products have been dispatched, the purchase of extra goods or services.

7. Confirmed Letter of Credit: A confirmed LC includes a confirming bank that adds its own guarantee to the LC on top of the issuing bank’s guarantee.

8. Unconfirmed Letter of Credit: An unconfirmed LC is entirely dependent on the guarantee provided by the issuing bank. Even if the seller still has some security, it can be viewed as riskier than an LC that has been confirmed.

9. Back-to-Back Letter of Credit: In this, a seller who is also a buyer may secure a second LC to pay for products from their own suppliers by using the first LC as security.

How does Letter of Credit (LC) works?

Letter of Credit (LC) works in a following manner:

1. Agreement: For a specific commercial transaction, the buyer and seller agrees to use a Letter of Credit as a payment method.

2. Issuance: The buyer asks their bank to grant the seller a Letter of Credit. The terms and conditions of the LC are established by the bank once it has evaluated the buyer’s worthiness.

3. LC Terms: Various information will be provided in the Letter of Credit, such as the amount to be paid, the products or services to be supplied, the dates of shipment and payment and any additional relevant information.

4. Presentation of Documents: The seller ships the items and gives their own bank the necessary paperwork such as invoices, bills of lading and inspection certificates after meeting the terms stated in the LC.

5. Examination: To make sure the documents comply to the requirements of the LC, the seller’s bank reviews them. The buyer’s bank receives the documentation if everything is in order.

6. Payment: After checking all the paperwork and confirming that it satisfies the LC’s requirements, the buyer’s bank can transfer funds to the seller’s bank.

7. Release of Goods: The seller may release the goods to the buyer upon receipt of payment or a guarantee of payment from the buyer’s bank.

Examples of Letter of Credit (LC)

1. Import of Electronics: A major items of cellphones from a US company is intended for import by an electronics shop in India. The retailer opens an irrevocable and verified Letter of Credit through their bank to guarantee payment to the manufacturer. The amount of smartphones, quality requirements, delivery conditions and documentation needed for payment are all detailed in the LC. The American manufacturer ships the devices, gets the required paperwork to their American bank and the LC is recognised, guaranteeing the company gets paid.

2. Supplier Financing: An Indian garment merchant purchases clothing from a Bangladeshi producer. The factory receives a standby Letter of Credit from the retailer, who has a track record of creditworthiness, giving its suppliers financial certainty. As the standby LC guarantees payments to suppliers in the event that the facility fails to pay, this enables the factory to acquire labor and raw materials without requiring advance payment.

Importance of Letter of Credit (LC)

1. Risk Mitigation: LCs helps in reducing risks for buyers and sellers equally.

2. Facilitation of International Trade: By offering a standard and safe payment option, LCs promote international trade.

3. Seller Security: LCs offer sellers a high degree of payment security, particularly when working with new buyers or in areas with erratic political or economic situations. They guarantee sellers that they will be paid as long as they stick to the provisions of the LC.

4. Payment Guarantee for Buyers: Buyers are guaranteed not to receive payment until the seller satisfies the certain requirements stated in the LC.

5. Reduced Currency Risk: As LCs can be issued in multiple currencies, buyers and sellers may negotiate for the one that best fits their needs.

6. Trust in Cross-Border Transactions: LCs promote trust in global trade by motivating companies to do cross-border transactions that they otherwise might not have done in the absence of this safe payment method.

7. Verification of Documents and Compliance: These processes aid in making sure that the right products or services are provided, meeting quality standards as well as all regulatory and legal responsibilities are fulfilled.

Advantages of Letter of Credit (LC)

1. Financing Access: LCs can be used by buyers and sellers to obtain financing. While sellers may utilise the LC as security to secure loans or credit lines, buyers can negotiate terms for delayed payments.

2. Trust in Trade: LCs establish mutual trust between parties, which promotes trust in transactions across borders and encourages companies to go into new markets and participate in international trade.

3. Payment Security: The high degree of payment security that LCs offer to the seller is one of their main benefits.

4. Risk Mitigation: LCs assist in reducing a number of the risks connected to global trade, such as fluctuations in currencies, political unpredictability and breach of contract.

5. International Trade Facilitation: LCs let parties to trade with confidence by bridging the trust gap that exists between buyers and sellers in various nations.

Disadvantages of Letter of Credit (LC)

1. Not Suitable for All Transactions: LCs might not be the best option in all situations, particularly if the buyer and seller have an established connection and level of confidence.

2. Possibility of Fraud: Although LCs are intended to offer security, fraud can still occur, thus parties should proceed with caution and proper investigation.

3. Time-Consuming Process: LC agreements may not be appropriate for transactions that need to be processed quickly because they need the creation, examination and approval of documents by banks.

4. Lack of Direct influence: As the LC is a bank-to-bank transaction, the seller has little direct control over the process and it may take some time to settle any complaints.

5. Cost and Complexity: Setting up an LC can be difficult because there are fees and charges associated with confirmation, issuance and amendment.