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TMI BlogLetter of Credit (LOC): An OverviewX X X X Extracts X X X X X X X X Extracts X X X X ..... Letter of Credit (LOC): An Overview X X X X Extracts X X X X X X X X Extracts X X X X ..... ment and present the proper documentation. Key Aspects of a Letter of Credit (LOC) 1. Parties Involved in a Letter of Credit The major parties involved in an LOC are: * Applicant (Buyer): The buyer who requests the issuance of the letter of credit, usually a company purchasing goods or services. * Beneficiary (Seller): The seller or exporter of the goods or services who will receive the payment as per the terms of the letter of credit. * Issuing Bank: The bank that issues the letter of credit on behalf of the buyer (applicant). This bank guarantees payment to the seller once the required documents are presented. * Advising Bank: A bank (often in the seller's country) that notifies the beneficiary about the issuance of the letter ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... of credit. The advising bank may or may not also confirm the LC. * Confirming Bank: This bank (which can be the advising bank or another institution) adds its guarantee to the letter of credit, ensuring the payment will be made even if the issuing bank fails to fulfil its obligations. * Paying/Negotiating Bank: The bank that will make the payment to the seller, usually once the seller presents the correct documents. 2. Types of Letters of Credit * Revocable vs. Irrevocable LOC: * Revocable Letter of Credit: Can be amended or cancelled by the buyer or issuing bank at any time without the consent of the seller. * Irrevocable Letter of Credit: Cannot be changed or cancelled without the agreement of all parties (buyer, seller, and th ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... e banks). It provides more security to the seller. * Confirmed vs. Unconfirmed LOC: * Confirmed Letter of Credit: A third-party bank (the confirming bank) adds its guarantee to pay the seller, in addition to the issuing bank's guarantee. * Unconfirmed Letter of Credit: Only the issuing bank guarantees payment. The seller has to rely on the creditworthiness of the issuing bank. * Sight vs. Usance (Time) Letter of Credit: * Sight Letter of Credit: Payment is made immediately when the required documents are presented by the seller to the bank. * Usance (Time) Letter of Credit: Payment is deferred, usually after a certain period (e.g., 30, 60, or 90 days), following the presentation of the required documents. * Standby Letter of C ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... redit: Functions as a backup payment mechanism, typically used as a guarantee in case the buyer fails to fulfil their payment obligations. * Revolving Letter of Credit: A LOC that automatically renews or replenishes after each payment or on a set schedule. Typically used for regular, repeat transactions. 3. Key Terms and Conditions in a Letter of Credit * Amount and Currency: Specifies the amount of money that will be paid to the seller and the currency of payment. * Expiry Date: The date by which the beneficiary must submit the required documents. After this date, the LOC becomes invalid. * Documents Required: Specifies which documents must be presented by the seller to receive payment. These may include: * Commercial invoice ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... * Bill of lading (indicating shipment of goods) * Insurance certificate * Certificate of origin * Inspection certificate * Packing list * Terms of Payment: Specifies whether payment is made upon sight (immediately after document presentation) or at a future date (e.g., after 30 days). * Shipment Conditions: Specifies shipping terms, such as the mode of transport, delivery point, and the time frame for shipment. * Discrepancy Rules: Addresses what happens if there is any discrepancy in the documents presented. Minor discrepancies may still allow the letter of credit to be honoured, while major discrepancies may cause the LOC to be invalid. 4. Process of Issuance and Payment Under a Letter of Credit a. Application and Issuance ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... * The buyer and seller agree on the terms of the sale and the use of a Letter of Credit. The buyer applies for the LOC through their bank (the issuing bank). * The buyer's bank reviews the buyer's creditworthiness and issues the LOC, which is sent to the advising bank. b. Notification to the Seller * The advising bank notifies the seller (beneficiary) about the issuance of the letter of credit, explaining the terms and conditions. * If the seller agrees to the terms, they ship the goods and prepare the necessary documents. c. Document Submission * The seller presents the required documents (such as the bill of lading, commercial invoice, etc.) to the bank. * The bank checks the documents against the terms of the letter of cre ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... dit for discrepancies. d. Payment * If the documents are in order, the bank will make payment to the seller (via the paying/negotiating bank). * If a sight LOC is used, payment is made immediately; if a usance LOC is used, payment is made at the end of the specified term. e. Reimbursement * The issuing bank reimburses the advising or confirming bank for the payment made to the seller. 5. Advantages of a Letter of Credit * For Sellers (Exporters): * Ensures payment: The seller is guaranteed payment if they comply with the terms. * Reduces risk: Eliminates the risk of non-payment, especially when dealing with unfamiliar buyers. * Encourages new business: Sellers may be more willing to deal with new customers who offer a lette ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... r of credit. * For Buyers (Importers): * Builds trust: Buyers can negotiate favourable terms with sellers by using a letter of credit. * Flexible payment terms: Some LOCs allow deferred payment, helping manage cash flow. * Protects against fraud: Since payment is only made after the required documents are presented and verified, it helps avoid fraud. 6. Disadvantages of a Letter of Credit * For Sellers: * Cost: The seller may have to pay for the fees associated with the letter of credit. * Complexity: The document requirements and processes may be complex and time-consuming. * For Buyers: * High costs: The buyer may incur substantial fees for opening and maintaining the letter of credit. * Risk of fraud: If not properly ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... verified, incorrect or fraudulent documents could be presented to the bank. * For Both Parties: * Delays: The process of document verification and payment could delay the transaction, especially if there are discrepancies. * Bank Fees: Both buyer and seller will likely incur fees, such as issuance, amendment, and confirmation fees. 7. Common Issues and Discrepancies in Letters of Credit * Documentary Discrepancies: If any document does not conform to the terms of the letter of credit, the bank may refuse to honour the LOC. Common discrepancies include mismatched names, incorrect dates, or incomplete documentation. * Fraudulent Documents: In rare cases, fraudulent or forged documents may be presented. * Time Limits: The LOC is ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... typically time-sensitive. Any delay in submitting the documents can lead to the rejection of the payment.
Conclusion: A Letter of Credit (LOC) is a widely used financial tool that facilitates international trade by providing security to both buyers and sellers. By acting as a payment guarantee, an LOC helps mitigate risks related to non-payment and ensures that both parties meet their contractual obligations. However, it also comes with its own complexities, fees, and requirements, which both parties need to carefully understand and follow to ensure smooth transactions. X X X X Extracts X X X X X X X X Extracts X X X X
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