Letter of credit Explanation

Letter of credit From Wikipedia, the free encyclopedia After a contract is concluded between buyer and seller, buyer's bank supplies a letter of credit to seller. Seller consigns the goods to a carrier in exchange for a bill of lading. Seller provides bill of lading to bank in exchange for payment. Seller's bank exchanges bill of lading for payment from buyer's bank. Buyer's bank exchanges bill of lading for payment from buyer. Buyer provides bill of lading to carrier and takes delivery of goods. Definition: A letter of credit is an irrevocable payment undertaking of an issuing bank issued to a beneficiary upon request of an applicant for supply of goods, services or performance with documents stated in the letter of credit presented to the issuing bank, a nominated bank or confirm‎ing bank, if any, within the expiry date of the letter of credit or within a stated number of days after shipment, where applicable, in full compliance with the terms and conditions of the letter of credit, the applicable UCP and international standard banking practice. It is a legally enforceable obligation or undertaking on the part of the issuing bank and is not a contract (although it is sometimes mistakenly referred to as such). A letter of credit, often abbreviated as an LOC ,LC or L/C, and also referred to as a documentary credit, often abbreviated as DC or D/C,documentary letter of credit, or simply as credit (in UCP 600 which is effective as from 1st July 2007) is a document issued mostly by a financial institution which provides an irrevocable payment undertaking to a beneficiary against complying documents as stated in the credit. This means that once the beneficiary or a presenting bank acting on its behalf, makes a presentation to the issuing bank or confirm‎ing bank, if any, within the expiry date of the LC, comprising of documents complying with the terms and conditions of the LC, the applicable UCP and international standard banking practice, the issuing bank or confirm‎ing bank, if any, is obliged to pay irrespective of any instructions from the applicant to the contrary. In other words, the obligation to pay is shifted from the applicant to the LC issuing bank or confirm‎ing bank, if any. Non-banks can also issue LC. The LC can also be the source of payment for a transaction, meaning that an exporter will get paid by redeeming the letter of credit. Letters of credit are used nowadays primarily in international trade transactions of significant value, for deals between a supplier in one country and a wholesale customer in another. They are also used in the land development process to ensure that approved public facilities (streets, sidewalks, stormwater ponds, etc.) will be built. The parties to a letter of credit are usually a beneficiary who is to receive the money, the issuing bank of whom the applicant is a client, and the advising bank of whom the beneficiary is a client. Since nowadays almost all letters of credit are irrevocable, (i.e. cannot be amended or cancelled without prior agreement of the beneficiary, the issuing bank and the confirm‎ing bank, if any). However, the applicant is not a party to the letter of credit. In executing a transaction, letters of credit incorporate functions common to giros and Traveler's cheques. How it works Let us imagine that a business called Acme Electronics from time to time imports computers from a business called Beijing Computers, which banks with the Shanghai Business Bank. Acme holds an account at Commonwealth Financial. Acme wants to buy $500,000 worth of merchandise from Beijing Computers, who agree to sell the goods and give Acme 60 days to pay for them, on the condition that they are provided with a 90-day LC for the full amount. The steps to get the letter of credit would be as follows: Acme goes to Commonwealth Financial and requests a $500,000 letter of credit, with Beijing Computers as the beneficiary. Commonwealth Financial can issue an LC either on approval of a standard loan underwriting process or by Acme funding it directly with a deposit of $500,000 plus fees between 1% and 8%. Commonwealth Financial sends a copy of the LC to Shanghai Business Bank, which notifies Beijing Computers that payment is ready and they can ship the merchandise Acme ordered with full assurance of payment. On presentation of the stipulated documents in the letter of credit and compliance with the terms and conditions of the letter of credit, Commonwealth Financial transfers the $500,000 to Shanghai Business Bank, which then credits the account of Beijing Computers by that amount. Note that banks deal only with documents under the letter of credit and not the underlying transaction. If the stipulated documents are presented and the terms and conditions of the letter of credit are met, then the issuing bank is obligated to pay under the letter of credit, even if the underlying transaction is not fulfilled. Also the bank is not required to pay if the stipulated documents are not presented or the terms and conditions of the letter of credit are not met, even if the underlying transaction was fulfilled.