One of the most known ways for payments, especially in the field of international trade, is the use of a quality called LC .The term LC, which stands for Letter of Credit, or more precisely, the Documentary Letter of Credit, is a method of payment in which there is a definite commitment to pay out by the issuing bank and is given to the buyer and seller, whereby the bank pledges that the buyer’s payment will be given to the seller at a specified time and with the same amount agreed upon.
in a simpler definition, when the buyer and seller are located at two different countries, the seller does not want to sell the goods before the payment is made, and the buyer also wants to make no payment before delivery of the goods, the “Letter of Credit” will be formed.
In fact, this credit is a commitment from the bank that is given to the buyer and seller. Credit letters can be a guarantee of payment for a transaction, which means that the repurchase is the issuer’s credit card. LC is primarily a priority in international business transactions of a significant value, and is used for transactions between a seller in one country and a customer in another country.
LC is in fact an obligation (irrevocable / revocable) to pay some money and includes the beneficiary (the person or vendor), the bank or the financial institution of the exporter (on behalf of the customer), and the notifying bank (on behalf of the interested party).
A Letter of Credit is a financial document issued by a financial institution, mostly by a bank, which is primarily used in commercial finance and usually provides a definite payout commitment.
Suppose that the buyer, who has an account at the bank of his country, usually imports goods from the seller, who has an account at the bank in his own country. The buyer wants to buy as much as $ 500,000 from the seller and import into the buyer’s country. The vendor agrees to give the buyer a 60-day payment deadline, provided that he gives him a 90-day LC for the entire amount. The steps to get the LC are as follows:
The buyer refers to the bank of his country (where he has an account) and requests a $ 500,000 LC for the seller, who is the beneficiary.
The buyer’s country bank can issue the LC with a loan through the approval process, or by receiving money from him (as the amount of the application plus the fee, which is usually from 1% to 8% of the nominal LC amount).
Then the buyer’s country bank sends a copy of the issued LC to the seller’s country bank, which the vendor has an account in there, in the sense that the money is ready and can deliver the goods shipped to the buyer with complete assurance of payment.
The buyer’s country bank, after receiving the documents specified in LC and in accordance with its terms, transfers $ 500,000 to the bank of the seller country, which will be deposited into the seller’s account.
The issuing bank (here the buyer’s country bank) is obliged to pay the amount only when the LC documents have been received and all the LC terms are met.
In fact, the followings are the parties of the LC document:
۱٫ A stakeholder (for example, a seller), who is supposed to receive the money.
۲٫ The issuing bank, which the buyer is a client of.
۳٫ The advising bank, which the beneficiary person is a client of.
Although it is the most widely used method of payment in the field of international trade, regarding its benefits this method can also be used for domestic trading and transactions payments. The use of this method of payment in both domestic and international trade areas will be subject to a series of specific regulations.
- The seller’s assurance that he will receive the credit from the correspondent bank or the verifier, upon presentation of the credit documents in accordance with the terms of credit.
- Possibility to control the shipping and delivery date of goods.
- Studying shipping documents in accordance with the terms of the initial agreement under the terms of the contract between the parties.
- Ensuring that payment of credit to the seller is carried out only after the transfer and the waiver of ownership are done by the seller.
- Possibility to obtain more facilities for the seller for opened credit of the ordered goods.
- The bank’s commitment to pay for deals on behalf of the seller
Almost all of the LCs are irrevocable and irreversible, in the sense that it cannot be revoked or changed without the consent of the beneficiary, the issuing bank and the confirming bank.
Perhaps, documentary credits seem to be a very modern and easy way to conduct large-scale trading and trading, but it can be extremely weak and ineffective behind the curtain.
- Risk of fraud: The beneficiary may receive money by forging the shipping documents, without delivery of the goods to the buyer. Even the text of the letter itself may be manipulated and forged.
- Risk of government restrictions: LC may be stopped by governments blockings (such as sanctions).
- Natural Disasters: Contract execution may be stopped due to natural disasters or war, etc.