WHAT IS A LETTER OF CREDIT?
A Letter of Credit (LC) is a document issued by a bank or other financial institution to another party that provides evidence of financial obligations. It can be used in international trade between parties who have no direct contact, such as buyers and sellers that do not have a physical presence in each other’s country.
In the United Arab Emirates (UAE), documentary credits are governed by Federal Law No. 18 of 1993, the Commercial Transactions Law. Letter of Credit is referred to as ‘Lifeblood of International Commerce’.
Letter of Credit can be stated as a contract in which the issuing bank approves to provide a substantial amount of finance at a precise period when the applicant requests for the payment. The financed amount will be provided in the name of the seller of the goods who is also known as the beneficiary. This financial assistance is secured by document that represents goods are being shipped or being prepared for the shipment.
Trade financing has become increasingly common in the UAE, and most local and international banks offer services to small and medium-sized enterprises, allowing them to trade with local and international markets. Commercial Letters of Credit (LCs) are extensively used as a means of
TYPES OF LETTER OF CREDITS
- Revocable letter of credit
- Irrevocable letter of credit
- Back-to-Back Letters of Credit
- Import letter of credit
- Export letter of credit
- Revolving letter of credit
-
Revocable Letter of credit
In this type of letter of credit, the credit can be canceled or amended at any time. Finally, it shall not hold any liability with regards to the beneficiary. Once the terms and conditions and documents are met the letter of credit is honored. It is generally used to provide guidelines for the shipment.
-
Irrevocable Letter of credit
An irrevocable letter of credit cannot be revoked without the agreement of the beneficiary, issuing bank, and the confirming bank. It provides a fine relationship between the bank and the beneficiary. Therefore, this kind of Letter of Credit assures security to the beneficiary regarding the payments.
-
Back-to-Back Letters of Credit
Back-to-back letters of credit consist of two letters of credit (LoCs) used together to finance a transaction. A back-to-back letter of credit is usually used in a transaction involving an intermediary between the buyer and seller, such as a broker, or when a seller must purchase the goods, it will sell from a supplier as part of the sale to his buyer.
Back-to-back letters of credit are actually made up of two distinct LoCs, one issued by the buyer’s bank to the intermediary and the other issued by the intermediary’s bank to the seller. With the original LC from the buyer’s bank in place, the broker goes to his own bank and has a second LC issued, with the seller as the beneficiary. The seller is thus ensured of payment upon fulfilling the terms of the contract and presenting the appropriate documentation to the intermediary’s bank. In some cases, the seller may not even know who the ultimate buyer of the goods is. Back-to-back LCs essentially substitute the two issuing banks’ credit to the buyer’s and intermediary’s and thus help facilitate trade between parties who may be dealing from great distances and who may not otherwise be able to verify one another’s credit.
-
Import letter of credit
Import Letters of Credit are the most common method of import financing. An Import Letter of Credit is a financial instrument issued by a bank that represents the commitment of the bank, on behalf of an importer that guarantees payment will be made to the exporter provided the terms and conditions specified in the Letter of Credit have been met. Conditions specified in Import Letters of Credit are typically evidenced by the presentation of documents. Since they are credit instruments, issuing banks rely on the creditworthiness of importers when issuing Import Letters of Credit.
-
Export letter of credit
Export Letters of Credit are financial instruments issued by banks that represents the commitment of the bank on behalf of an importer that guarantees payment will be made to the beneficiary (exporter) provided the terms and conditions specified in the Letter of Credit have been met. Conditions which specified in Letters of Credit are typically evidenced by the presentation of specified documents. Since they are credit instruments, issuing banks rely on the creditworthiness of importers when issuing Letters of Credit.
What is the difference between import and export letter of credit?
A letter of credit is a vital tool for facilitating international trade. It benefits both the importers and exporters. An import letter of credit enhances the importer’s creditworthiness, while an export letter of credit mitigates the credit risk for the exporter and helps improve his cash flow.
- Revolving letter of creditA revolving letter of credit is a single letter of credit that covers multiple transactions over a long period of time. It is used for regular transactions of the same commodity between the same buyer and the seller. A letter of credit that is continually replenished as it is drawn by the beneficiary. It is normally used when an importer and exporter have an ongoing supply arrangement under which the exporter makes regular shipments for which the importer must make regular payments.
KEY PARTIES TO A LETTER OF CREDITS
- Applicant: An applicant (buyer) is a person who requests his bank to issue a letter of credit.
- Beneficiary: A beneficiary is basically the seller who receives his payment under the process.
- Issuing bank: The issuing bank (also called an opening bank) is responsible for issuing the letter of credit at the request of the buyer.
- Advising bank: The advising bank is responsible for the transfer of documents to the issuing bank on behalf of the exporter and is generally located in the country of the exporter.
Other Key contents to a Letter of Credits
- Specified time limit: The specific time limit within which the payment should be made
- Agreement: An agreement on which the parties agree to the terms & conditions set out in the Letter of Credit)
- Specified place: The specified place where the documents are mandated to be presented
LETTER OF CREDIT – PROCESS
Once the bank has confirmed the credit amount, the beneficiary will be informed directly or any other communicator bank in the place of the beneficiary about the credit. The communicator bank will then contact the beneficiary and get authorization from them. Henceforth the communicator bank will be accountable to make payment to the beneficiary.
DOCUMENTS REQUIRED FOR LC
Here are a few documents that are required to obtain an LC in global trade transaction:
- Importer’s financial documents
- Bills of exchange
- Certificate of Origin
- Commercial Invoice
- Packing, shipping, and transport documents
- Landing airway bills or cargo receipts etc.
TRADE FINANCE SOLUTION SERVICES
Ahmad Alagbari Chartered Accountants expert team can assist you in
- Letter of credit
- Bank Guaranties
- Opening bank account (Business account and individual account)
- Credit cards , loans
- Mortgage Services
- Auto loan
- Manager’s Cheque
- Corporate loan buyout facility
- Wealth management
- Bridge Finance
Alia Noor (FCMA, CIMA, MBA, GCC VAT Comp Dip, Oxford fintech programme, COSO Framework)
Associate Partner
Ahmad Alagbari Chartered Accountants