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message: Definition of Letters of Credit:
“Credit means any arrangement that is irrevocable and thereby constitutes a definite
undertaking of issuing bank to honour a complying presentation”
A letter issued by a bank to another bank for an underlying trade ( either goods or
services) transaction between a buyer and a seller in same or different countries.
This letter provides below facilities:
• Authentication of a Buyer/ Seller via their respective banks.
• Ensures payment , if required documents are presented under agreement of the
two parties.
• Helps in financing of a trade transaction.
• Covers various risks involved in international/local trade.
L/C is a tool which enables concluding various complex trade transactions and are
usually issued under guidelines from International Chamber of Commerce , e.g.
Uniform Customs and Practices of Documentary Credits (UCPDC 600) , International
Standard Banking Practices (ISBP) , INCOterms , Uniform Rules of Reimbursements
(URR), etc.
Types of Letters of Credit:
A letter of credit is a versatile instrument. Changes may be made to the structure
to suit the requirements of the beneficiary and the applicant
• Instalment credits: used by applicants who require regular supply of goods.
• Transferable credits: used by middlemen traders.
• Back-to-back letters of credit: used by middlemen for ultimate suppliers who
require independent LCs.
• Red clause letters of credit: for beneficiaries who require a pre-shipment advance.
• Green clause letters of credit: for beneficiaries who require a pre-shipment
advance after goods have been produced and stored in a warehouse.
• Revolving credits: used by trading parties who have several similar shipment
contracts.
and
• Standby credits: used to cover default / non-performance by the applicant.
The LC Process
The LC process has four distinct parts:
• Part 1: Issuance of a letter of credit
• Part 2: Advising a letter of credit
• Part 3: Presentation of documents under a
letter of credit
• Part 4: Payment
Part 1: Issuance of a letter of Credit
The role of Applicant
• Enters into a contract with Beneficiary.
• Party on whose behalf LC is issued.
• Banks do not examine underlying contract.
• LC is independent of Contract.
Sample of LC Application
Adobe Acrobat
Document
The role of Issuing Bank
• Applicant is client of the bank.
• Applicant has sufficient credit limit.
• Agreement between Issuing bank and Applicant
being application to issue LC and reimburse Issuing
Bank for Drawings and applicable charges.
• LC application is signed by Authorized Signatories.
• LC application is workable.
• LC transmission via SWIFT / Airmail etc.
• SWIFT Format – MT700
The role of Advising Bank
• Satisfy themselves with Authenticity of LC.
• Ensure completeness of the LC received and
advised.
• Some Advising banks check if LC is workable.
The role of Beneficiary
• Should check whether underlying contract
terms with Applicant are covered under LC.
Selection of Advising Bank
• Usually located in Beneficiary’s country.
• Beneficiary to advice bank details to Applicant for
incorporation in LC application.
• Issuing bank can choose its own branch/
correspondent, helps establish authenticity easily.
Second Advising Bank
• LC sometimes requires to further advise credit
through another bank, this is Second Advising Bank.
Request for Confirmation
• If MT 700 field 49 contains “CONFIRM/MAY ADD”.
• Confirmation refers to a definite undertaking of the confirming bank, in
addition to that of the issuing bank, to honour or negotiate a complying
presentation (without recourse). (Article 2 of UCP 600)
• Generally requested by beneficiary to add in LC.
• Confirm/May add – LC confirmation charges usually to Beneficiary’s
Account. Must check LC workability.
• May depend on risk appetite and expected return on risk.
• May Add – Confirmation may be added at request of beneficiary. Charges
are mostly to account of beneficiary.
Risk Mitigation
• Country risk associated with Issuing bank’s country.
• Bank risk associated with Issuing Bank.
Available With “…..”
• The LC term 'available with' refers to the bank where the
beneficiary is authorised to present documents under the LC
and claim payment.
• Available with Issuing Bank
• Available with Nominated Bank – still available with Issuing
bank.
• Mere nomination by the issuing bank does not obligate the
nominated bank to settle any drawing presented to it. It is
only obligated to do so if it has added its confirmation.
• A nominated bank may be a bank specifically identified by the
issuing bank or may be any bank.
• “Honourmeans to pay, incur a deferred payment
undertaking or to accept a bill of exchange."
The nominated bank is authorised to:
• Receive documents presentations.
• Check and determine if documents are credit
compliant.
• Pay against credit compliant sight drawings.
• Accept to pay (or pre-pay) against credit compliant
usance / term drawings. Checking documents to see
if they conform with the LC requirements.
• Crediting / routing funds.
• Corresponding with the issuing bank.
• Discounting (pre-paying) documents (in case of
usance / term drawings).
If no nominated bank ???
• Direct presentation to Issuing Bank only.
• Beneficiary may choose a Presenting Bank for sending
documents and routing funds.
Credit Compliant Documents:
A drawing under an LC is said to be credit compliant (or said
to "conform to the credit") when the following conditions are
met:
• All documents (as called for in the LC) are presented.
• The documents presented conform to:
- all terms and conditions of the LC
- provisions of the UCP and
- international standard banking practice.
Checking Documents
The documents are checked for:
• Consistency with the terms and conditions of the LC
• Consistency with other documents in the presentation
• Consistency with the provisions of the UCP and international standard banking practice
Credit Compliant Documents:
A drawing under an LC can be honoured or negotiated only when it is compliant.
• The nominated bank, which decides to act on the nomination, will honour or negotiate such documents
and forward the presentation to the issuing bank.
Discrepant Documents:
Documents that are not compliant are referred to as discrepant documents. In such cases, the nominated bank
has the following options:
• Return documents: Documents may be returned to the beneficiary for correction (provided there is
sufficient time to present them again).
• Amend LC: If required by the beneficiary, a request for an amendment to the LC may be sent to the issuing
bank (so that the discrepancies are set right).
• Ask permission: A message may be sent to the issuing bank requesting permission to honour / negotiate
documents despite the discrepancies.
• Send on approval: The discrepant documents may be sent to the issuing bank for their decision (referred
to as being sent on 'approval' basis). In such cases, the issuing bank will usually refer the discrepancies to
the applicant who will choose whether or not to honour the documents.
LC Settlement Methods :
A letter of credit will state the manner in which a drawing under an LC is to be settled. This may
take one of the following forms:
• By Sight Payment: The drawing under the credit is settled by immediate payment on receipt
of compliant documents.
• By Deferred Payment: Documents presented under this settlement method are payable at
maturity.
On receipt of compliant documents, the issuing bank (or nominated bank) gives an
undertaking to the beneficiary to pay on a future date. This undertaking is referred to
as 'deferred payment undertaking'.
• By Acceptance: Documents presented under this settlement method are payable at maturity.
On receipt of compliant documents the nominated or issuing bank accept a usance draft / bill
of exchange drawn on it. Payment is effected on the maturity date of the bill of exchange.
By accepting the bill of exchange, the accepting party creates an independent and negotiable
payment obligation.
• By Negotiation: This refers to the purchase of drafts and / or documents by the nominated
bank under a complying presentation. The nominated bank will advance or agree to advance
funds to the beneficiary on or before the banking day on which reimbursement is due.
Tenor, Settlement Method and Availability
• Depending on the tenor, settlement method and availability,
an LC could have one of the following structures:
Part 3: Presentation of documents under LC
Tenor* Settlement method that can be used
in the LC
Banks with which an LC can be
made available
Sight
Sight Payment Issuing Bank / Nominated Bank
Negotiation Nominated Bank
Usance / Term
Deferred Payment Issuing Bank / Nominated Bank
Acceptance Issuing Bank / Nominated Bank
Negotiation Nominated Bank
*The tenor i.e. the time of settlement may either be:
• Sight i.e. where payment is made on receipt or 'sight' of documents or
• Usance / Term i.e. where payment falls due on a determinable future date. For example, "60 days from the date of bill of
lading date", "120 days sight" etc.
It could also be a combination of the two; in which case it is important to carefully structure the correct settlement method
Part 3: Presentation of documents under LC
Detailed LC
Workflow
Credit
Compliant
Documents
(LC available by
acceptance /
deferred
payment with
the issuing
bank):
Negotiation :
While negotiating under a credit, the negotiating bank advances or agrees to advance funds to
the beneficiary prior to the date on which reimbursement is due from the issuing bank.
• Negotiation is with recourse
When a nominated bank acts on its nomination under an LC available by negotiation, it is
referred to as the negotiating bank and its action is with recourse to the beneficiary.
In the event the issuing bank does not honour the drawing, the negotiating bank is entitled
to be reimbursed by the beneficiary.
• Negotiation without recourse
However, if the negotiating bank has agreed with the beneficiary to negotiate without
recourse or has added confirmation to the credit, they do not have recourse to the
beneficiary.
Recourse
• Recourse refers to the right to ask for reimbursement in case the original payer refuses to do
so.
Negotiation v Other Settlement Methods ( Important !!! )
• Negotiation is a little different from the other methods of settlement. For example, only a
nominated bank can negotiate documents (an issuing bank cannot do so). Also, the
negotiating bank also has a right of recourse (which is not available to a bank acting on its
nomination under other settlement methods).
Why is negotiation different from other settlement methods?
Negotiation differs from other settlement methods because a bank negotiates a drawing on its
own behalf and not on behalf of the issuing bank. (An issuing bank cannot negotiate drafts /
documents, it can only honour.)
• Therefore, if the negotiating bank does not receive reimbursement from the issuing bank, it
has recourse to the beneficiary.
• However, in case of other settlement methods (sight payment / acceptance / deferred
payment), the nominated bank acts on behalf of the issuing bank and the action is without
recourse to the beneficiary
• With regards to letters of credit, the word 'honour' means to:
- pay
- incur a deferred payment undertaking or
- accept a bill of exchange
Payment is made by the issuing bank in the following
cases post scrutiny of documents:
• Documents are compliant (or)
• Documents are discrepant. However, the issuing
bank (and the applicant) has accepted the
discrepancies.
Sight Credits: To be paid immediately.
Term Credits: To be paid at maturity of the term
In case Applicant’s account is having insufficient funds,
issuing bank must make the payment for credit
compliant documents on sight / at maturity.
Discrepant documents
• If the issuing bank finds that documents are discrepant, they
may refuse to pay against such documents. In such cases, as
per UCP 600, the notice of refusal must be sent to the
presenter within 5 banking days following the date of receipt
of the documents.
• If this notice is not sent as per the provisions of the UCP, the
issuing bank loses the right to refuse such documents and
they must honour the documents.
When sending a refusal message, the issuing bank must ensure
that it states:
• That the presentation is being refused.
• Each discrepancy for which the refusal is sent.
• Future course of action relating to the documents.
Future course of action relating to discrepant documents:
Once it is determined that documents are discrepant, the issuing bank can choose one of four course of
actions. This must be communicated to the nominated bank / presenter in the refusal message:
1) Refer discrepancies to the applicant (NOTIFY*)
• The issuing bank may advise the discrepancies to the applicant. If the applicant waives the discrepancies,
the issuing bank may also choose to waive the discrepancies and accept documents / make payment.
• If the applicant does not wish to accept the discrepancies, documents will be returned to the nominated
bank / presenter.
2) Hold documents (HOLD*)
• The issuing bank may hold documents at its counters at the risk and responsibilities of the nominated
bank / presenter and wait for further instructions as to its disposal.
3) Return documents (RETURN*)
• Documents may be returned to the nominated bank / presenter if the issuing bank does not wish to
handle the discrepant documents. (This option is normally used at the request of the applicant or for other
regulatory reasons.)
4) Follow previously received instructions (PREVINST*)
• The issuing bank may also follow previously received instructions from the nominated bank / presenter
with regards to the disposal of discrepant documents.
*The codes in bracket refer to SWIFT Codes (used in MT 734) to communicate course of action taken by the
issuing bank..
Part 4: Payment  — Preceding unsigned comment added by 203.201.220.36 (talk) 14:12, 11 February 2015 (UTC)
thread_title:  LETTER OF CREDIT