Category talk:Start-Class Finance & Investment articles

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)