Definition
Basing on the demand and order of the buyer (issuer/exporter), it is a commitment of a bank (issuing bank) that it will make a payment to the seller in a defined amount and within a defined maturity period, upon issuance of the documents, which are specified for the letter of credit.
By means of letter of credit international commercial activities will be regulated by banks, a mutual guarantee will be assured in favor of the parties, the payment will be guaranteed when the letter of credit terms are fulfilled and the payment in question will be based on the documents.
Letter of credit processes are subjected to International Chamber of Commerce’s (ICC) example procedures and application rules related to letter of credit. The leaflet in question is binding on all parties unless otherwise indicated in the letter of credit.
For letter of credit processes, banks make their transactions by taking into account not the goods but the documents. Opening of a letter of credit is determined by sales contract. So as to meet the provisions of this sales contract, the buyer offers his own bank (issuing bank) to open a letter of credit.
Seller’s bank informs the seller about the letter of credit. Then, seller loads the goods and via his intermediary bank sends the documents, which are supposed to be issued in accordance with the letter of credit, to the issuing bank. Providing that the documents issued are in line with the letter of credit terms, it’s the bank that makes the payment to the seller. By collecting the cost from issuer, the bank which has opened the letter of credit, delivers the documents in order to clear the goods from the customs.
Letter of credit is a reliable payment method as,
On condition that the beneficiary meets all the requirements of the letter of credit and issues all the required documents thereof, as the issuing bank has to fulfill its obligations relevant to payment to the beneficiary, this method is very safe for the latter.
This method is very safe for the issuer as he knows that he will not have to make any payment to the beneficiary against improper documents.
Letter of credit can be opened as confirmed or unconfirmed. Confirmed letter of credit is opened when the seller cannot do with only guarantee of issuer’s bank, he also wants to get another bank’s guarantee either his own country or another.
Confirmation for a letter of credit by a bank means the exact commitment of the confirming bank along with the commitment of the issuing bank on condition that the required documents to the confirming bank or other authorized bank are issued. For unconfirmed letter of credit, it is only the issuer’s bank that has the irrevocable commitment against the issuance of the proper documents.
4 types of usage of letter of credit are available:
Sight payment / payment
Deferred payment
Acceptance
Negotiation
Types of Letter of Credit
Revolving Letter of Credit (Revolving Documentary Credit)
Revolving Letter of Credit is generally used by buyers and sellers that are constantly signing purchase and sale agreements. Instead of opening for each loading time, they open only one letter of credit that will be valid between the dates specified. Letter of credit is automatically renewed and becomes valid.
Revolving Letter of Credits is opened on the basis of time and quality.
Red-Clause Letter of Credit (Red-Clause Documentary Credit)
Red-Clause Letter of Credits is used when there is a need for a pre-financing for the preparation of goods. For this type of credit, partial or total amount of the letter of credit is paid in advance to the seller before the shipment of goods. The reason why it is called red-clause is advance payment condition for this kind of credit is written in red to attract the attention. Nowadays, there is not such an application, but all the same this letter of credit continues to be called as red-clause.
Standby Credit Letter of Credit (Standby Credit)
Standby Letter of Credit is a sort of a guarantee. The bank that opens the letter of credit gives guarantee for a third party against the beneficiary and the bank confirms that it will make the relevant payment unless the contracts that are made with the third party are applied. For Stand-by letter of credits, the document issued that enables the payment to be made is not the shipment document but the document proving fulfillment of the process which is the subject of the guarantee.
Transferable Letter of Credit (Transferable Documentary Credit)
Transferable Letter of Credit is used when the first beneficiary is not the real seller or producer of the goods but the middleman/mediator. This middleman gives the opportunity to the producer or supplier of the goods or else let the beneficiary to export the goods instead of producing on its own, when they have not enough money or they cannot get a bank guarantee, transferable letter of credits are preferred as a financing means. A letter of credit can only be transferred when the issuing bank calls clearly it as “transferable”.