Understanding and Using Letters of Credit


letter of credit

letter of credit

Understanding and Using Letters of Credit

Letters of credit accomplish their purpose by substituting the credit of one party for another, such as a bank, corporation, or other financial institution for that of the customer, for the purpose of facilitating trade, balance sheet enhancement, or project financing. There are basically two types: commercial and standby. The commercial letter of credit is the primary payment mechanism for a specific or specific set of transaction(s), whereas the standby letter of credit is a secondary payment mechanism. The funds or assets securing an LOC may be seen as “primary” collateral, whereas the assets, or future assets of a project, for example, may be utilized as “secondary” collateral. Here, the term “bank” will be used to designate the issuer of an LOC.


Letters of credit could be listed as a guarantee of payment by a bank (issuing institution) to a third party for a specific amount of money, if certain conditions are met. A letter of credit is generally a term used for the guarantee that a bank or any other financial body grants to an applicant business group. Letters Of Credit will explain the details of Letters of credit in this article. For example, via such a letter, a financial body may take the responsibility of payment to an exporter. This is an irrevocable document, which means that even if the applicant wants to do otherwise, the financial organization will have to pay for the transaction. Letters of credit are used extensively for financial transactions, today, with more and more financial organizations specializing in the practice. This is especially beneficial for large transactions between two far-off countries.

Irrevocability is a major criterion of most credit letters today and the financial institution and the receiver are considered the most important parties. Thus, often, the applicant is not even taken as a party to the transaction. The bank can call back the letters of credit anytime during the transaction, a step that is subject to certain terms and conditions. In case the applicant turns insolvent, the bank can claim a major portion of its loss from the credit risk that the applicant has already paid for. The applicant has to submit certain documents in order to avail the facilities of Letters of credit. Letters Of Credit may be structured that the entire transaction is also based on a certain time level after which the bank will have to pay back the entire amount.


The oldest known LOC type device is the ancient south Asian credit instrument called Hundi. The most important class of credit Instruments that evolved in India were termed Hundis. Their use was most widespread in the twelfth century, and has continued till today. In a sense, they represent the oldest surviving form of credit instrument. Hundis were used

* as remittance instruments (to transfer funds from one place to another) * as credit instruments (to borrow money [IOUs]) * for trade transactions (as bills of exchange)

Hundis were of various kinds and each type had certain distinguishing features. Darshani Hundi : This was a demand bill of exchange, payable on presentation according to the usage and custom of the place. These were mainly of four types. Sah-jog – was a hundi transferable by endorsement and delivery but payable only to a Sah or to his order. A Sah was a respectable and responsible person, a man of worth and substance who was known in the market.

Dhanni-jog – was a demand bill of exchange payable only to the dhanni, i.e. the payee. This hundi was not negotiable. Firman-jog – hundis came into existence during the Muslim period. Firman is a Persian word meaning order and therefore, firman-jog hundis were payable to the order of the person named. These hundis could be negotiated with a simple or conditional endorsement. D] Dekhavanhar – hundi was a bearer demand bill of exchange payable to the person presenting it to the drawee. Thus it corresponded to a bearer cheque.

Muddati Hundi : This is a usance bill and is payable after stipulated time or on a given date or on a determinable future date or on the happening of a certain stipulated event. Muddati hundis of Sah-jog, dhanni-jog and firman-jog types had the same features as those attached to the same types of darshani hundis. However, the most important type of muddati hundi was the jokhami hundi, which was a documentary bill of exchange corresponding to the present day bill of lading. This had been in use for centuries and payment was conditional on the safe arrival of goods.

The first Western Letters of Credit in recorded history date back to late 15h Century Europe. Letters Of Credit will now try to trace back the history of Letters of credit in and around the United States. Different forms of financial transactions have been present in the world all through the ages. We have had moneylenders who conducted large business based on financial transactions. They often conducted even international businesses. One such moneylender, Shylock has been made immortal by Shakespeare in his play “The Merchant Of Venice”. In today’s world, with the increase in technology and transport system, letters of credit are a very important part of trans-continental businesses. In fact letters of credit play a very important role in the progress of the global economy in today’s world Examples of Letters of Credit and Related Instruments


Import Letters of Credit Import Documentary Collections

Banker’s Acceptance Export Letters of Credit

Export Documentary Collections Banker’s Acceptance

L/C Confirmations Standby L/Cs / Bid & Performance Bonds / Payment Guarantees


Offshore L/C Issuance Authority to Pay Open Account Management “Silent Confirmation” or Commitment to Purchase Discounting of Accepted Drafts Electronic Export Document Preparation A/R Financing

Impact on Corporate Law Internationally:

Of great consequence for the later development of International commercial law was the foundation of colonial companies, usually through royal charter, for the exploitation and administration of the colonies of the European countries. The first, the Dutch East India Company, was chartered in 1602. Only such companies were able to attract the immense amounts of capital that were needed. The liability of each member was limited to his contribution, which was represented by share certificates that were transferable. Limited liability of shareholders and negotiability of shares were in fact fundamental to the operation of these companies. They were adopted and refined later into the most important vehicle of modern capitalism—the corporation. Of great importance in international trade is the letter of credit. A letter of credit is essentially an authorization made by a buyer to his agent (usually a bank) to make payment to a seller.

The letter of credit comes into use when there is a substantial time lag between the dispatch of goods by a seller and their receipt by the buyer – such as shipping of goods from the “mother country” to colonies, or vice versa. The seller, having sent the goods off, has fulfilled his part of the contract and seeks payment. The buyer, not having received the goods and being unable to inspect them, will be reluctant to pay. To overcome this difficulty, the buyer and seller make arrangements to have intermediaries operating in each of the two countries involved make settlement. The buyer instructs his bank to issue a letter of credit authorizing payment to be made to the seller when the latter’s part of the contract has been fulfilled (usually when the seller has dispatched the correct quantity of conforming goods). The buyer’s (or issuing) bank ascertains whether or not this has been done by obtaining the cooperation of a bank in the seller’s country. This bank (the “corresponding” bank), having inspected all the relevant documents of title and bills of lading to ensure that the seller has performed, makes payment to the seller, often by means of a bill of exchange or other credit device. The document of title, bills of lading, and so forth are then mailed to the buyer. The buyer then reimburses his bank, which in turn reimburses the corresponding bank for making payment to the seller.

In no other branch of international trade have the efforts at unification of law been more successful than in that of letters of credit. In 1933 the International Chamber of Commerce in Paris published the Uniform Customs and Practice for Documentary Credits, which was revised in 1951, in 1962, and once again in 1983. It has been adopted by banks and by banking associations in almost all countries of the world.

Commercial Letter of Credit:

Commercial letters of credit have been used for centuries to facilitate payment in international trade. Their use will continue to increase as the global economy evolves. Letters of credit used in international transactions are governed by the International Chamber of Commerce Uniform Customs and Practice for Documentary Credits. The general provisions and definitions of the International Chamber of Commerce are binding on all parties. Domestic collections in the United States are governed by the Uniform Commercial Code.

A commercial letter of credit is a contractual agreement between a bank, known as the issuing bank, on behalf of one of its customers, authorizing another bank, known as the advising or confirming bank, to make payment to the beneficiary. The issuing bank, on the request of its customer, opens the letter of credit. The issuing bank makes a commitment to honor drawings made under the credit. The beneficiary is normally the provider of goods and/or services. Essentially, the issuing bank replaces the bank’s customer as the payee.

Elements of a Letter of Credit:

• A payment undertaking given by a bank (issuing bank) • On behalf of a buyer (applicant) • To pay a seller (beneficiary) for a given amount of money • On presentation of specified documents representing the supply of goods (for example) • Within specified time limits • Documents must conform to terms and conditions set out in the letter of credit • Documents to be presented at a specified place


The beneficiary is entitled to payment as long as he can provide the documentary evidence required by the letter of credit. The letter of credit is a distinct and separate transaction from the contract on which it is based. All parties deal in documents and not in goods. The issuing bank is not liable for performance of the underlying contract between the customer and beneficiary. The issuing bank’s obligation to the buyer, is to examine all documents to insure that they meet all the terms and conditions of the credit. Upon requesting demand for payment the beneficiary warrants that all conditions of the agreement have been complied with. If the beneficiary (seller) conforms to the letter of credit, the seller must be paid by the bank.

Issuing Bank:

The issuing bank’s liability to pay and to be reimbursed from its customer becomes absolute upon the completion of the terms and conditions of the letter of credit. Under the provisions of the Uniform Customs and Practice for Documentary Credits, the bank is given a reasonable amount of time after receipt of the documents to honor the draft. Basically, think of the “bank” as the co-signer of a loan.

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