What is Letter of Credit | Instruments | Parties | How to Open It

Letters of credit are an important financial instrument used in international trade. They are a means of payment that provide a guarantee to both the seller and the buyer involved in the transaction.

Here, we will discuss what letters of credit are, how to open them, the instruments associated with them, and the parties involved in letters of a credit.

Table of Contents

What is Letter of Credit

A financial tool used by companies in international trade is known as a letter of credit. It is a legal paper that a bank issues to ensure that the seller of goods or services will be paid when the buyer has fulfilled their end of the bargain.

The correspondence of credit provides security to both parties in a transaction as it protects the seller from non-payment and it also allows the buyer to receive goods and services without having to make payment upfront.

Letters of Credit Instruments

A financial tool called a letter of credit offers a guarantee to both the buyer and the seller in a transaction.

It is a document issued by a bank or other financial organization that, if particular requirements are completed, ensures payment to the seller. The instruments used in letters of credit are typically the following:

Credit Application

The buyer’s request to the issuing bank for the opening of a letter of credit, and an agreement between the buyer and seller that they will adhere according to the letter of credit’s terms and conditions.

Credit Agreement

A written agreement between the buyer and the issuing bank setting out the terms and conditions of the credit. This agreement is usually sent with the application for a letter of credit.

Letter of Credit

The document issued by the issuing bank containing the terms and conditions of the letter of credit, including the beneficiary’s name, amount, currency, expiration date, and payment details.

Negotiable Documents

Any documents that must be presented to the issuing bank for payment to be made, such as invoices, bills of lading, certificates of origin, and other documents that prove that goods have been shipped and/or received.

Reimbursement Agreement

An agreement between the issuing bank and the buyer which sets out how the issuing bank will be reimbursed for any payments made under the letter of credit.

Confirmation

A form of additional assurance provided by an independent bank to the beneficiary that they will be paid even if the issuer defaults on their obligations under the letter of credit.

Advising Bank

The independent bank that advises the beneficiary of the letter of credit on behalf of the issuing bank.

Parties of Letter of Credit

The parties of letter of credit are the applicant, the issuing bank, the beneficiary, and the nominated bank.

Applicant

The applicant is the party who applies for the letter of credit and will typically be a customer or buyer. The applicant is responsible for making payments under the terms of the letter of credit.

Issuing Bank

The issuing bank is the financial institution that issues the letter of credit on behalf of the applicant.

The issuing bank has the responsibility to make payments under the terms of the letter of credit if the beneficiary fulfills its obligations.

Beneficiary

The beneficiary is the party who is to receive payment from the issuing bank if they fulfill their obligations under the terms of the letter of credit. The beneficiary can also be referred to as an exporter, seller, or supplier.

Nominated Bank

The nominated bank is the financial institution that is responsible for verifying that the beneficiary fulfills their obligations under the terms of the letter of credit before payment is made by the issuing bank.

This nominated bank may also be referred to as an advising bank, confirming bank, or paying bank.

How to Open a Letter of Credit

The process of opening a letter of credit begins when the buyer sends an application to the bank along with all the necessary documents, such as a bill of lading and invoices. The buyer will also need to provide a deposit to cover the total amount of the transaction. Once the bank receives all of the required documents and funds, they can then open the letter of credit.
The bank will then send a copy of the letter of credit to the seller, who can review and confirm that all the requirements are correct. Once the seller has accepted the terms and conditions, they can proceed with the shipment and send the goods to the buyer’s address.
When the goods arrive at their destination, the buyer must present documents such as a bill of lading, proof of delivery, and other documents to their bank as evidence that the goods have been shipped and received. The bank will then compare these documents to those outlined in the letter of credit, and if everything is in order, they will issue a payment to the seller.
Once the payment has been made, both parties can close out the letter of credit and complete the transaction.

Conclusion

Letters of credit are an important financial instrument that is used by businesses and organizations around the world.

It is a contract between the parties involved in which the buyer promises to pay for goods or services received from the seller, with a bank providing security for the payment.

The instruments of letters of credit include the issuing bank, the beneficiary, the letter of credit document, and any supporting documents.

The parties involved in a letter of credit are the issuing bank, the applicant (buyer), and the beneficiary (seller).

Opening a letter of credit can be complicated and time-consuming, but understanding the process is key to ensuring success.

By understanding the instruments, parties, and process of opening a letter of credit, businesses can be better prepared to take advantage of this important financial tool.