A letter of credit, also known as documentary credit, or bankers commercial credit, or letter of understanding is a payment mechanism used in international trade to provide an economic guarantee from a credit worthy bank to an exporter of goods.
Letter of credit is used extensively in the financing of international trade where the reliability of contracting parties cannot be readily and easily determined or ascertained for completeness, accuracy, and validity.
Its economic effect is to introduce a bank as an underwriter, where it assumes the credit risk of the buyer paying the seller for goods.
Importance of Letter of Credit
- Letter of Credit is an important payment method in international trade
- Letter of Credit is very useful where the buyer and seller may not know each other personally and are separated by distance, different laws in each country, and different trading terms (Incoterms).
- Letter of Credit is a fundamental method in international trade to mitigate the risk a seller of goods takes when providing those goods to a buyer.
- Letter of Credit is a payment method used to discharge the legal obligation for payment from the buyer to the seller.
- Most Letter of Credit are governed by rules promulgated by the international Chamber of Commerce known as Unified Customs and Practice for Documentary Credit.
Parties Involve In Letter of Credit Transaction
- The Applicant: This is the person or company who has requested the Letter of Credit to be issued. This will normally be the buyer / importer.
- The Beneficiary: This is the person or company who will be paid under the Letter of Credit. This will normally be the seller / exporter / recipient.
- The Issuing Bank: This is the bank that issues the Letter of Credit, following a request from the applicant. This is the bank that gives the written undertaking.
- The Nominated Bank: This is the bank mentioned within the Letter of Credit at which the credit is available.
- The Advising Bank: This is the bank that will inform the beneficiary or their nominated bank of the credit, send the original credit to the beneficiary or their nominated bank, and provide the beneficiary or their nominated bank with any amendment of the Letter of Credit.
- Confirming Bank: This is a bank other than the issuing bank that adds its confirmation to credit upon the the issuing bank authorization or request thus providing more security to beneficiary.
Various Types Of Letter of Credit
We shall be looking at only three(3) types of Letter of Credit that are commonly used while others will just be mentioned in passing.
- Confirmed Letter of Credit: A confirmed Letter of Credit is a Letter of Credit in which the seller or exporter has payment guarantee from a second bank or a confirming bank. This is to ensure that in case the first bank fails to pay, then the payment will be done by the second bank.
- Unconfirmed Letter of Credit: This is a Letter of Credit in which only the issuing bank gives the written undertaking without involving a second bank or a confirming bank to guarantee payment to the seller or exporter.
- Irrevocable Letter of Credit: An irrevocable Letter of Credit is a financial instrument used by banks to guarantee a buyer’s obligation to a seller. It is irrevocable because the Letter of Credit cannot be modified unless all parties agree to the modification.
Other Types Of Letter of Credit (LC)
- Export / Import Letter of Credit
- Transferable Letter of Credit
- Nontransferable Letter of Credit
- Revocable Letter of Credit
- Standby Letter of Credit
- Revolving Letter of Credit
- Back-to-Back Letter of Credit
- Red Clause Letter of Credit
- Green Clause Letter of Credit
Requirements To Establish A Letter Of Credit in Nigeria
The following documents are required to establish a Letter of Credit in Nigeria:
- An accepted Form M
- Application Form for Letter of Credit
- Customer Instruction Letter
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