Friday, January 30, 2015

Letter of Credit

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Letter of Credit (L/C)
It is a guarantee in the form of a letter, issued by a buyer's bank. Suppose you want to buy or sell some goods from or to a foreign country. It is very much possible that you don't know the seller or buyer. And also the laws regulating the trade may be different. Therefore, both the seller and the buyer need some kind of guarantee to seamlessly perform the trade. Here Letter of Credit comes into action.

The steps involved is very much as follows -

Step 1 - First a contract is signed between the buyer and the seller.
Step 2 - The buyer comes to his bank, and the bank issues a Letter of Credit, on behalf of the buyer, to the seller.
Step 3 - After getting the Letter of Credit, seller knows that he will be paid surely. So he consigns the goods to a Carrier, in exchange of a Bill of Lading (Carrier provides it to the Seller)
Step 4 - Seller takes the Bill of Lading and provide it to his bank (i.e., seller's bank), who eventually transfers it to buyer's bank, who then provides it to the buyer.
Step 5 - Buyer takes the Bill of Lading, and gives it to the Carrier. The Carrier then getting his own Bill of Lading, delivers the goods to the buyer.
Step 6 - Carrier then asks his payment from the Seller, by providing his Bill of Lading, that he has actually delivered the goods.
Step 7 - Seller then asks his bank (i.e., sellers bank) for payment, who eventually asks the buyers bank. The buyers bank settles the payment.

Now you can see that the risks involved is much minimized by using the Letter of Credit, as the seller is guaranteed to be paid by the buyers bank upon delivery of goods.

Even in case, if the buyer doesn't pay the full amount to his bank (buyers bank), the buyers bank is obliged to pay the amount to the sellers bank. The buyers bank can later settle the amount with his buyer, as happens in loans or advances.

Since bank guarantee also provides a type of guarantee. Then what is the difference between a Letter of Credit and Bank Guarantee?

Letter of Credit
Bank Guarantee
Paid only if the contract is satisfied Paid only if the contract is breached, i.e., not satisfied
Ensures a transaction proceeds as planned
Insures a buyer or seller from loss or damage due to non-performance by the other party

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