A-301, Titanium Square, Thaltej Crossroad, S.G. Highway, Ahmedabad - 380054 T: +91 79 4008 1101-2 E: Info@edgewise - in W: WWW - Edgewise.in

A-301, Titanium Square, Thaltej Crossroad,
S.G. Highway, Ahmedabad - 380054
T : +91 79 4008 1101-2

E : info@edgewise.in
W : www.edgewise.in
Letter of Credit
(LC)
Basic of Letter of
Credit (LC)
PART - I
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A presentation by- Puneet

Harjani
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>Introduction
Principles and Theory :

it is most important segment of non fund based business for banks.
it is also known as documentary credit.
a need for a streamlined system involving banks as an intermediate

was felt by the trading world because of the inherent drawbacks of the
documentary collection system prevailing earlier, which poses risk both
for importer and exporter , which led to the evolution of Letter of
Credit or Documentary Credit system.

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>Introduction
Definition:
A Letter of Credit, simply defined, is a written instrument issued by

a bank at the request of its customer, the Importer (Buyer),
whereby the bank promises to pay the Exporter (Beneficiary) for
goods
or
services,
provided
that
the
Exporter
presents
all
documents called for, exactly as stipulated in the Letter of Credit,

and meet all other terms and conditions set out in the Letter of
Credit.
If the Letter of Credit is issued in course of international

trade
the Letter of Credit should comply with FEMA regulations,
and are also subject to provisions of Uniform Customs and Practices

for
Documentary
Credit
(UCPDC)
A-301, Titanium Square, Thaltej Crossroad, T : +91 79 4008 1101-2

S.G. Highway, Ahmedabad
- 380054of Commerce
Chamber
(ICC)
framed
by
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International
>Introduction
Synopsis :
Letter of Credit therefore:
Are an arrangement by banks for settling international commercial
transactions.
Provide a form of security for the parties involved.
Ensure payment, provided that the terms and conditions of the
Letter of Credit have been fulfilled.
Mean that payment by such means is based on documents only,
and not on merchandise or services involved.
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>Parties in LC
Transaction
A transaction in a Letter of Credit may involved several

parties from the issue of the LC till making payment of the
bills to the Seller:
Applicant
The buyer who finalizes the terms and conditions of purchase

transaction and submits a request to his bank for issuing a LC
in favor of the seller.
Beneficiary
The beneficiary of the letter of credit is generally the seller of

the goods and services or the person in whose favor the
credit has been issued.

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>Parties in LC
Transaction
Issuing Bank / Opening Bank
An issuing bank is the one which on receipt of request from

its customer, the applicants (purchasers) bank examines
the proposal and open a LC in favor of the beneficiary with
the stipulated terms and condition.
Advising Bank/ Correspondent Bank
In case seller (beneficiary) resides in a different lace or in a

foreign country, the issuing bank may contact some other
bank in the beneficiarys country may agree to advise the
credit to the beneficiary and thus play the role of an advising
bank.

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>Parties in LC
Transaction
Confirming Bank :
The Confirming bank adds its guarantee to the credit opened

by another bank, thereby undertaking the responsibility of
payment/negotiation
acceptance
under
the
credit,
in
additional to that of the issuing bank. Confirming bank play

an important role where the exporter is not satisfied with the
undertaking of only the issuing bank.
Reimbursing Bank
Reimbursing Bank is the bank authorized to honor the

reimbursement claim in settlement of
negotiation/acceptance/payment lodged with it by the
negotiating bank. It is normally the bank with which issuing
bank has an account from which payment has to be made.

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>Parties in LC
Transaction
Nominated/ Negotiating Bank :
The Negotiating Bank is the bank who negotiates the

documents submitted to them by the beneficiary under the
credit either advised through them or restricted to them for
negotiation. On negotiation of the documents they will claim
the reimbursement under the credit and makes the payment
to the beneficiary provided the documents submitted are in
accordance with the terms and conditions of the letters of
credit.
Second Beneficiary:
Second Beneficiary is the person who represent the first or

original Beneficiary of credit in his absence. In this case, the
credits belonging to the original beneficiary is transferable.

The rights of the transferee are subject
toWterms
of transfer.
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>Parties in LC
Transaction
Terms
Definitio
n
Applicant
Importer
Beneficiary
Exporter
Issuing/Opening
Bank
Importers Bank
Advising Bank
Exporters Bank
Confirming Bank
Advising Bank or
3rd Party Bank
Paying Bank
Any
bank
as
specified in L/C

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Activity
Buy
Sell
Issues L/C
Advises L/C
Confirms L/C
Pays the
Draft
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>Mechanism of LC

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>Mechanism of LC
1st Principle of Letters of Credit: Letters of Credit are
documentary.
Step 1.
The seller and the buyer enters into a sales contract where buyer agrees to
purchase goods from the seller. This agreement may be a purchase order, an
accepted pro-forma invoice, a formal contract, as to how and when goods are to
be shipped and insured, and how and when payment is to be effected. In this
case they agree that letter of credit will be used as the mechanism of payment.
Step 2.
The buyer applies to his bank for a letter of credit in favor of the seller
(beneficiary), signing the banks letter of credit application/agreement form
specifying the terms and condition under which the Letter of Credit shall be
issued.
Step 3.
After approving the application, the issuing bank issues the actual letter of credit
instrument and sends it to the beneficiary (the seller), thus undertaking the
definite obligation of effecting payment to the beneficiary upon presentation of
documents, strictly complying with the terms and condition of the credit .
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>Mechanism of LC
2nd Principle of Letters of Credit:
Letters
independent of any other contract or obligation.
of
Credit
are
Note: There are 3 separate contracts in a letter of credit transaction:

a) The contract of sale
b) The L/C application/agreement
c) The L/C itself.
Step 4.
) As soon as the seller receives Letter of Credit (issuing banks assurance of
payment), the seller ships the goods to the buyer provided the terms of credit
meets the terms of underlying sales contract.
Step 5 & 6.
) The seller prepares the documents called for in the letter of credit and presents
them to the Issuing bank. The issuing bank examines the documents whether
they strictly comply with the terms of letter of credit. If the documents meet the
requirement the issuing bank pays the beneficiary (seller) in the manner
stipulated under the credit.
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>Mechanism of LC
Step 7 & 8.
The issuing bank sends the documents to the buyer (applicant) and obtains
payment in accordance with the terms of the applicants letter of credit
agreement ( usually by debit to the applicants account)
Step 9
On receiving the documents from bank, the applicant (buyer) is in a position to
pick up the merchandise from the carrier, completing the letter of credit
cycle.

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>Mechanism of LC
Confirmed Letters of Credit
Contract
1
Applicant
Applicant
Goods
12
L/C
10
Debit
Appli
catio Docu
11
n
ment
2
s
Applicant
Applicant
ssBank
Bank
Beneficiar
Beneficiar
yy
L/C
L/C
8
Documents
Payment
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Payment
Docu
ment
s
Confirmin
Confirmin
ggBank
Bank
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>Mechanism of LC
In case of Confirmed Letter of Credit the issuing bank invite another bank into
the transaction, having presence in the country of the seller. This second bank
is called the confirming bank, it will confirm the letter of credit issued by the
issuing bank , and thus undertakes the primary obligation to effect payment
to the beneficiary (seller) [But if it merely informs the seller of the LC
without any obligation on its part they will just act as an advising
bank]. They become a third party to the letter of credit contract and have
the right to refuse amendments.
For Conforming Bank
When a bank adds their confirmation to a letter of credit, they are engaging
to treat the letter of credit as if they issued it themselves. If and when the
beneficiary presents compliant documents to the confirming bank, the
confirming bank must pay. The confirming bank takes the risks of being able
to then collect payment from the issuing bank. [It may also act as a
nominating bank, if the LC calls for negotiation]

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The major effect is to shift country risks to the confirming bank.
>Mechanism of LC

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<How LC works in
Reality
Step 1.
The buyer agrees to purchase goods from the seller using a letter of credit as
the mechanism of payment.
Step 2.
The buyer applies to his bank for a letter of credit, signing the banks letter of
credit application/agreement form.
Step 3 a
After approving the application, the issuing bank issues the actual letter of
credit instrument and forwards it to their chosen advising bank.
Step 3 a
At the time the L/C is sent, the issuing bank also sends a reimbursement
authorization to their chosen reimbursing bank. This bank is the clearing bank
the issuing bank uses when making payments in the currency of the L/C and
will play a role when the time comes to pay the L/C.

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<How LC works in
Reality
Step 4.
The advising bank authenticates the letter of credit and delivers it to the
beneficiary (the seller). If the issuing bank has requested them to do so, the
advising bank may add their confirmation to the L/C (and thereby become the
confirming bank).
Step 5.
Having received the issuing banks assurance of payment (and that of the
confirming bank if the L/C has been confirmed), the seller delivers goods to a
freight forwarder, who ships the merchandise to the buyer.
Step 6.
The seller, the freight forwarder, and/or a document preparation company

prepares the documents called for in the letter of credit and presents them to
the nominated bank. The letter of credit may nominate a specific bank
where documents are to be presented or it may say it is available with any
bank, giving the seller the freedom to choose where to present documents.
A-301, Titanium
Square,
T : +91 79 4008documents
1101-2
If the
L/C Thaltej
has Crossroad,
been confirmed,
must be presented to the
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advising/confirming bank.
<How LC works in
Reality
Step 7.
The nominated bank examines the documents and, if they comply, obtains
funds for payment to the beneficiary in accordance with the terms of the
letter of credit, generally by sending a reimbursement claim to the
reimbursing bank.
Step 8.
The reimbursing bank matches the negotiating banks claim against the
reimbursement authorizations they are holding, charges the issuing banks
account, and transfers funds to the nominated bank.
Step 9 a & b.
The nominated bank transfers payment to the beneficiary (seller) and
forwards the documents to the issuing bank.

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<How LC works in
Reality
Step 10 a & b
The issuing bank examines the documents. If it agrees with the nominated
bank that the documents comply with the letter of credit, the issuing bank
obtains payment from the applicant (buyer) in accordance with the terms of
the applicants letter of credit agreement and forwards the documents to the
applicant.
Step 11.
The applicant (buyer) uses the documents to pick up the merchandise from
the carrier, completing the letter of credit cycle.

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Types of Letter
of Credit

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>Types of Letter of
Revocable
Credit & Irrevocable Letter of Credit
Irrevocable LC : A letter of credit is deemed to be an

irrevocable credit, which can neither be amended nor
cancelled without an express agreement of all the parties
concerned. i.e. the applicant, issuing bank, beneficiary and
confirming bank (if any).
*Revocable
LC : The concept of Revocable Credit
which was in effect till UCPDC 500 (till 30th June, 2007) has
been withdrawn under the latest revision. Thus an LC can
only be irrevocable in nature.

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>Types of Letter of
Sight
Credit & Acceptance (Usance) Credit
Credit
Sight Credit :
is the LC prescribes the condition of
payment at sight , in this the beneficiary gets the benefit of

immediate payment upon presentation of the proper
documents laid down as per the terms of LC at the paying
bank.
Usance Credit: If the beneficiary decides to grant a

period of credit to importer after sight such a LC is called
Acceptance Credit. The period of credit is called Usance, in
this type of LC the beneficiary draws a usance draft on the
buyer or issuing bank or confirming bank depending on the
terms. This draft is presented along with documents and the
beneficiary is advised that the amount in the draft will be
A-301, Titanium
Square,
Thaltejon
Crossroad,
: +91 79 4008
1101-2
paid
to him
prefixedT future
date
.
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>Types of Letter of
Standby
CreditLetter of Credit
standby letter of credit is the one which is opened for nonperformance of some activity it is very much similar in
nature to a bank guarantee. The main objective of issuing
such a credit is to secure bank loans.
Unlike a traditional letter of credit where the beneficiary

obtains
payment
against
documents
evidencing
performance, the standby letter of credit allow a beneficiary

to obtains payment from a bank even when the applicant
for the credit has failed to perform as per the terms.
Standby LC is payable only in case where an event had

occurred but performance for the event has not happened.

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>Types of Letter of
Credit
An example of this could be a construction of a bridge. An

agreement would be in place between the applicant and
the beneficiary that in case after construction of the bridge,
if the payment is not made for the services rendered, a
claim
would
be
made
under
the
Standby
LC.
A standby letter of credit is subject to "Uniform

Customs and Practice for Documentary Credit" (UCP),
International Chamber of Commerce Publication No
500,
1993
Revision,
or
"International
Standby
Practices" (ISP), International Chamber of Commerce

Publication No 590, 1998.

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>How Standby Letter of

Credit Works
9
Contract
Applicant
Applicant
Beneficiary
Beneficiary
8
2
Payment
Debit
Letter of Credit
Application
Documents
Letter of Credit
Documents
Applicants
ApplicantsBank
Bank
3

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Credit Works
Step 1.
Two parties enter into a contract that calls for one party to arrange a letter of
credit in favor of the other. With a standby letter of credit, the agreement is
that the L/C will not be drawn unless the applicant defaults on the contract.
Standby letters of credit can be used as bid bonds, performance bonds,
advance payment guarantees, and for many other purposes.
Step 2.
The first party applies to his bank for a letter of credit, signing the banks letter
of credit application/agreement form, and indicating what documents the
beneficiary will be required to present in order to be paid.
Step 3.
After approving the application, the issuing bank issues the actual letter of
credit instrument and sends it to the beneficiary (the seller), thus undertaking
the definite obligation of effecting payment to the beneficiary upon
presentation of documents, strictly complying with the terms and condition of
the credit .
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Credit Works
Note: There are 3 separate contracts in a letter of credit transaction:

a) The contract of sale
b) The L/C application/agreement
c) The L/C itself.
Step 4.
) Having received the issuing banks assurance that the applicant will perform (or
the L/C can be drawn), the beneficiary performs his end of the contract.
Step 5
) In the event the beneficiary feels the applicant has defaulted, he prepares the
documents called for in the letter of credit and presents them to the issuing
bank.

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Credit Works
Step 6
The issuing bank examines the documents. If it determines that the documents
comply with the letter of credit, the issuing bank pays the beneficiary. Note
that there is no inquiry into the truth of the documents and permission to pay is
not sought from the applicant, who is likely to not want the bank to pay and to
insist he is not in default on the contract
Step 7 & 8
The issuing bank obtains reimbursement for the payment from the applicant
and forwards the documents to the applicant
Step 9
If the applicant feels the drawing was not justified, he can seek to get the funds
returned under the terms of the contract.

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>Types of Letter of
Revolving
Credit Letter of Credit:
Single L/C that covers multiple-shipments over a long period.

Instead of arranging a new L/C for each separate shipment,
the buyer establishes a L/C that revolves either in value (a

fixed
amount
is
available
which
is
replenished
when
exhausted) or in time (an amount is available in fixed

installments over a period such as week, month, or
This type of LC is used when the buyer needs shipments of

the same commodity at specified intervals e.g. monthly. It
may revolve automatically or subject to certain conditions.
Example 1: Supply of coal to the iron industry is an ongoing

material and therefore as and when the goods are delivered,
documents are submitted and payment is made.

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>Types of Letter of
Credit
For the next supply of coal, there is no new LC that is issued,

rather the existing one is "Reinstated"
(bring back into use
again) to the original amount.
Assume that the supplier and the buyer agrees that 200MT of
coal would be delivered on a monthly basis for 12 months.
The value of the LC for 200MT of coal is Rs 12 lakhs . Every
month 200MT of coal will be shipped and documents for Rs 12
lakhs would be submitted for payment. Once it get's paid in
the first month, the LC amount is automatically reinstated to
Rs 12 lakhs for the next month's payment.
Revolving L/Cs can be either cumulative or noncumulative

Under a cumulative resolving L/C, the exporter is allowed
to carry over any amounts not drawn in previous periods. For

example,
if- a
revolving L/C
is issued for
S.G. Highway,
Ahmedabad
380054
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US$100,000
monthly,
>Types of Letter of
Credit
month, the unutilized amount (i.e. USD20,000) may be carried over

to next month. That means the sum of US $120,000 becomes
available the next month.
Whereas under a non-cumulative revolving L/C, any amount
not drawn during a given period may not be available for
drawing in next period. As in the above example, the
unutilized amount of USD20,000 can not be carried over and
added to the amount of next shipments, that means the
exporter can draw only US$100,000 in each succeeding month.
As per the Exchange Control Manual, revolving LCs should

not be established for import of goods into India without
prior approval of RBI.
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Risk
Assessmen
t

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<Risk Assessment
Positive
Cash in
Advance
Vendor
Financin
g
Insurance
Ex-Im Bank
CEFO
Exporter
(Seller)
Beneficiary)

Open Account
Negative
Negative
Standby
Commercial (Acceptances)
Confirmed
Transferable
Back-to-Back
Assignment of Proceeds
Foreign
Exchange
Foreign
Receivables
Letters of Credit
Importer
(Buyer)
(Applicant)
Neutral
Zone
e
pm
i
h
S
nt
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Documenta
ry
Collection
Positive
<Risk Assessment
On the part of opening bank risk associated with Import LCs can be
classified into :
The financial standing of the Importer:
he should be in a position to arrange for funds required at the time of

retirement of bills under LC. This involves an appraisal of the
creditworthiness of the importer as a borrower.
Acceptability and saleability of the goods:
This is a generic risk associated with all modes of international trade,

and may affect the importers ability to pay for his consignment.
The status of the Exporter ( or beneficiary of the LC)
This is the risk inherent in a situation that an errant exporter may ship
substandard goods.

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<Risk Assessment
Country Risk:
This includes risk elements like the political and economical stability of
a country and exchange controls etc. Country Risk is however more
pertinent for exporters rather than importer..
Foreign exchange Risk:
A depreciation in the local currency vis-a-vis the transaction currency

may lead importer to pay more for the consignment than originally
envisaged.
The disadvantage attached with the LC is that it assures correct

documents but not necessarily correct goods.
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>Communication
through SWIFT
The communication in respect of documentary credit among

the
banks
take
place
through
SWIFT
(Society
for
Worldwide Inter-Bank Financial Telecommunication)

network.
SWIFT provides secure network to banks and financial

institution to transfer financial transactions
worldwide
through a 'financial message'.
SWIFT messages consist of five blocks of data including

three headers, message content, and a trailer.
SWIFT messages are present and categorized in specific MT

(Message Type) numbers. MT are crucial to identifying
content.
Example: MT304
A-301,
Square,
Thaltej
Crossroad,
Titanium
The first
digit
(3)
represents
T : +91
the
79 category.
4008 1101-2
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>Communication
through SWIFT
A category denotes messages that relate to particular

financial instruments or services such as Precious Metals (6),
Treasury (3), or Travelers Cheques (8). The category denoted
by 3 is Treasury Markets.
The second digit (0) represents a group of related parts in a

transaction life cycle. The group indicated by 0 is a
Financial Institution Transfer.
The third digit (4) is the type that denotes the specific
message. There are several hundred message types across
the categories. The type represented by 4 is a notification.

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Thank You
A-301, Titanium Square, Thaltej
Crossroad,
S.G. Highway, Ahmedabad 380054
W : www.edgewise.in
T : (+91) 79 4008 1101 / 2
T : +91 79 4008 1101-2

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A-301, Titanium Square, Thaltej Crossroad, S.G. Highway, Ahmedabad - 380054 T: +91 79 4008 1101-2 E: Info@edgewise - in W: WWW - Edgewise.in

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A-301, Titanium Square, Thaltej Crossroad,

S.G. Highway, Ahmedabad - 380054

T : +91 79 4008 1101-2

T : +91 79 4008 1101-2

A presentation by- Puneet

Principles and Theory :

a need for a streamlined system involving banks as an intermediate