5 Types of Letter of Credit (LC)

In all there are 5 types of letters of credit. Banks and huge financial institutions are involved in issuing L/C to importers and accepting L/C on behalf of the exporters in an international trade. Letter of credit is a boon to exporters and importers as it takes away the risk of non-payment for the delivery and non-receipt or faulty order deliveries and wrongful discharge of the terms of a contract. Before you go on to read about different types of letter of credits do read the previous article on Letter of credit-meaning, process, parties involved with an example.

Let us read and understand them one by one:-
  • Revocable letter of credit

    The word “revocable” means “cancellable”. So, a revocable letter of credit means that the letter of credit can be cancelled by the Issuing bank without the consent of or without intimating the beneficiary (the exporter in whose favour the letter of credit is issued). A letter of credit is revoked/ cancelled only when the beneficiary does not present documents to the buyer as per the terms of the contract. This type of letter of credit is risky for the beneficiary because he is unaware of the cancellation of the letter of credit while he is still feeling assured that the payment will be received on time from the issuing bank.
  • Irrevocable letter of credit

    This type of letter of credit cannot be cancelled or withdrawn by the issuing bank without informing and receiving an approval from the beneficiary. In this type of letter of credit the beneficiary is intimated about the reason of cancellation and is given an opportunity to correct the errors in the documents presented to the buyer only if the buyer approves.
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    Main Types of Letters of Credit
  • Confirmed letter of credit

    There are instances when the advising bank (bank of the exporter) asks for another bank to reassure the issuing bank’s letter of credit. In these cases the reassuring bank is called the confirming bank and a confirmation of backing the issuing bank’s letter of credit is sent by it to the advising bank. Such a letter of credit is called confirmed letter of credit.
  • Sight letter of credit

    When an issuing bank makes payment to the beneficiary immediately on receipt and verification of the documents from the beneficiary (exporter) it is called a sight letter of credit.
  • Usance letter of credit

    Letters of credit generally carry an expiry date on them. In an L/C contract where the issuing bank agrees to pay the beneficiary only on the expiry of the letter of credit, the L/C issued is called usance letters of credit. This is considered risky from the point of view of an exporter because he is left unpaid for a considerable period of time after the delivery of the documents and shipment. He might also be running short of working capital for his other orders because of this.
As letter of credit aims to protect the interest of the exporter by making payments against the documents sent to the importer, from the point of view of an exporter, a letter credit that is irrevocable, paid on sight and is confirmed by a confirming bank is the most secure and best option. Also read what is bank guarantee (b/g) with example in simple words.

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What is Letter of Credit (LC) ? Parties involved, Process

Trade between different countries of the world to exchange goods and services among themselves is called international trade (read what is International trade). There are innumerable risks associated to an international trade which create hindrances to the trade. That is exactly when a risk minimising option called Letter of Credit or LC offered by banks and financial institutions comes to the rescue of both the sides of a trade. (Read types of letter of credit)

Let us see what a Letter of Credit means, who are the parties, involved in LC and how the LC process takes place in simple words using an example.

Letter of Credit : Definition

Letter of Credit is a piece of paper issued by the bank of the importer on the request of the importer by which it agrees to pay the exporter the amount of money to be paid in exchange for the delivery of the goods if the importer fails to pay only after all the goods delivered on time and are as per the order. So, the entire risk of payment is borne by the bank of the importer. (Read What Is Bank Guarantee (BG) With Example )

Illustration of Letter of Credit

Let us assume that there is an international trade contract between Mr. A from the U.S.A. being the importer and Mr. X being the exporter from Singapore. Now, there is ABC bank of the U.S.A., called the issuing bank, which is the bank connected with Mr. A and XYZ Bank of Singapore, called the advising bank which is the bank connected with Mr. X. The advising and the issuing banks charge a certain amount of fees and commission for the services they provide.

Parties involved in Letter of Credit

So in a simple LC scenario there are 4 parties involved.
  1. Mr. A – the importer from USA
  2. ABC Bank - the issuing bank (bank which supports the importer)
  3. Mr. X – the exporter from Singapore
  4. XYZ Bank – the advising bank (bank connected with the exporter)

Steps in a Letter of Credit

In all, a letter of credit has 8 steps from the time the transaction originates to when both the sides are compensated.
  1. Mr. A places an order with Mr. X and is expected to submit a Letter of Credit to Mr. X.
  2. So, he goes to ABC bank and submits an application requesting a Letter of Credit in favour of Mr. X.
  3. Once the issuing bank, ABC Bank satisfies itself with the credentials of Mr. A, it issues an LC which it passes on to XYZ Bank, the advising bank.
  4. After XYZ bank checks the authenticity of the LC issued by ABC bank and makes all other relevant checks, approves it and informs Mr. X that an LC is issued in his favour.
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    Procedure of Letter of credit
  5. Then Mr. X prepares all the necessary documents related to the contract submits his bank for approval and simultaneously releases his goods for delivery to Mr. A.
  6. These submitted documents are verified by XYZ bank which after approving them sends it to the ABC Bank.
  7. After the issuing bank, ABC Bank checks and approves the documents sent by the advising bank, it releases the documents to Mr. A and also charges commission and fees from him, who can now take the delivery of his order against these documents.
  8. ABC bank now releases the payment to XYZ bank who then credits to the Mr. X’s account after charging some commission for the services provided.

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What Is Bank Guarantee (BG) With Example

Every trade transaction/ monetary dealing either domestic or international (read more about What is International trade/ foreign trade? Meaning, purpose & types) is faced with the possibility of innumerable risks from both the sides of the business contract. That is when a Bank Guarantee and a Letter of Credit offered by banks help to ease the tension of dealing with risks in carrying out the trade contract.Let’s understand what is a Bank Guarantee- the parties involved and its process with help of an example.

What is a Bank Guarantee?

A Bank Guarantee is a an assurance given by a financial institution (usually a bank) to pay on behalf of its client (buyer/importer/borrower) who is obligated to pay money to a seller of some goods and services or a lender or anyone who is to be paid for a certain transaction that is going to take place. Bank Guarantee can be claimed only when the seller has performed his part of the contract and the issuing bank’s client (buyer) has failed to make the payment.In other words, it is always the obligation of the buyer to pay for the purchase/borrowing and only if he is unable to make the payment on the date of payment, the bank guarantee can be put to use. In such a case the bank will pay the amount to the seller’s bank and later collect the amount from its client. There is no interest charged to the applicant unless the bank has had to pay the money to the seller. Bank Guarantees are issued for a commission on the contract value.

Parties involved in a Bank Guarantee

There are usually 4 parties in a BG. They are-
  1. A buyer/importer/borrower- the applicant
  2. The buyer’s/ importer’s/borrower’s bank- the issuing bank
  3. The seller/exporter/lender- the beneficiary
  4. The seller’s/exporter’s/lender bank’s- the advisory bank
But in case of large contracts like real estate and infrastructure projects the seller/builder also needs to present a Bank Guarantee from his bank to prove his credit worthiness to the purchaser to be able to perform his part of the contract without delay as these contracts require a huge amount of money to be executed efficiently.

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Bank Guarantee Procedure

Process of Bank Guarantee using an example

Imagine that James makes a purchase order for 1000 tables for his school from M&S. A& Co. for $20,000. M&S.A& Co. wants an assurance from James that he will not default the payment for the order. So, James goes to his bank, say, XYZ Bank and applies for a Bank Guarantee. The bank upon receiving the application does a thorough background and credit worthiness check of James and approves to issue a Bank Guarantee. James provides the details to M&S. A& Co. who then passes this on to its bank, say, ABC bank where the authenticity of the BG is verified and accepted. BG provides M&S. A& Co. to claim for the payment from XYZ Bank in case of a default by James. Now, suppose that M&S. A& Co. has delivered the tables as per the contract on time to James and he is unable to meet the payment due to some reason. Then, M&S.A&Co. makes a claim for payment from XYZ bank. After satisfying itself regarding the fulfilment of the seller’s part of the contract, XYZ Bank releases the amount. Later on, XYZ Bank collects the amount from James along with an interest on the money paid to M&S. A&Co. and a commission on the contract value for the Bank Guarantee service.

Important points:
  • Bank Guarantees provide a security from credit risk to the seller/exporter/lender.
  • Bank Guarantees are intended to protect the interests of both the buyer and the seller as explained above regarding large scale contracts.
  • Bank Guarantees are majorly used in real estate and infrastructure projects.
  • The primary obligation to pay for the contract is on the buyer (applicant) while the secondary obligation to pay is on the buyer’s bank (issuing bank).

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What is International trade/ foreign trade? Meaning, purpose & types

Meaning of International Trade:

International trade is the relationship between different countries for the purpose of trade and commerce. It comprises Imports (buying from another country) and Exports (selling to another country. The trade taking place may be of goods like garments, agricultural products, gems, petroleum etc., or of services such as inviting and/or sending people who possess technical knowledge and expertise like a doctor, diplomat, engineer etc. (Read what is a letter of credit)

Purpose of foreign/international trade:

The answer is pretty simple. Since not everything that the residents need is available or available in adequate quantities in a country, there is a need to purchase (import) from the countries that have more or surplus of that product. So, while countries need diamonds and gold more than they have, they inevitably import them from Africa. Similarly when a country has a shortage of professional engineers and doctors, it looks for professionals who are ready to immigrate. Secondly, there are times when a country has excess or surplus of a product or service which will be wasted if not sold to other countries. We can think of China exporting huge volumes of steel to its Asian neighbours because it has more than it needs. Thirdly, if a country/ a tradesman feel that a particular product or service earns more abroad than in the home country, they are tempted to engage in exporting off such cash cows.

Types of international trade:

A. Based on agreement
  • Bilateral trade- if there is an agreement between two countries to buy and sell certain kinds of goods and services in exchange of money, it is called bilateral trade agreement. A country can have bilateral trade agreement with any number of countries.
  • Multilateral trade- if there is a trade agreement between more than two countries to buy and sell certain kinds of goods and services among themselves in exchange of money, it is called multilateral trade agreement. Any number of multilateral trade agreements can be signed by a country.
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Components of International Trade

B. Based on activity
  • Import trade- If a country purchases goods and services from another it is called an import trade for the purchasing country.
  • Export trade- If a country sells goods and services to another it is called an export trade for the selling country.
  • Entrepot trade- if goods and services are sent or received from a country for the purpose of sending to another country, it is called entrepot trade.

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5 Mistakes Not To Be Made While Investing In Mutual Funds

When it comes to investing our hard earned money, we want be aware and cautious of what we are doing and what is to be done to make the best decisions. But many times in this endeavour of ours we tend to make unpardonable mistakes that cost us a lot in the future and hurt our money. (read myths about mutual funds busted)

Here are 5 mistakes that you must not do while investing in mutual funds:

  1. Waiting for the right time
    Mutual fund investments or any investment in the markets are subject to a lot of economic, social and political pressures from around the world. And as such no moment is a good time or a bad time unless it becomes a moment of the past. The sheer lack of unpredictability makes determining the right time impossible for a mutual fund investment. Moreover, long term investors (5-7years) need not worry about entering the market at the right time because over the span of the investment, markets are going to see the ups and the downs and at the end the downs are going to be balanced by rewarding ups. A rational investor would opt for a SIP (read what is a SIP) where in the investor makes a regular investment while reducing the risk of loss in investment value and still reaping average returns of around 12%.
  2. Investing all money at a time
    As discussed above, it is very difficult to define the best time to make an investment because the definition of “good time” keeps changing every moment. And given this understanding, investing all the money at a time in a mutual fund can harm the invested money in case a downfall in the economy follows soon after the investment is made. We cannot foretell the ups and downs that are in store. Hence, again the best and safest option would be to opt for a mutual fund SIP after researching a few funds and seeing their past performances and management skills. (read 20 things to consider while investing in a mutual fund)
  3. Diversifying too much
    All of us have heard “Do not put all your eggs in the same basket”. This is relevant to investments as well. Yes, it is important to stay invested in equity, debt and hybrid but only after ascertaining the objectives of and expectations from the investment. Just picking tens of schemes and investing in each of them so as to reduce the risk of losses is a foolish decision. Firstly, an investor should realise that he is paying annual charges on each of his mutual fund schemes. Secondly, he should understand that investing in 10 different schemes but all of the same equity or debt or hybrid or sector based will lead him nowhere. If an investor has a low risk taking capacity but still wants to see substantial returns on the investments rather than diversifying in a haphazard manner he must look to invest in a well managed and good performing MF scheme for a long period of time.
  4. Panicking and redeeming your mutual fund investments
    It is a human tendency that once he has invested money he will try his best to keep a track of how the markets are moving, how the economic situation in the country and abroad is, how any new regulation would affect the investment and so on and so forth. A less informed and an irrational investor would panic once he comes across a negative piece of news or believes the rumours that are circulated on any mass media platform. Staying invested at such times is the wisest decision to make if he is investing in a mutual fund SIP. Mutual fund SIPs have a feature of averaging out the ups and downs and compensating for the same and yet providing a decent return of investment. And long term investors of any type of mutual fund should never opt to redeem their investment at such times because it is the rule of the market and economy to stabilise and grow over the long term, thus nullifying any losses. (read mistakes people do while investing in mutual funds)
  5. Going only by past performances and or star-ranks
    Although an investor must look at the past performance of a mutual fund scheme before choosing to invest in it, going just by the past performance is a huge mistake. That means what an investor must look for is a scheme that may or may not be the best star-rated or the best performing scheme of its category, but also see how the scheme has performed when the economy has seen the ups and downs that we have been talking about. He must also see the expense ratio, the entry and exit charges (read what is a expense ratio and entry & exit load). He should also pay heed to how the other mutual fund schemes under the same AMC are performing. He should look at the risk involved in the mutual fund schemes he is looking at and see if they match his risk appetite. Lastly, he must see if taxes under one category of mutual funds are eating too much into his returns.

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