LETTER OF CREDIT
A letter of credit, or “credit letter” is a letter from a bank guaranteeing that a buyer’s payment to a seller will be received on time and for the correct amount. In the event that the buyer is unable to make a payment on the purchase, the bank will be required to cover the full or remaining amount of the purchase.
Types of Letter of Credit
There are various types of letters of credit in trade transactions. Some of these are classified by their purpose. The following are the different types of letters of credit:
Commercial Letter of Credit
A standard LC also called as a documentary credit.
A commercial letter of credit is the most common type of letter of credit in usage. In fact, it is commonly known as a regular letter of credit.
Global trade is on a rise and brings its own difficulties for all the parties involved. The major difficulties include each country’s different laws, different custom rules, and different languages. Also, a major problem is not being able to know a foreign buyer or a seller personally. Therefore, it becomes difficult to judge credibility. It has become essential to have a common tool that gives security to both the buyer and the seller. This is where the letter of credit comes into the picture.
Letter of credit is a payment term used for international trade. By availing a letter of credit the buyer knows that he will receive the goods that he is paying for and the seller is sure that he will receive the payment against his supply.
There are many types of letters of credit, in today’s post, we are going to discuss the commercial letter of credit:
Table of Contents [show]
Commercial Letter of Credit – Definition
A commercial letter of credit is a legal document from a bank or a financial institution, it represents a promise to pay the holder if the holder fulfills his obligation. Sellers in international transactions often require a guarantee of payment. This guarantee comes from the bank in the form of a letter of credit. If the buyer fails to make payment against his purchases, the bank will cover the full or remaining amount of purchase.
Commercial Letter of Credit Process with Example
Let us understand the process flow of letter of credit with an example.
There are four parties involved in a commercial letter of credit as follows –
- Buyer – Tom residing in the USA
- Issuing Bank – Bank of America, the USA
- Correspondent Bank – Bank of India, India
- Beneficiary/Seller – Ram residing in India
Step 1: Sales Agreement
On 1st January 2018, Mr. Tom from the USA agrees to buy goods worth USD 10,000.00 from Mr. Ram in India. During the negotiations, it was agreed that payment would be done in a commercial letter of credit.
Step 2: Opening Instructions
Mr. Tom requests Bank of America to open a letter of credit of USD 10,000.00 in favor of Mr. Ram. The Bank of America checks Mr. Tom’s creditworthiness and completes the required formality to issue a letter of credit for this transaction.
Step 3: Issuing Letter of Credit
On 8th January 2018, The Bank of America issues the requested letter of credit that expires 90 days from the date of issue and forwards it to the corresponding bank i.e. Bank of India. The corresponding bank is usually located in the country in which the seller resides, in our example, it is in India. Bank of India will authenticate the letter of credit and send it to Mr. Ram.
It is necessary that Mr. Ram exports the goods and submits the required documents before the expiry of the letter of credit. If not then the bank of America is not obliged to pay if Mr. Tom doesn’t.
Export/Import Letter of Credit
The Same LC becomes an export or import LC depending on who uses it.
The exporter will term it as an exporter letter of credit whereas an importer will term it is an importer letter of credit.
A letter of credit is a vital tool for facilitating international trade. It benefits both the importers and exporters. An import letter of credit enhances the credit worthiness of the importer while an export letter of credit mitigates the credit risk for the exporter and helps improve his cash flow.
Import Letter of Credit
Import letter of credit is issued by the importer’s bank on behanf of the importer with the exporter being the beneficiary. It is a guaranteed by the importer’s or buyer’s bank that the payment will be giver to the exporter or seller. The credit capacity of the importers is substituted by the credit capacity of the issuing bank. This improves credibility and reduces the risk of fraud. There are terms and conditions regarding the type, quantity, place of delivery and time of delivery mentioned in the import letterof credit.
It also mentions the documents to submitted as proof os shipment. The exporter has to submit some specified documents fulfilling the conditions before the payment can be released to him.
Import Letter of Credit
Advantages of Import Letter of Credit
The biggest advantage of import letter of credit is fraud risk mitigation. The exporter has to submit valid documents as proof of shipment of agreed upon goods before the payment can be made. The terms and conditions under import letter of credit cannot be changed unless all the parties agree, so it’s legally binding. An import letter of credit increases the credit-worthiness of the importer because credit capacity is transferred to the issuing bank. This enables importer to get a better bargain on the prices of imported goods and also access extra funding for expanding his business. Since an import letter of credit is of immense help in less established trade relationships, it provides a safe way to expand sourcing into new geographies for getting lower prices and hence increasing importer’s business margins.
Disadvantages of Import Letter of Credit
The issuing bank is required to pay the exporter as and when he presents the documents covered in terms and conditions of the import letter of credit. There is a risk of receiving bad or damaged goods even if the documents are satisfactory. An importer can mitigate this risk by verifying the exporter’s reputation and checking a sample of goods beforehand. He can also hire an independent third party to do the physical inspection of goods before they are shipped. Issuing a letter of credit adds to the cost of doing business.
Transferable Letter Of Credit
A letter of credit that allows a beneficiary to further transfer all or a part of the payment to another supplier in the chain or any other beneficiary. This generally happens when the beneficiary is just an intermediary for the actual supplier. Such LC allows the beneficiary to provide its own documents but transfer the money further. Transferable Letter of Credit
Definition of Transferable Letter of Credit
Transferable Letter of Credit is a credit facility in which the first beneficiary has the right to pass on the available credit to another party i.e. secondary beneficiary. This is possible only when the Letter of Credit is marked as transferable by the issuing bank upon the instructions of the buyer or the importer of goods.
Let us under the concept in simple words:
Concept of Transferable Letter of Credit
There are four parties involved in it. The parties are first beneficiary, secondary beneficiary, final buyer and the bank. The middlemen/exporter i.e. the first beneficiary is one who receives an order from the final buyer. The middlemen is always in shortage of money. So, he requests the final buyer for Transferable Letter of Credit. If the final buyer finds it valuable to engage in the foreign transaction, he will request his bank to issue Irrevocable Transferable Letter of Credit. Now the first beneficiary can purchase the raw materials from the supplier to manufacture goods. Instead of making a cash payment, the middlemen can pay his supplier by giving him the Transferable Letter of Credit. Here the supplier becomes the secondary beneficiary.
Let us understand it with the help of an example.
Example of Transferable Letter of Credit
Kira Ltd, a German company places an order to Sim Ltd., an American company. Sim Ltd. requests Kira Ltd to issue a Transferable Letter of Credit so that it can avail credit facility from its supplier on the basis of such letter of credit. Kira Ltd. requests its bank to issue Transferable Letter of Credit. In this scenario, if the bank refuses to issue Transferable Letter of Credit, Sim Ltd. cannot further avail credit facilities. However, if the bank agrees to the request of Kira Ltd., Sim Ltd. can issue the Transferable Letter of Credit to its supplier i.e. the secondary beneficiary.
Un-transferable LC
A letter of credit that doesn’t allow the transfer of money to any third parties. The beneficiary is the only recipient of the money and cannot further use the letter of credit to pay anyone.
Revocable Letter of Credit
An LC that Issuing bank or the buyer can alter any time without any notification to the seller/beneficiary. Such types of letters are not used frequently as the beneficiary is not provided any protection.
Revocable Letter of Credit – Meaning
A revocable letter of credit is a type of letter of credit in which the issuing bank can amend the terms of the letter of credit or cancel the letter of credit completely without giving prior notice to the beneficiary.
Reasons due to Which a Bank Revokes a Letter of Credit
There are many reasons due to which the issuing bank decides to revoke the revocable letter of credit.
Firstly, there are adverse circumstances such as political tension, deteriorated market conditions, etc. due to which the bank is incapable to honor the terms of the letter of credit. There are high chances of the letter of credit being revoked by a bomb hit bank in Afghanistan.
Secondly, there is a possibility that the issuing bank doesn’t have sufficient funds to honor the letter of credit in which case it cancels the letter of credit. For example after the 2008 financial crisis, Merrill Lynch filed for bankruptcy. In such a condition, it may revoke all its revocable letter of credit.
Irrevocable LC
An LC that does not allow the issuing bank to make any changes without the approval of all the parties.
Standby Letter of Credit
A letter of credit that assures the payment if the buyer does not pay. After fulfiling all the terms under SBLC, if the seller proves that the promised payment was not made. In this situation, the bank will pay to the seller,\.
In a nutshell, it does not facilitate a transaction but guarantees the payment. It is quite similar to a bank guarantee.
Definition of Standby Letter of Credit
A Standby Letter of Credit is a document that provides a guarantee to the beneficiary that, if due to any circumstances, the importer is unable to pay, then the bank will make the payment to the beneficiary, i.e., the exporter.
Let’s try to understand the concept of Standby Letter of Credit with the help of the following example.
Example of Standby Letter of Credit
Niya Ltd., an exporter from India, received an order to supply goods to John Ltd., an American company. Niya Ltd. wants an assurance from John Ltd. that it will make timely payment for the goods. Obliging to the request of Niya Ltd., John Ltd. issued a Standby Letter of Credit in favor of Niya Ltd. In this case, if due to any circumstances John Ltd. fails to make the payment to Niya Ltd., the Indian company can claim the credit on the Standby Letter of Credit. Thus, the Standby Letter of Credit acts as an assurance to the exporter that he will be paid for the export of goods.
The concept of a Standby Letter of Credit is often confused with a Letter of Credit. However, there are some differences between the two:
Standby Letter of Credit vs. Letter of Credit
A Letter of Credit is a credit document used to make payment to the beneficiary upon the fulfillment of contractual obligations. However, a Standby Letter of Credit is a standby payment mode that can only be used by the beneficiary when the purchaser fails to make the payment for any reason.
For a detailed explanation of the differences, please read: Standby Letter of Credit vs Letter of Credit
LC Vs. SBLC
Both the regular letter of credit and standby letter of credit are payment instruments used in international trade. However, there are some basic differences in the product which we will discuss in the following post –
Meaning
A letter of credit is a promise from the bank that the buyer i.e. importer will fulfill his payment obligation and pay the full invoice amount on time. The role of the issuing bank is to make sure that the buyer pays. In case the buyer is unable to fulfill his obligation, the bank will pay to the seller i.e. the exporter, but the funds come from the buyer.
On the other hand, a standby letter of credit is a secondary payment method where bank guarantees the payment when terms of the letter of credit are fulfilled by the seller. It is a kind of additional safety net for the seller. The buyer may not pay the seller due to multiple reasons such as cash flow crunch, dishonesty, bankruptcy, etc. But as long as the seller meet’s the requirement of a standby letter of credit, the bank will pay.
Features within the Instrument
A letter of credit does not have any specific features that the buyer must adhere to for completion of a transaction. It does have basic requirements such as documentation, packing, etc. But all in all, it’s a plain vanilla payment instrument.
A standby letter of credit may have specific clauses that the buyer must fulfill so he can use this instrument. For example, Mr. Harry who resides in the UK agrees to buy 5000 pairs of socks from Mr. Chang who resides in China. Mr. Chang does not want to take the risk so he asks Mr. Harry to get a standby letter of credit. Mr. Harry obtains a standby letter of credit from HSBC bank and he adds following clauses –
- The material of the socks should be – 80% cotton 20% polyester
- Each pair should be packed in a clear plastic bag having a logo tag
- There can be only 1% defect margin i.e. only one pair of defective socks in a hundred pairs is acceptable
Mr. Chang should fulfill all the above-mentioned performance criteria to be eligible for payment through a standby letter of credit. A regular letter of credit cannot have such performance criteria
The Requirement of Issuing Bank
When issuing a letter of credit the bank checks the buyer’s credibility and credit score. Furthermore, it is usually the case that a buyer asks his banker for a letter of credit, i.e. the buyer is usually dealing with the said bank for a long time. So the letters of credit are usually unsecured.
Conversely, a standby letter of credit creates an obligation for the bank, therefore the bank will require a collateral in the form of security to issue a standby letter of credit.
Goal
The letter of credit is a primary instrument of payment, so the goal is to use the letter of credit to complete the transaction.
In contrast, a standby letter of credit is a secondary instrument of payment. If a seller is paid by a standby letter of credit, it means that something went wrong. The goal here for all the parties involved is to avoid using standby letter of payment.
Time Period
A letter of credit is a short-term instrument, where the expiry is usually 90 days.
A standby letter of credit is a long-term instrument, in which the validity is usually one year or so.
Purpose
A letter of credit is used to provide security for a transaction such as a sale agreement.
A standby letter of credit is often used to provide security for a long-term obligation such as a long-term construction project.
Geographical Scope
A letter of credit is usually used in an international transaction where the buyer is the importer and the seller is the exporter.
A standby letter of credit is used in an international transaction but it is also frequently used in domestic transactions as well. Its scope is not limited to any geographical area.
Cost
A standby letter of credit is more expensive than a regular letter of credit. While the fees of a regular letter of credit range from 0.75% to 1.50% of the amount covered, a bank may charge anywhere between 1% to 10% to cover the same amount under a standby letter of credit.
Confirmed LC
Which the seller or exporter acquires the guarantee of payment from a confirming bank (also called the second bank). This is primarily to avoid the risk of non-payment from the first bank.
Confirmed Letter of Credit
Confirmed Letter of Credit – Meaning
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 i.e. in case the first bank fails to pay then the payment will be done by the second bank. This is a trade payment method used for international trade.
Why Confirmed Letter of Credit?
The underlying intention of obtaining any type of letter of credit is the sense of security, especially for the seller. In an international transaction, the holder of a letter of credit i.e. the seller must be assured that he will get the payment from the issuing bank if he complies with the terms of payment, but this is not always the case. Sometimes, the seller is not sure whether he will receive the payment against his goods or not. This uncertainty can arise from numerous factors such as questionable creditworthiness of issuing bank or political or economic vulnerability associated with the geographical location of the issuing bank. For example, payment of a regular letter of credit from a bank in Syria is questionable as the country has disturbances. In such cases taking a second guarantee i.e. obtaining a confirmed letter of credit is a wise decision.
The buyer has to go through the same procedure to obtain a second letter of credit. The buyer has to find a second bank who can give confirmation. In general cases, the second bank is the correspondent bank in the seller’s country.
Unconfirmed LC
A letter of credit that is assured only by the issuing bank and does not need a guarantee from the second bank. Mostly the letters of credit are an unconfirmed letter of credit.
Revolving Letter of Credit
When a single LC is issued for covering multiple transactions in place of
issuing separate LC for each tranaction is called Revolving LC. They can
be further classified into Time Based ( Could be Cumulative or Non-Cumulative and Valued-Based.
Meaning
A revolving letter of credit is a single letter of credit that covers multiple transactions over a long period of time. It is very specific in a way that it is used for regular shipments of the same commodity between the same buyer (importer) and the seller (exporter). This letter of credit is issued only once for a certain period of time or a certain number of transactions. It avoids the need for repetitive arrangements to open a new letter of credit for every transaction.
Types of Revolving Letter of Credit
The revolving letter of credit can be further divided into two subcategories. One is based on time, the other is based on value. Let’s understand each in detail. Following are the two types of revolving letter of credit:
Revolving Letter of Credit Based on Time
In the revolving letter of credit that is based on time, a specific amount (payment) is allowed to be drawn within a defined period of time. Let’s understand with an example.
Example – Mr. Cho from China is a manufacturer of ball pens and is a regular supplier to Mr. Will who is based in the UK. They decide to have a transaction with a revolving letter of credit. On January 1, 2018, Mr. Will obtains a revolving letter of credit of USD 60,000.00 to be drawn each month by USD 10,000.00 for the next 6 months in the name of Mr. Cho.
Following is the line of transactions –
| Month | Transactions on the part of Mr. Cho | Payment through revolving letter of credit |
| January 2018 | Goods worth USD 10,000.00 manufactured and shipped | Payment received USD 10,000.00 |
| February 2018 | Goods worth USD 3,000.00 manufactured and shipped | Payment received USD 3,000.00 |
| March 2018 | Goods worth USD 4,000.00 manufactured and shipped | Payment received USD 4,000.00 |
| April 2018 | Goods worth USD 12,000.00 manufactured but shipping of only USD 10,000.00 allowed. So goods of USD 10,000.00 shipped and remaining goods kept in stock | Payment received USD 10,000.00 |
| May 2018 | Goods worth USD 8,000.00 manufactured and goods worth USD 10,000.00 shipped (USD 8000.00 of May + USD 2000.00 of April) | Payment received USD 10,000.00 |
| June 2018 | Goods worth USD 10,000.00 manufactured and shipped | Payment received USD 10,000.00 |
| End of June 2018 | Revolving letter of credit expired |
Further, a revolving letter of credit based on time can be of two types as follows –
Cumulative
In a revolving LC based on time, if it is the cumulative type, the previous unused L/C limits can be used in future months. In the previous example, if Mr. Cho doesn’t ship any good in the month of May 2018, then he can ship goods worth USD 20,000.00 in the month of June 2018.
Non-Cumulative
In a revolving letter of credit based on time, if it is the non-cumulative type, then the previous unused L/C limits cannot be used in future months. In the previous example, if Mr. Cho doesn’t ship any good in the month of May 2018, still he is allowed to ship only goods worth USD 10,000.00 in the month of June 2018. The USD 10,000.00 unused limit of May 2018 becomes void.
Revolving Letter of Credit Based on Value
The second type of revolving letter of credit is based on value. In this, an amount and a validity for the letter of credit is set, and the seller has to work on these criteria.
Let’s extend our previous example and make it revolving letter of credit in relation to value. Other things same on January 1, 2018, Mr. Will obtains a revolving letter of credit of USD 60,000.00 to be drawn each month by USD 10,000.00 for the next 6 months in the name of Mr. Cho.
Back-To-Back Letter of Credit
Back to Back Letter of Credit is an LC wich commonly involves an intermediary in a transaction. There are two letters of credit, the first issued by the bank of the buyer tothe intermediary and the second issued by the bank of an intermediary to the seller.
Back-to-Back Letter of Credit Definition
Back-to-Back Letter of Credit is a negotiable instrument in which the seller gets a Letter of Credit from the buyer and the seller further transfers the Letter of Credit to its supplier. In simple words, the seller first gets the Letter of Credit from the buyer to ensure timely payment and further the same seller hands over the Letter of Credit to someone from whom he buys goods or materials. There are various advantages and disadvantages of Letter of Credit. Let us take an example to under the concept of Back-to-Back Letter Of Credit.
Example of Back-to-Back Letter of Credit
Suppose a garment manufacturer Xion Ltd. sells its product to Harry. In return, Harry did not make the payment. Instead, he gave Xion Ltd. a Letter of Credit. This Letter of Credit is an assurance to Xion Ltd. that if Harry fails to make timely payment, Xion Ltd can use the negotiable instrument to get its claim from the bank. To process the order of Harry, Xion Ltd. purchases raw material from its supplier, Noble Ltd. Xion Ltd. does not make any payment to it. Instead, it hands over the original Letter of Credit received from Harry after changing the beneficiary name with its intermediary bank. Now Noble Ltd. is assured that it will receive the payment for the material purchased by Xion Ltd. This transfer of Letter of Credit from one seller to another seller is Back-to-Back Letter of Credit (BBLC).
Parties to BBLC
- Issuing Bank
- Confirming Bank
- Beneficiary
- Transferring Bank
- Applicant
- Advising Bank
- Accepting Bank
Procedure for Back-to-Back Letter of Credit
The issuing bank upon getting the instructions from the customer agrees to issue Letter of Credit, which is transferable to the first beneficiary. This means that the first beneficiary can transfer the letter of credit to its customer or third party or secondary beneficiary. The transferring bank i.e. the bank issuing the letter of credit shall issue a “Transferred Letter of Credit”. The “Transferred Letter of Credit” looks identical to the original Letter of Credit. The first beneficiary holding the original Letter of Credit gives the “Transferred Letter of Credit” to the secondary beneficiary.
Essential Documents Required for Letter of Credit
Payment Clause in Back-to-Back Letter of Credit
When the first beneficiary transfers the original LC to the secondary beneficiary, it is assumed that the payment has been made to the first beneficiary of the transaction when LC is presented at the bank. However, if partial payment is made to the secondary beneficiary, in such case the original beneficiary has the right to present the invoice and draft to the bank after the secondary beneficiary has presented the documents.
Example of Payment in Back-to-Back Letter of Credit
Suppose Xion Ltd. has handed over Noble Ltd. a Back-to-Back LC. Noble Ltd. approaches the bank to claim its payment that was due from Xion Ltd. The original LC was issued for $ 15,000, but the payment due to Noble Ltd was only $ 10,000. Here the bank will require not only the original LC but also a written request to hand over the specified amount. Bank requires original LC to endorse it further by writing the amount due and the name of the party. LC being a negotiable instrument can be endorsed further. After making the payment to Noble Ltd, the bank shall issue a document suggesting the payment made to the party of the original LC and the amount due on it.
Red Close Letter of Credit
A letter of crefit that partially pays the beneficiary before the goods
are shipped or the services are performed. The advance is paid against
the written confirmation from the seller and the receipt.
Meaning
A red clause letter of credit is a specific type of letter of credit in which the buyer can extend the facility of advance payment to the seller against a certain documentary requirement. In other words, under the red clause letter of credit, the issuing bank will make an advance payment to the exporter i.e. the seller before the seller ships the goods to the importer i.e. buyer. This is usually done to provide aid to the seller in the form of working capital to purchase raw material, processing and packaging of goods, etc. The advance payment is done against documentary requirement which includes written undertaking and receipts.
Thus we can say that a red clause letter of credit facilitates pre-shipment finance for the beneficiary. Originally these letters of credit were written in red ink, so they are called red clause letter of credit.
Advantages of Red Clause Letter of Credit
Interest-Free Unsecured Working Capital Finance for the Seller
The most defining and major benefit of a red clause letter of credit is that the beneficiary i.e. the seller has easy availability of working capital. If the seller avails a regular means of finance, he may have to pay anywhere between 7% to 15% interest for the financing facility. The seller can save on interest expense with red clause letter of credit.
Advantage to the Buyer
When the seller saves interest expense on working capital, he can pass on this benefit to the buyer. Thus the buyer will have an advantage of lower cost product. This is a competitive advantage for the buyer. Thus red clause letter of credit creates a win-win situation for both the buyer and the seller.
Disadvantages in Red Clause Letter of Credit
Beneficiary may not Use the Advance for Right Purpose
The main intent of red clause letter of credit is to provide finance to the seller for his working capital needs. This way he can have enough liquidity to pay for raw material, production costs, labor, etc. It also acts as a surety to the buyer that the order placed will be manufactured on time and without any hitches. However, it may happen that the seller will not use the advance payment for its intended purpose. In many cases, it has happened that the seller used the money to pay off his past debt. This actually nullifies the purpose of red clause letter of credit.
Risk of Bad Debt
In any transaction when one party gives an advance payment to another party, there is always a risk that the receiver may simply take the money and run off. This risk intensifies when the seller (receiver of the advance) is from another country. This is an intrinsic risk that a red clause letter of credit carries.
The mechanism of the red clause letter of credit is such that the issuing bank extends an advance to the seller on instructions of the buyer. After the seller fulfills his obligation, the buyer pays to the bank. If the seller doesn’t oblige to his side of the promise, then the issuing bank will ask for the money it has advanced from the buyer. Thus it is very important for the buyer to have trust in the seller, else this arrangement can actually backfire on the buyer.
Interest, Fees and Other Expenses
The red clause letter of credit is quite an expensive tool. It carries a fixed fee which is higher than the regular letter of credit. Also, the advance payment that issuing bank gives to the seller carries an interest rate. At the time of final payment, the buyer has to pay this interest rate plus the letter of credit amount. Furthermore, the issuing bank may ask for a collateral from the buyer against this letter of credit. It will also check the buyer’s credibility and past records.
Therefore, it is necessary that the buyer does a proper cost-benefit analysis before applying for the red clause letter of credit.
Green Clause L
An LC that pays advance to the seller just not against the written undertaking and a receipt, but also a proof of warehousing the goods.
Green Clause Letter of CreditGreen clause letter of credit is a type of letter of credit that is available for international trade. It is called green clause letter of credit because originally these were written in green ink.
Understanding Green Clause Letter of Credit
To understand the green clause letter of credit, it is first important to understand the red clause letter of credit.
Red Clause Letter of Credit
In the simplest words, we can say that red clause letter of credit is an advance payment letter of credit. Under the red clause letter of credit, the issuing bank will make an advance payment to the exporter i.e. the seller before the seller ships the goods to the importer i.e. buyer. This is usually done to provide aid to the seller in the form of working capital to purchase raw material, processing and packaging of goods, etc. The advance payment will be done against documentary requirement under the red clause letter of credit. Generally, documents required are written undertaking and receipts.
Now let’s move on to green clause letter of credit.
Green Clause Letter of Credit
Green clause letter of credit is an extension of red clause letter of credit. Which means it provides the advance not only for the purchase of raw materials, processing, and packaging of goods, etc. but also for pre-shipment warehousing at the port of origin and insurance expense. In usual cases, the advance under this letter of credit is granted only after the purchased goods are stored in bonded warehouses. This type of letter of credit is usually used in transactions related to commodity market such as wheat, rice, gold, etc.
The documentary requirement for green clause letter of credit is more than the red clause letter of credit. In addition to written undertaking and receipts, the issuing bank requires documents of title to transfer advance under green clause letter of credit. The document of title just proves that the goods to be shipped are already warehoused.
Let us now understand the difference between the green clause letter of credit and red clause letter of credit.
Difference between Green Clause Letter of Credit and Red Clause Letter of Credit
Documentation Requirement
As mentioned in previous paragraphs, the defining difference between a green clause and a red clause letter of credit is its documentary requirement. While advance can be transferred in red clause letter of credit by presenting written undertaking and receipts, an additional document of title is required in green clause letter of credit for transfer of advance.
Proportion of Advance
In red clause letter of credit, usually, the percentage of advance available is 20% to 25% of the face value of the letter of credit. In contrast, the availability of advance can be expanded to 75% to 80% of the face value of the letter of credit under the green clause letter of credit.
Security
In such international transactions, the buyer is always concerned about his safety as he is paying advance money to the seller. The buyer i.e. the importer is more secured in green clause letter of credit than the red clause letter of credit. This is because the buyer is extending the advance against the document of title. Which means the buyer knows that the goods in question are already warehoused and only the shipment procedure is remaining. On the other hand, in the red clause letter of credit, the advance can be extended even before the production begins this makes it more risky for the buyer.
Green Clause Letter of Credit Process with an Example
Let’s now understand the green clause letter of credit process with an example.
Example –
Mr. Mac from Canada is buying wheat worth USD 10,000.00 from Mr. Shiv from India. Mr. Shiv requests Mr. Mac to issue a green clause letter of credit with an advance payment of USD 5000.00 (i.e. 50%). Mr. Mac agrees and applies for green clause letter of credit with his bank – Bank of Canada
Importer/Buyer – Mr. Mac from Canada
Exporter/Seller – Mr. Shiv from India
Green clause letter of credit issuing bank – Bank of Canada
Advising bank – Bank of India
Following is the detailed process for the above example –
- The sale transaction in agreed upon.
- On request of Mr. Mac, Bank of Canada issues Green Clause Letter of Credit of USD 10,000.00 in the name of Mr. Shiv (beneficiary)
- Bank of India advises the Green Clause Letter of Credit received from Bank of Canada to Mr. Shiv
- Mr. Shiv collects warehouses the wheat that is to be shipped on Mundra Port (Port of origin) of India
- Mr. Shiv submits the advance payment document, i.e. written undertaking, receipt and document of title to the Bank of India
- Bank of India checks these documents and sends it to Bank of Canada
- Bank of Canada checks the advance payment documents and informs Mr. Mac that the documents have arrived
- Mr. Mac provides an undertaking to Bank of Canada that he will pay the 50% advance i.e. USD 5000.00 to the Bank of Canada in future.
- Bank of Canada pays USD 5000.00 to the Mr. Shiv through Bank of India. Which means Bank of India receives the payment from the Bank of Canada and notifies Mr. Shiv.
- Upon receiving the advance payment, Mr. Shiv starts shipment procedure and ships the goods to Mr. Mac.
- Mr. Shiv submits the shipping documents such as invoice, packing list, bill of lading, etc. to Bank of India
- Bank of India checks the shipping documents and forwards it to Bank of Canada
- Bank of Canada checks the documents and informs Mr. Mac that they have received the shipping documents.
- Mr. Mac makes the payment of USD 10,000.00 to the Bank of Canada (100%) + plus pays interest for the 50% advance payment that has been paid by Bank of Canada earlier.
- Bank of Canada remits the remaining unpaid portion of USD 5000.00 (50%) to the Mr. Shiv through Bank of India.
- Bank of India receives the payment of USD 5000.00 and further remits this payment to Mr. Shiv’s account
- Using the shipping documents, Mr. Mac clears the goods from the shipping line.
This is the entire process of green clause letter of credit.
Sight LC
A letter of credit that demands payment on the submission of the required
documents. The bank reviewsthe documents amd pays the beneficiary if
the documents meet the conditions of the letter.
sight Letter of Credit
A sight letter of credit is a special type of letter of credit in which a payment term “sight” is used in a letter of credit. It basically means “payment at sight”. It is also known as letter of credit at sight.
Table of Contents [show]
Meaning
In a sight letter of credit, the payment for the transactions is released immediately after the seller presents the required documents to the advising bank. The documents required as per the terms of a letter of credit is usually the proof of shipment. This includes invoice, packing list, bill of lading, insurance, etc.
A regular letter of credit is a document that guarantees payment to the seller if the conditions of the letter of credit are confirmed by both the buyer and the seller. However, the time by which buyer releases payment to the seller depends on the type of the letter of credit. For example, a red clause or a green clause letter of credit gives an option of advance payment before the shipment of goods, whereas the usance letter of credit gives an option of differed payment. In case of sight letter of credit, the payment is released immediately after the required documents are presented to the advising bank.
Here when we say payment is released immediately it usually means in five to ten business days. This is because the advising bank needs time to review the documents submitted by the seller. In most cases, the advising bank sends the documents to the bank that has issued the sight letter of credit. Thereafter, once the documents get confirmation from the issuing bank, it will release the payment.
Deferred Payment LC
An LC that ensures payment after a certain period. The bank may review the documents early but the payment to the beneficiary is made after the agreed-to time passes. It is also known as Usance LC. For more information click on Differed payment LC
Direct Pay LC
A letter of credit where the issuing bank directly pays the beneficiary and then asks the buyer to repay the amount. The beneficiary may not interact with the buyer.
Why use Sight Letter of Credit?
The letter of credit by itself is used as a payment tool to ensure the safety of both the parties involved in the international trade. However, the sight letter of credit is very specific in its usage.
A sight letter of credit helps manage the seller’s working capital cycle. It is a boon especially for small companies who are working on tight bootstrapping principles. Such companies may insist on sight letter of credit from their buyers.
Furthermore, a sight letter of credit may prove to be a very useful tool when the seller is doubtful of receiving payment. This can be due to numerous reasons such as the buyer may be located in a volatile region where there is political or economic tension or buyer himself may be in some financial turmoil. In this case, the seller prefers that he gets paid as quickly as possible, so he asks for sight letter of credit.
Conclusion
Letter of Credit has become an important tool for reducing the risk of business and to speed up the cash flow cycle. It facilitates business to trade at ease. Being a negotiable instrument, it can be endorsed multiple times making it the most flexible payment tool. Back-to-Back Letter of Credit facilitates payments to subcontractors. The first beneficiary can transfer the LC in the favor of the secondary beneficiary, assuring payment to the supplier. This helps the business to continue its functions smoothly.
Leave a Reply