Letter of Credit (LC) Presentation

Letter of Credit (LC)

Basic of Letter of Credit (LC)
PART - I

1. Letter of Credit (LC) Basic of Letter of Credit (LC) PART - I A presentation b y- Puneet H arjani

2. 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. Introduction

3. 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) framed by International Chamber of Commerce (ICC) Introduction

4. 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.

5. 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.

6. Parties in LC Transaction Issuing Bank / Opening Bank An issuing bank is the one which on receipt of request from its customer, the applicant’s (purchaser’s) 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 beneficiary’s country may agree to advise the credit to the beneficiary and thus play the role of an advising bank.

7. 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. Parties in LC Transaction

8. 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 to terms of transfer. Parties in LC Transaction

9. Parties in LC Transaction Terms Definition Activity Applicant Importer Buy Beneficiary Exporter Sell Issuing/Opening Bank Importer’s Bank Issues L/C Advising Bank Exporter’s Bank Advises L/C Confirming Bank Advising Bank or 3rd Party Bank Confirms L/C Paying Bank Any bank as specified in L/C Pays the Draft

10. Mechanism of LC

11. Mechanism of LC 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 bank’s 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 . 1 st Principle of Letters of Credit: Letters of Credit are documentary .

12. Mechanism of LC 2nd Principle of Letters of Credit: Letters of Credit are independent of any other contract or obligation. Note: There are 3 separate contracts in a letter of credit transaction: The contract of sale The L/C application/agreement The L/C itself. Step 4. As soon as the seller receives Letter of Credit (issuing bank’s 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.

13. 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 applicant’s letter of credit agreement ( usually by debit to the applicant’s 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.

14. Confirmed Letters of Credit Applicant Beneficiary Contract Goods Applicant’s Bank L/C Application Documents Debit Confirming Bank L/C Documents Payment L/C Documents Pay- ment 1 2 3 4 5 8 7 6 10 9 11 12 Mechanism of LC

15. 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] The major effect is to shift country risks to the confirming bank .

16. Mechanism of LC

17. 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 bank’s 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.

18. 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 bank’s 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. If the L/C has been confirmed, documents must be presented to the advising/confirming bank.

19. 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 bank’s claim against the reimbursement authorizations they are holding, charges the issuing bank’s 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.

20. 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 applicant’s 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.

21. Types of Letter of Credit

22. Revocable & 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 30 th June, 2007) has been withdrawn under the latest revision. Thus an LC can only be irrevocable in nature. Types of Letter of Credit

23. Sight Credit & Acceptance (Usance) 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 paid to him on prefixed future date . Types of Letter of Credit

24. Standby Letter of Credit standby letter of credit is the one which is opened for non-performance 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. Types of Letter of Credit

25. 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. Types of Letter of Credit

26. Applicant Beneficiary Applicant’s Bank Letter of Credit Application Documents Debit Payment Documents Letter of Credit Contract 1 9 7 6 5 4 3 2 8 How Standby Letter of Credit Works

27. 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 bank’s 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 . How Standby Letter of Credit Works

28. How Standby Letter of Credit Works Note: There are 3 separate contracts in a letter of credit transaction: The contract of sale The L/C application/agreement The L/C itself. Step 4. Having received the issuing bank’s 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.

29. How Standby Letter of 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.

30. Revolving 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. Types of Letter of Credit

31. 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 non-cumulative 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 US$100,000 monthly, cumulative, and the exporter draws only USD80,000 in one Types of Letter of Credit

32. 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. Types of Letter of Credit

33. Risk Assessment

34. Cash in Advance Exporter (Seller) (Beneficiary) - Negative Positive + Vendor Financing Foreign Receivables Insurance Ex-Im Bank CEFO Neutral Zone Letters of Credit Standby Commercial (Acceptances) Confirmed Transferable Back-to-Back Assignment of Proceeds Foreign Exchange Open Account Documentary Collection Shipment Importer (Buyer) (Applicant) + - Negative Positive Risk Assessment

35. 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 importer’s 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.

36. 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 .

37. 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 The first digit (3) represents the category. Communication through SWIFT

38. 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.

39. Thank You