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Letter of Credit
Introduction
Banks, as we know, lend money to the public, for various purposes. Like
purchase of a home, a car, or other consumer durables etc. They also extend loans to
Industries that manufacture various goods, and machineries, and also to service
industries that provide various services, like a salon, internet kiosk, etc., to the
community.
Banks play a vital role in the development process of any nation, by providing
finance for different activities related to trade and commerce. This includes both
domestic and international trade and commerce.
One of the ways in which commercial banks facilitate international trade and
commerce, is by way of extending a non funded financing facility or mechanism
called the Documentary Credit (DC), or the Letter of Credit (LC).
This mechanism to facilitate international trade was developed under the
auspices of the International Chamber of Commerce, Paris. The rules and regulations
etc., governing the Documentary Credits, and the transactions there under, are
contained in what is known as the Uniform Customs and Practices for Documentary
Credits.
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Letter of Credit
Meaning
Documentary Credit is an International trade procedure in which the credit
worthiness of an importer is substituted by the guarantee of a bank for specific
transaction. Under documentary credit arrangement (also called as letter of credit
arrangement) a bank (usually in the importer’s country) undertakes to pay for a
shipment, provided the exporter submits the required documents (such as clean bill of
lading, certificate of insurance, certificate of origin) within a specific period.
Definition
A Documentary Credit (DC), or Letter of Credit (LC), (they are one and the
same), is a legally binding undertaking given by a Bank on behalf of its customer, in
favor of a third party, to make payment to him (the third party), the stated sum of
money against submission of the required documents, as per the terms of the
Documentary Credit.
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Letter of Credit
Mechanism of Letter of Credit
Letter of Credit is usually subject to the Uniform Customs and Practice for
Documentary Credits, International Chamber of Commerce Publication No. 600
(UCP 600).The mechanism of letter of credit is as follows :
1. Availability of Letter of Credit
Under UCP 600, an LC can be made available with:
a. Payment
Payment at sight against compliant documents.
b. Negotiation
Payment with or without recourse to the beneficiary or bona
fide holder against compliant documents presented under the credit.
c. Acceptance by a Drawee Bank
Payment at a future determinable date against compliant
documents. A tenor draft is normally required for presentation under
an acceptance credit and is drawn on the acceptance bank rather than
the issuing bank.
d. Usance Credit
Payment at a future determinable date against compliant
documents. A tenor draft is normally required (but not mandatory) for
presentation under a usance credit and is drawn on the Issuing Bank.
Usance credit is available by Negotiation, Acceptance and Deferred
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Letter of Credit
Payment. A tenor draft is not required for presentation under a deferred
payment credit.
2. Parties in Letter of Credit Transaction
a. LC Applicant:
LC Applicant is normally the buyer under the sales contract and
the party that initiates the request to the Issuing Bank to issue an LC on
its behalf. The LC Applicant normally maintains banking facilities
with the Issuing Bank.
b. LC Beneficiary:
LC Beneficiary is normally the seller under the sales contract
and the party who will receivepayment under the LC if it can fulfill all
the terms and conditions of the credit.
c. Issuing Bank:
An Issuing Bank (or LC opening bank) is the bank that issues
the LC in favour of a seller at the request of the LC applicant. The
Issuing Bank is normally located in the applicant’s country with
established banking relationship with the applicant.
By issuing an LC, the Issuing Bank undertakes to pay the
beneficiary the value of the draft and/or other documents if all the
terms and conditions of the LC are complied with.
d. Advising Bank
An Advising Bank (or sometimes known as notifying bank) is
the bank that advises the LC beneficiary that there is an LC issued in
his favour. Advising Bank is normally located in the seller’s country
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Letter of Credit
and is either appointed by the Issuing Bank or LC applicant. Its
primary responsibility is to authenticate the LC to ensure that the LC
comes from genuine source.
e. Confirming Bank:
A Confirming Bank (normally also the Advising Bank) is the
bank that adds its own undertaking to pay the LC beneficiary if all
terms and conditions of the credit are complied with. Such undertaking
is in addition to that given by the Issuing Bank at the request of the
Issuing Bank.
The Confirming Bank will only confirm an LC upon
satisfactory evaluation on the conditions of the Issuing Bank and its
domicile country.
f. Nominated Bank:
A Nominated Bank is a bank authorised by the Issuing bank in
the credit to pay, negotiate, issue a deferred payment undertaking or
accept drafts under the LC. If the LC does not specify a Nominated
Bank, the LC is deemed as freely negotiable and any banks that receive
documents from the LC beneficiary are qualified to be a Nominated
Bank.
A Nominated Bank is not responsible to pay under the credit
unless it has added its confirmation to the credit. In such a case, it will
become a Confirming Bank.
g. Negotiating Bank:
A Negotiating Bank is the bank that examines the drafts and/or
documents presented by the LC beneficiary and gives values to such
drafts and/or documents. Negotiation could be in the form of
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Letter of Credit
Purchasing or agreeing to purchase the drafts and/or documents
presented.
h. Reimbursing Bank:
A Reimbursing Bank is the paying agent appointed by the
Issuing Bank to honour claims submitted by the nominated or
negotiating bank.
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Letter of Credit
The Flow of Letter of Credit
Stage 1: Letter of Credit Issuance and Advising/Confirmation
Step 1: Buyer and seller conclude the sales contract and agreed to use an LC as the
method of payment.
Step 2: Buyer approaches the Issuing Bank to issue an LC on his behalf in favour of
the seller with all the terms and conditions specified.
Step 3: Issuing Bank issues the LC and requests the advising bank to advise or
confirm the credit to the LC beneficiary (seller).
Step 4: Advising/confirming bank authenticates the LC and sends the LC to the LC
beneficiary.
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Letter of Credit
Stage 2: Presentation of Documents and Settlement (Sight LC with Reimbursing
Bank)
Step 5: Seller prepares and dispatches the goods to the buyer’s country.
Step 6: Seller presents the drafts and/or documents to the nominated bank.
Step 7: Nominated (nominated as the negotiating bank) Bank checks documents
presented against the LC terms and conditions and seeks instructions from seller on
documentary discrepancies.
Step 8a: Nominated Bank forwards the drafts and/or documents to the Issuing Bank.
Step 8b: If documents are free from discrepancies or discrepancies are supported by
seller’s indemnity, nominated bank claims reimbursement from the appointed
reimbursing bank.
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Letter of Credit
Step 8c: Reimbursing Bank pays the nominated bank against a valid reimbursement
authority received from the Issuing Bank and statement from negotiating bank that the
documents complied with LC terms.
Step 9: Nominated Bank credits the net proceeds into the seller’s account.
Step 10: Issuing Bank checks documents presented against the LC terms and
conditions. If documents are free from discrepancies, Issuing Bank reimburses the
reimbursing bank.
Step 11: Issuing Bank presents documents to the buyer for payment.
Step 12: Once payment is received from the buyer, Issuing Bank releases documents
to the buyer for the latter to collect his goods.
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Letter of Credit
Essentials of Letters of Credit
1. Inexpensive means of payment in domestic and international trade
Letters of credit (L/C) have long served as a convenient, inexpensive
means of payment in domestic and international trade. L/Cs may serve as
guaranties, securing performance obligations with a bank,s commitment to pay
upon presentation of a draft, default notice or other documents specified by the
L/C. L/Cs have long been governed by Article 5 of the Uniform Commercial
Code. The L/C is intended to assure the vendor of payment before the goods
leave its warehouse.
2. What is a Letter of Credit?
An L/C may be broadly defined as an undertaking by an issuer, the
bank, to pay a third party, the vendor who is the beneficiary for the account of
the banks customer, the debtor, when the vendor submits documents specified
by the L/C. If the vendor submits proper documents before the credit expires,
the bank will pay the L/C, and the debtor must reimburse the bank. An L/C
may be either revocable or irrevocable. An irrevocable L/C can be modified
only with the consent of the vendor. A revocable L/C can be modified by the
bank without the vendors consent. L/C s come in two varieties: commercial
L/Cs, commonly used to pay for goods, and "standby L/Cs, which secure
performance by assuring payment after default. Under either type, the credit of
the bank is substituted for the credit of the debtor in favor of the vendor.
3. Essential Principles Governing Law
Within the United States, Article 5 of the Uniform Commercial Code
(UCC) governs L/Cs. Article 5 is founded on two principles: (1) the L/C,s
independence from the underlying business transaction, and (2) strict
compliance with documentary requirements.
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Letter of Credit
4. The Independence Doctrine
L/Cs are purely documentary transactions, separate and independent
from the underlying contract between the debtor and the vendor. The bank
honoring the L/C is concerned only to see that the documents conform with
the requirements in the L/C. If the documents conform, the bank will pay, and
obtain reimbursement from the debtor. The bank need not look past the
documents to examine the underlying sale of merchandise. The letter of credit
is independent from the underlying transaction and, except in rare cases of
fraud or forgery, the issuing bank must honor conforming documents. Thus,
vendors are given protections that the issuing bank must honor its demand for
payment (which complies with the terms of the L/C) regardless of whether the
goods conform with the underlying sale contract.
5. Strict Compliance
The bank may insist upon strict compliance with the requirements of
the L/C. In the absence of conformity with the L/C, the vendor cannot force
payment and the bank pays at its peril. The question remains, how strict
compliance? Some courts insist upon literal compliance, so that a misspelled
name or typographical error dooms the vendors demand for payment. Other
courts require payment upon substantial compliance with documentary
requirements. Careful vendors should remember that the bank may insist upon
strict compliance with all documentary requirements. If the documents do not
conform, the bank should give the vendor prompt, detailed notice, specifying
all deficiencies.
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Letter of Credit
Forms of Letters of Credit
1. Commercial Letters of Credit
This form of L/C is commonly used when the contract involves sale of
goods. Many exporters require payment by letter of credit. Typically, the
buyer applies to his bank, which opens a letter of credit in favor of the
exporter, payable upon presentation of the sellers draft, bill of lading and other
shipping documents specified in the credit. When the goods are shipped, the
seller delivers those documents to the bank and collects full payment. The
bank holds the documents and usually takes a security interest, pending
reimbursement by its customer, the buyer. The transaction involves three
relationships: (1) the letter of credit, which obligates the bank to pay the
beneficiary upon presentation of the documents; (2) the reimbursement
agreement between the bank and its customer, which obligates the beneficiary
to reimburse the bank and pay a fee; and (3) the underlying contract for the
sale of goods.
2. Standby Letters of Credit
A standby L/C is customarily used in non-sales transactions. This form
of L/C assures payment in case of nonperformance. Under the commercial
L/C, the vendors right to payment is conditioned upon submitting certain
documents; with standby L/Cs, a vendor draws down on the L/C only when
the vendor establishes that the debtor has defaulted. For the commercial L/C,
payment is expected; for the standby L/C, payment should be the exception.
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Letter of Credit
The Parties, Rights and Obligations
1. Issuing Bank
When an issuer receives a draft and demand for payment, it must
decide to honor or dishonor within three banking days under the UCC. The
bank must examine the documents with reasonable care. If the documents
conform, the bank must pay, and be reimbursed by its customer, the debtor.
Failure to honor within three banking days constitutes dishonor. If the
documents do not conform, the bank should give the beneficiary prompt,
detailed notice, specifying all deficiencies.
2. Vendor
The vendor is entitled to payment upon submission of proper
documents. By presenting its draft and demand for payment, the vendor
represents that all conditions of the L/C have been complied with.
3. Debtor
The debtor must reimburse the bank when the bank honors conforming
drafts and demands, i.e. the debtor unconditionally agrees to reimburse the
bank.
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Letter of Credit
Types of Letter of Credit
Import/export Letter of Credit
It is said to the credit which buyer assigns i so that he imports a
product to his own country and in general this credit is in another country and
its value is export value.
Revocable Letter of Credit
In this type of credit buyer and the bank which has established the LC,
are able to manipulate the letter of credits or make any kinds of corrections
without informing the seller and getting permissions from him. This type of
LC is not used a lot.
Irrevocable LC
In this type of LC, any kinds of change and manipulations from the
buyer part and the establisher bank require the permission and satisfaction of
seller part. According to the last rules of international business room, return
ability or none return ability, the credit will be none returnable.
Confirmed LC
They are the guaranties that buyer will be given so that, the buyer will
give the guaranty from his own bank to any other valid bank that the seller
will desire it.
Unconfirmed LC
This type of letter of credit, does not acquire the other bank's confirmation.
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Letter of Credit
Transferrable LC
It is said to the credit that the seller can give a part or parts of credit
(Completely) to the person or persons he decides. This type of credit is a
benefit for seller.
Untransferable LC
It is said to the credit that seller cannot give a part or completely right
of assigned credit to somebody or to the persons he wants. In international
commerce, it is required that the credit will be untransferable.
Usance LC
It is kind of credit that won't be paid and assigned immediately after
checking the valid documents but paying and assigning it requires an indicated
duration which is accepted by both of the buyer and seller. In reality, buyer
will give an opportunity to the seller to pay the required money after taking the
related goods and selling them.
At Sight LC
It is a kind of credit that the announcer bank after observing the
carriage documents from the seller and checking all the documents
immediately pays the required money.
Red Clause LC
In this kind of credit assignment seller before sending the products can
take the pre-paid and parts of the money from the bank. The first part of the
credit is to attract the attention acceptor bank. The reason why it named so, is
that the first time this credit is established by the assigner bank, to take the
attention of the offered bank, the terms and conditions were written by red ink,
from that time it became famous with that name.
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Letter of Credit
Back to Back LC
In this type of LC consisted of two separated and different types of LC.
First one is established in the benefit of the seller that is not able to provide the
corresponding goods for any reasons. Because of that reason according to the
credit which is opened for him, neither credit will be opened for another seller
to provide the desired goods and sends it.
Back-to-back L/C is a type of L/C issued in case of intermediary trade.
Intermediate companies such as trading houses are sometimes required to open
L/Cs by supplier and receive Export L/Cs from buyer. SMBC will issue a L/C
for the intermediary company which is secured by the Export L/C (Master
L/C). This L/C is called "Back-to-back L/C".
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Letter of Credit
ICC’s New Rules on Documentary Credits
ICC’s new rules on documentary credits, which are used for letter of credit
transactions worldwide, were approved by the ICC Commission on Banking
Technique and Practice on 25 October 2006. UCP 600 is the first revision of the rules
since 1993 and represents more than three years of work by the commission. The
implementation date is 1 July 2007.
UCP 600 contains significant changes to the existing rules, including:
A reduction in the number of articles from 49 to 39;
New articles on “Definitions” and “Interpretations” providing
more clarity and precision in the rules;
A definitive description of negotiation as “purchase” of drafts of documents;
The replacement of the phrase “reasonable time” for acceptance or refusal of
documents by a maximum period of five banking days.
UCP 600 also includes the 12 Articles of the eUCP, ICC’s supplement to the
UCP governing presentation of documents in electronic or part-electronic form.
The UCP were first published by ICC in 1933. Revised versions were issued
by the ICC in 1951, 1962, 1974, 1983 and 1993. Written into virtually every letter of
credit, the UCP are accepted worldwide. They are the most successful private rules
for trade ever developed and illustrate the importance ICC attaches to self-regulation.
Following the sell-out event in October this year, Understanding the UCP 600,
presented by Chair of the UCP 600 Drafting Group Gary Collyer, will take place on
26 January, at the Prince de Galles hotel, Paris.
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Role of UPC 600 for Documentary Credits
UCP 600 is the latest version of the rules that govern letters of credit
transactions worldwide. UCP 600 is prepared by International Chamber of
Commerce’s (ICC) Commission on Banking Technique and Practice. Its full name is
2007 Revision of Uniform Customs and Practice for Documentary Credits, UCP 600,
and (ICC Publication No. 600). The ICC Commission on Banking Technique and
Practice approved UCP 600 on 25 October 2006. The rules have been effective since
1 July 2007.
UCP 500 was the rules that had been in implementation before UCP 600.
There are several significant differences exist between UCP 600 and UCP 500. Some
of these differences are as follows;
• The number of articles reduced from 49 to 39 in UCP 600;
• In order to reach a standard meaning of terms used in the rules and prevent
unnecessary repetitions two new articles have been added to the UCP 600.
These newly added articles are Article 2 “Definitions” and Article 3
“Interpretations”. These articles bring more clarity and precision in the rules;
• A definitive description of negotiation as “purchase” of drafts of documents;
• New provisions, which allow for the discounting of deferred payment credits;
• The replacement of the phrase “reasonable time” for acceptance or refusal of
documents by a maximum period of five banking days.
The Uniform Customs and Practice for Documentary Credits (UCP 600)
establishes an international standard of letter of credit practice. This set of rules for
the issuance and use of Letters of Credit for bankers went into effect July 1, 2007 in
consultation with bankers, the International Chamber of Commerce and other
interested parties from around the world. In other words, UCP 600 are the latest
revision of the Uniform Customs and Practice that govern the operation of letters of
credit. Historically, the UCP have been revised about every ten years to keep up with
changing business and banking practices as well as changes in technology.
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Letter of Credit
Although the UCP defines rights and obligations of the various parties in a
letter of credit transaction, it is not law and any given letter of credit is subject to the
UCP only to the extent indicated in the letter of credit itself. The latest revision of
UCP is the sixth revision of the rules since they were first promulgated in 1933. The
current version is the result of year of effort by the International Chamber of
Commerce's Commission on Banking Techniques and Practices.
History of UCP
First uniform rules published by ICC in 1933. Revised versions were issued in
1951, 1962, 1974, 1983 and 1993.
1933 – Uniform Customs and Practice for Commercial Documentary Credits
1951 Revision - Uniform Customs and Practice for Commercial Documentary Credits
1962 Revision - Uniform Customs and Practice for Documentary Credits
1974 Revision – Uniform Customs and Practice for Documentary Credits
1983 Revision – Uniform Customs and Practice for Documentary Credits
1993 Revision – Uniform Customs and Practice for Documentary Credits
Currently majority of letters of credit issued everyday is subject to latest
version of the UCP. This widely acceptance is the key sign that shows the importance
of the UCP, which are the most successful private rules for trade ever developed.
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Letter of Credit
Legal Acts Regulating the Payment by Documentary Credit
The advantage of payment by documentary credit over other forms of payment
on the basis of an analysis of its main features and some issues that surround it. The
success of the application of payment by credit is directly linked to the level of the
development of its respective legal framework. International payment relations
areregulated both by normative acts of certain states as well as customs and practices
in business dealings. Moreover, the universality of banking operations causes the
unification of international payment. To this end the International Chamber of
Commerce elaborated “The Uniform Customs and Practice for Documentary Credits”
(hereinafter referred as Uniform Customs and Practice). This entered into force on 1
January 1994. It is a reflection of the progressive achievements made in the payment
relations of the banking sector. The latter caused the wide application of this form of
payment in export-import operations.
Despite the fact that Uniform Customs and Practice has a recommending
nature and represents the unofficial codification of the rules for business, a majority of
banks throughout the world carry out payment by documentary credit. It should also
be noted that the Uniform
Customs and Practice serves as a basis for relevant national legislation in many
countries. The Uniform Customs and Practice provides the definition of the credit and
determines its type, rules and means of its application, obligations and the liability of
banks. It also lays down the requirements of the documents presented on the basis of
credit as well as the rules on their presentation. If a bank applies the Uniform Customs
and Practice then the provisions there from are considered binding both for the bank
and the clients. The legal framework for payment by credit is Article 876 of the Civil
Code. It provides only the definition of the documentary (commercial) credit, but it
has been supplemented by “the Rules of Georgia on Non-Cash Payment” approved by
Order No. 220 of the President of the National Bank of Georgia of 2 September,
1999.5 These rules stipulate the following forms of payment: payment orders, credits,
payment-collection orders, cheques and collection order. Another legal act regulating
payment relations is the “Interim Instruction on Opening the Settlement,
Correspondent, Currency, Budgetary, Current and other Accounts (Temporary, Cash
Service) in the Banking Institutions of Georgia” approved by Order No. 222 of the
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President of the National Bank of Georgia of 2 September 1999. We should
distinguish between forms of payment and settlement documents. The latter can have
the same designation as a respective form of payment (e.g. a payment order, credit or
cheque), although they have an accounting and informational function.
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Letter of Credit
Legal Construction of Payment by the Credit
According to the Civil Code of Georgia, by opening a credit, the credit
institution (issuing bank) undertakes, at the request and instruction of a customer (the
purchaser of credit), to pay the money to a third person (the remittent8 ) under the
order of this person against a said document, or pay drafts presented by a remittent,
accept drafts, or assign another bank with this transaction, if the credit terms are
fulfilled. The customer undertakes to pay the agreed commission. Thus, a
documentary credit is a bank’s fixed obligation to pay to the buyer a definite sum of
money within an agreed time frame (or authorise another bank (the nominated bank)
to make such payment), in the case of the timely presentation of appropriate
documents, certifying the shipment of cargo (the rendering of service) and the exact
fulfilment of the terms of the credit. For making payments by credit it is not the
movement of goods as such but more the documents that bear the principal
importance. It is according to the documentation that the control over the movement
of goods, works or services is carried out.
The payment operation on the basis of documentary credit can be described as
follows:
1. The form of payment for the supplied goods (rendered service) shall be
defined in the contract between the exporter and the importer. If the payment
is made on the basis of documentary credit, the parties determine the type of
credit, the expiry date and the place of its fulfilment, the authorised banks etc.;
2. At the request and instruction of a customer (creditor), the issuing bank shall
open the credit. The application on opening the credit shall include
information such as the name of a remittent and the amount of the credit; the
place and means for its use; goods on paying of which the credit was opened;
documentation to be presented to the bank; the expirydate for shipment and
the presentation of documentation;
3. The next stage is to notify the exporter by sending an advice that the credit is
open. Further more the issuing bank sends the credit (advice, notification on
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the opening of the credit) to the exporter, usually through a service bank
(advising bank) of an exporter, which in its turn carries out the notification
procedure;
4. The advising bank retains a copy of the advice because it is authorised to
receive from the exporter documents stipulated by the credit and to carry out
an examination of them. The advising bank at the same time may be
categorized as a nominated bank, i.e. a bank, that is authorized to pay under
the credit;
5. Upon receipt of the credit (advice), the exporter examines its compliance with
the terms of credit as settled in the concluded contract. If there is no evidence
of non-compliance, it starts the fulfillment of obligations (e.g. the shipment of
cargo);
6. After receiving the transport documents from the carrier, the exporter presents
them together with other documents listed in the credit to the nominated bank.
The credit also stipulates a specified period of time, after the date of shipment,
during which the presentation of documents must be made. If no such period is
stipulated, banks will not accept documents presented to them twenty-one
days after shipment.9 In any event, documents must be presented not later than
the expiry date of the credit;
7. Furthermore, the nominated bank examines the documents no later than seven
banking days after receiving them;
8. The issuing bank withdraws the amount from the importer’s account or (in
accordance with the terms of the credit) and withdraws it from the special
account on which the money was deposited in advance. After examination of
the documents the issuing bank transfers the money to the nominated bank;
9. Finally, the nominated bank transfers the money to the exporter;
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10. From the moment of receiving the documents from the issuing bank, the
importer is deemed to be the owner of the goods. In this case, the credit is not
only a form of payment but also it performs the function of being an
instrument for securing the performance of the payment obligation. Here, it
should also be noted that the above scheme of payment by credit is of a
general nature and may vary according to the particular type of credit issued.
One of the principal advantages of documentary credit is its diversity.
It enables the parties, by taking into account existing circumstances, to select
the form that best meets their requirements.
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Risks in Letters of Credit
Although letters of credit are a balanced payment method in terms of risk
issues for both exporters and importers, each letters of credit party bears some amount
of risk. As we have explained before letters of credit transactions are handled by
banks. This responsibility makes the banks one of the parties that bears risks in a letter
of credit transaction.
Risks in letters of credit can be discussed under four groups; general risks in
letters of credit, risks to the applicant, risks to the beneficiary and risks to the banks.
General Risks in Letters of Credit:
1. Country Risk: (Political Risk)
The first risk factor that can be mentioned in the general risks
group is the country risk or the political risk. Let us assume that we are an
exporter located in a country X and we have a customer from the country
Y. Our customer, which is from the country Y, opened a L/C in favor of
us. We have checked the L/C conditions and they seem workable. We have
produced and shipped the order as per the L/C and transmit the required
documents to the issuing bank before the expiry date. The issuing bank
found our presentation complying and informed us that they will be
honoring our payment claim at the maturity date. However, before the
maturity date due Country Y has changed its export regime, which makes
it impossible for the issuing bank to honor our presentation. This
illustrative is a good example of a country risks. Other examples of
country risks are mass riots, civil war, boycott, sovereign risk and transfer
risk.
2. Fraud Risk
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As we have described before all conditions stated in a letter of
credit must be connected to a document, otherwise banks will disregard
such a condition. In addition, banks deal with only documents but not
goods, services or performance to which the documents may relate. This
feature of the letters of credit is the source of the fraud risk at the same
time. As an example, a beneficiary of a certain letter of credit transaction
can prepare fake documents, which looks complying on their face, to make
the presentation to the issuing bank. As the documents are complying on
their face, the issuing bank may honor the presentation and in this case, the
applicant must pay to the issuing bank for the goods it will never be
receiving. Beneficiaries of L/Cs bear also fraud risks. This happens if an
applicant issues a counterfeit letter of credit. In this case, the beneficiary
never receives its payment for the goods it has shipped.
3. Risks to the Applicant
In a letter of credit transaction, main risk factors for the applicants
are non-delivery, goods received with inferior quality, exchange rate risk
and the issuing bank's bankruptcy risk.
4. Risks to the Beneficiary
In a letter of credit transaction, main risk factors for the
beneficiaries are unable to comply with letter of credit conditions,
counterfeit L/C, issuing bank's failure risk and issuing bank's country risk.
5. Risks to the Banks
Every bank in a L/C transaction bears risks more or less. The risk
amount increases as responsibility of the bank increases.
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Conclusion
Banks, as facilitators of international trade and commerce have been served
well by the mechanism of the Documentary Credit. The beauty of these credits is that
they provide appropriate protection, as required, by the seller, buyer, the seller's Bank,
and the buyer's Bank, while extracting their share of responsibility under the
transaction.
The DCs have acted as a sort of bridge between buyers and sellers of goods
and services, based in different countries, bringing them together, through the agency
of the Banks.
Since they came into being in 1933, DCs have no doubt played a significant role in
cross border trade, overcoming the barriers of language, customs and practices,
currencies, etc. And last, but not the least, they are an important source of business
and revenues to the Commercial Banks, and are expected to grow even more in
importance, in the coming years.
It could be concluded that documentary credit is a reliable and convenient
instrument of international settlement. However, we have to agree with those views
expressed in legal literature that this type of payment is complicated and expensive.
The application of credit in export-import operations is complicated both in legal as
well as economic terms. If several banks participate in a settlement by credit,
ultimately the purchaser of the credit will have to reimburse the costs of all the
authorized banks. Usually, the cost for each operation, such as the opening of credit,
sending a letter of advice, confirmation, the examination of documents envisaged by
the credit to name but some of the procedures is determined in the form of a fixed
interest on the amount of credit for any operation.
It is also noteworthy that the advantage of credit is directly linked with the
relevant experience of the participating banks in this field and with the existence of a
wide network of correspondent banks. Under these circumstances operations are less
complicated.
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