Letter of credit (LC) also known as Documentary credit is an undertaking from a bank on behalf of its customer (importer/buyer) wherein the beneficiary (exporter) is fully assured of payment provided he fulfills his part of the sale contract embodied in Letter of Credit.
To understand LC mechanism, let us take an example of a seller (exporter) who wants to sell his products to a buyer of another country. He may come across problems associated with the international trade like exchange control regulations of importer’s country or credentials of the buyer (importer) not known to the seller. Naturally, seller carries the risk of non-payment or delayed payment of goods sold by him, if he does the transaction directly with the buyer. In this circumstance, he needs someone like a banker of good reputation, who could guarantee him of the payment on behalf of the buyer, in terms of the agreement he had with the buyer. The buyer, on the other hand, is also at risk of not receiving the goods or services as per contract, for the payment directly made to the seller. He also needs someone like a banker of good reputation, who could guarantee him of the supply goods or service for the payment made by him.
The buyer approaches his banker to open (issues) an LC on his behalf, which assures the beneficiary (seller of the goods or service) that the bank would give the guarantee of payment provided he fulfills all the conditions precisely embodied in Letter of Credit issued by it. By virtue of above LC mechanism, the seller is assured of full payment for goods/service sold by him. The buyer is also happy that the payment will be done to the seller, only after the seller complies all the terms of contract embodied under precisely defined conditions in the contract of LC. Thus banks act as intermediaries to sort out the transaction complications of the seller as well as of buyer.
If an LC is issued to a beneficiary (seller) in the same country, such LC is called ‘Inland LC’ and if the LC is issued to a beneficiary of the foreign country such LC is called ‘LC (foreign)’.
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