Letter of Credit is a financial document used in international trade. It is a payment guarantee given by the bank to the supplier of the goods. A “Credit Letter” issued by the bank will be a sort of promise to the goods seller if the buyer fails to make the payments.
Letter of Credit is referred to as ‘Lifeblood of International Commerce’.
In the UAE, Federal Law No. 18 of 1993, the Commercial Transactions Law governs Letter of Credit.
Letter of Credit is a contract in which a bank (Issuing Bank) agrees to provide a significant amount of finance at a specific period when the applicant requests for it. The finance will be provided in the name of the goods seller who is otherwise known as the beneficiary. This financial assistance is secured in the document which represents goods being shipped or prepared for the shipment.
Components of Letter of Credit
- Issuing Bank- The banks that offer credit
- Applicant- arranges for payment
- Beneficiary- receives payment from issuing bank
- Specified time limit- payment has to be in a specified time
- Agreement- parties agree on Terms and Conditions listed in the letter of credit
- Specified place- documents must be presented at a specified place
In Letter of credit, the credit provided will be mentioned with respect to the sales agreement which will be agreed by the buyer and seller. If the credit mentioned in the Letter of Credit and the agreement are not the same, the seller can reject it.
Process of Letter of Credit
So, once the bank confirms the credit, the beneficiary will be informed directly or another correspondent bank at the place of the beneficiary. The correspondent bank will contact the beneficiary and get confirmation from them. Hence the correspondent bank will be responsible to make payment to the beneficiary.
Types of Letter of Credit
According to Commercial transactions law, there are two types of letter of credits namely revocable and irrevocable.
Revocable Letter of credit
In this type of letter of credit, the credit can be canceled or amended at any time. Finally, it shall not hold any liability with regards to the beneficiary.
Once the terms and conditions and documents are met the letter of credit is honored. It is generally used to provide guidelines for the shipment.
Irrevocable Letter of credit
An irrevocable letter of credit cannot be revoked without the agreement of the beneficiary, issuing bank, and the confirming bank. It provides a fine relationship between the bank and the beneficiary. Therefore this kind of Letter of Credit assures security to the beneficiary regarding the payments.
Letter of Credit is more important in trade in the UAE because the country has business deals across the globe. A documentary credit transaction or letter of credit transaction demand trust towards banks. Both the buyer and seller should have confidence that the bank will fulfill the payment commitments. A letter of credit builds confidence for both the transacting parties.
About the author
Vinay Kumar Goguru is a finance professional with more than 8 years of diverse experience as a researcher, instructor and Industry work experience with both public and private entities. Prior to MyMoneySouq, he spent 6 years in Berkadia, It's a commercial mortgage banking company. He has a "Doctoral Degree in Commerce" and two master's degrees with a specialization in Finance, one as Master of Commerce and other as Master of Business Administration. He has written several articles on personal finance, published by different International journals. He loves traveling, reading and writing is his passion. He has a dream of writing a book on his favorite finance topics.