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 the credibility. It has become essential to have a common tool which 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
- 1 Commercial Letter of Credit – Definition
- 2 Commercial Letter of Credit Process with Example
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.
Step 4: Seller Ships the Goods and Prepares Documents
On 1st March 2018, Mr. Ram ships the goods to Mr. Tom and prepared the required shipping documents as per the instructions of the letter of credit. The usual documents required are – commercial invoice, packing list, transport document (bill of lading or airway bill) and insurance policy. Some banks require additional documents but these are necessary.
Step 5: Document Submission and Verification
Mr. Ram submits the documents to the Bank of India. Bank of India checks all documents to confirm whether they are in compliance with the instructions of the letter of credit. Thereafter the Bank of India sends the documents to Bank of America and asks for payment.
Step 6: Confirmation and Payment
Bank of America again checks the documents for compliance and if all the documents are in place, it debits Mr. Tom’s account of USD 10,000.00 + letter of credit fees and pays USD 10,000.00 to Bank of India who further deducts its own fees and deposits the remaining amount in Mr. Rams account.
As the banks are involved in the transaction, both parties are secured that the other one will fulfill its obligation else the bank will intervene.
There are many different types of letters of credit, but that is a story for another day.Last updated on : August 7th, 2018