Letters of credit (LC) are usually used in international trade and foreign exchange. This document is an official statement guaranteeing the seller’s payment in any transaction. LC is crucial in maintaining this payment secured and trading compliance.
In countries like Bangladesh, where economic balance heavily relies on exports and imports, LC has no alternative. Various types of LC are available, such as confirmed, standby, transferable, revocable, and irrevocable. Each of these have unique specialties and are well-suited for different trade sectors. To issue LCs, businesses need practical steps and documentation for efficient trading.
Key Takeaways
- A letter of credit is a financial statement that ensures the sellers are paid on time while dealing with international transactions.
- The basic components of the letter of credit (LC) are the applicant, beneficiary, issuing and advising bank, amount, payment terms, and required documents.
- Based on the trading requirements, there are several types of LC, such as irrevocable, revocable, green clause, red clause, confirmed, standby, and transferable.
- To issue an LC, the applicant must submit all the required documents, from the trading license to the insurance and IRC certificate, and follow the right steps.
- Even after close monitoring, there are several regulatory challenges that the businesses need to overcome while obtaining an LC.
What is (LC) Letter of Credit
A letter of credit, shortly known as LC, is a financial document to guarantee payment between the sellers and the buyers. This is provided by the bank to ensure the seller pays the buyers the appropriate transaction on time. As international trading often includes distance risk and different countries’ laws, LC works best to secure individuals’ payments.
Buyers usually ask the bank to open a special account and issue an LC on their behalf. The bank then reviews the buyer’s creditworthiness before issuing the LC. The buyer does not need to transfer funds immediately. Here, The LC acts as a guarantee. The payment will be made once the seller meets the conditions specified in the LC.
As the sellers fulfill the requirements, the funds are sent to the sellers’ account. So, the LC secures payment for the seller while ensuring the buyer’s terms are met.
As a result, LC is used in the international export and import sector for efficient and secured payment processing. In general, it helps mitigate any cross-border trade hassles, like political instability and currency changes.
With LCs, businesses get the payment on time and can customize the transactions as needed. Depending on the size and type of letter of credit, the bank charges different fees for issuing. For example, confirmed LCs charge higher fees than unconfirmed ones.
Basic components of an LC
There are several essential components in an LC that define the structure and conditions of the transaction. Here is a detailed breakdown of the key elements of an LC:
- Applicant: The applicant section refers to the person who applied for the LC. In this case, it is the buyer who will be applying to the bank.
- Beneficiary: It is the opposite of the applicant. The beneficiary is the person who receives the payment. In this case, it is the seller.
- Issuing Bank: Issuing bank or opening bank is the term used to refer to the bank that is issuing the LC for the buyer. They often fix terms and conditions, issue and pay the LC, and lend credits if required.
- Advising Bank: This is the bank that verifies and advises the LC to the seller. Advising bank transfers the funds to the beneficiary’s bank directly. They usually have no obligation to check and verify the documents. With an additional fee, they can process the payments.
- Amount: The amount refers to the sum guaranteed by the LC that the applicant needs to pay the beneficiary with the transaction’s cost.
- Expiration date: This indicates the deadline of using the LC to get payments. After the expiration date, the LC can’t be used to receive payments. The beneficiary must meet all conditions before the expiration date to get the payment. Otherwise, they lose the right to get paid under that LC.
- Terms and Conditions: Similar to any other documents, this highlights the terms, policies, and conditions of the LC that the applicant and beneficiary must adhere to. This can be payment policies, time limits, currency rates, etc.
- Payment terms: Often, the buyers and sellers discuss and decide payment terms. Each LC can have different terms that the beneficiary and applicant must follow to ensure secure payment processing.
- Document requirements: The document requirements section outlines the specific documents to be submitted for the LC. These documents depend on the transaction LC type and the goods. Most often, the documents used are invoices, packaging lists, government documents, etc.
- Governing rules: Every country has unique government rules for LC processing. Thus, this section includes the country’s legal laws that the buyer, seller, and bank should comply with.
Types of Letters of Credit in Bangladesh
LC can be divided into several types based on the trading scenario and individual needs. Some common ones are revocable, irrevocable, red clause, green clause, confirmed, and standby. Knowing their details helps the business decide which one to choose based on their transactions and requirements.
Revocable Letter of Credit
Revocable letters are usually preferred less by banks. This gives banks the ultimate right to change or modify the LC without prior notice.
Definition
The revocable letters of credit allows the bank to change or modify the LC without notifying the seller or beneficiary. They can even cancel the LC if they want. This type of LC is rare as beneficiaries do not agree with them, and they have less to no power of rights.
Features
- Do not guarantee any payment to the beneficiary.
- The issuing bank has the ultimate power to amend or cancel the LC.
- Used when both parties lack terms and conditions.
- It is inexpensive and used in less-budget trading.
Pros and Cons
Pros
- Less costly
- Puts the buyer on the safe side
- The buyer gets the flexibility
Cons
- Risk of payment for the seller
- Lacks security and authority
- Can be changed or canceled anytime
Use cases in Bangladesh
In Bangladesh Revocable letter of credit is used when the price of the goods can rise and fluctuate or for the budget shortage.
Irrevocable Letter of Credit
As the name suggests, the irrevocable letter of credit is the opposite of the revocable one. It is more commonly used than other LCs. They are official and secure the payment of the buyers and sellers, giving them the right to LC.
Definition
Irrevocable letters of credit are the authorized ones that can’t be edited or canceled by the banks. For any step, the consent of both parties is required. Whether it is confirmed or unconfirmed – it does not matter. They can’t be revoked or changed without the agreement of the buyers and sellers. Irrevocable LCs are often used in international trade as it gives more security and guaranteed payment.
Features
- Guarantee of goods and services.
- No risk of cancellation, and all the parties – applicant, beneficiary, and the issuing bank are informed and included in the decision-making process.
- Extra risk protection for the seller and security in payment.
- Payments are made only with the proper submission of the documents.
- A charge of 1-2% is required for the amount.
Importance for Sellers
Irrevocable LC brings additional security for the sellers. Unlike the revocable ones, this does not give the banks the right to revoke or edit the LC for any reason. They are bound to pay the sellers legally. The most important part is bringing about any change, and the parties must be informed. This gives the beneficiaries security for payment and the buyer for goods.
Common applications in Bangladeshi trade
Most commonly used in international trade and large projects beyond national borders.
Confirmed Letter of Credit
Confirmed letters of credit are like extra assurance for the sellers. It provides more security by involving a second bank to guarantee the payment.
Confirmation by a second bank
Confirmed LC adds another bank’s confirmation besides the issuing bank. This bank is usually the seller’s bank and is added for extra security for the beneficiary. If the issuing banks fail to deliver the money, the additional bank (confirming bank) ensures the payment is delivered in a timely manner.
This type of LC is used in special situations, such as transactions in foreign markets or when sellers have less trust in the buyers.
Benefits for exporters
In Confirmed LC, the additional bank acts as a plus point for the exporters. This gives them double security in payments. Though it may involve a relatively higher fee this type of LC ensures secure and efficient transactions for the seller. This type of LC makes international trading easier and more flexible as businesses can easily deal in a market that they do not trust. They can also operate in politically unstable areas.
Examples of use in Bangladesh
- Used in international export sectors like RMG
- Infrastructure development projects
- Importing from volatile regions
- While dealing with untrustworthy buyers
- To export in a high-risk market
Standby Letter of Credit
There are times when the transactions fail, and as a result, the beneficiaries are not paid compensation. To save from this trouble, banks often issue standby LC. This ensures the beneficiary is paid regardless of any transaction issues.
Definition
The standby letter of credit is the type of LC that serves as a secondary payment guarantee. If any transaction issue occurs or the applicant can’t pay the amount, this is compensated to the beneficiary. Also, this letter of credit comes with high charging fees of 1 to 10%.
Purpose
The purpose of this LC is more like insurance, rather than an exchange facility. In case of any trouble related to the transaction, the beneficiary is ready to be compensated with the amount. The only thing they need to do is to submit the proper documents. All these papers should prove the amount of transaction and how they failed to receive this. When provided with the necessary information, the sellers are paid the compensated amount in no time.
Situations where it's used
- Used in international trade
- Can be used in domestic trade where parties do not know each other
- When parties do not know each other properly
- For loan repayments Advance payment guarantee
Relevance in Bangladesh’s business environment
For Bangladesh’s economy and business environment, standby LCs are really helpful. It is often used while dealing in foreign markets and international trading with politically unstable situations. Also, when approaching a new buyer, sellers often prefer this type of letter of credit. As this gives the exporter more security in payments, it also helps them to get the compensated amount.
Red Clause Letter of Credit
The red clause letter of credit itself contains a special function regarding the payment. It allows the sellers to get an advance payment to cover pre-shipment expenses.
Advance payment feature
The main difference between the red clause LC and the others is its advance payment feature. This is often referred to as the red clause advance. Here, the buyer pays the seller in advance for production or financing the shipment process. Despite this, LC offers funds to the sellers in situations where they fulfill the order upfront. However, it comes with a hefty price tag.
Scenarios for use
Buyers often use red clauses when they know the seller closely and have a trusted bond. In this case, the applicant (buyer) can pay the transaction in advance to the beneficiary (seller) so that they can finance the production or buy the raw materials.
Red Clause letter of credit is more common in custom order. When buyers need to produce unique requirements, they often pay the seller in advance. This works as an unsecured loan.
Red clauses are also more used in international trading than any other LCs. This helps the seller to secure the working capital and cover production, packaging, and operational costs.
Suppliers in Bangladesh
The suppliers in Bangladesh often use red clause LC to finance their productions. This is more common in textile and garments sectors. The production costs of these industries are usually hefty to produce on a large scale. As a result, the suppliers need huge upfront payment for fabric, stitching and other materials. Using red clause LC, the suppliers can easily get a partial advance payment from the buyer and process the production. As timely delivery and client satisfaction remains sealed.
Green Clause Letter of Credit
Similar to the red clause, the green clause letter of credit serves as the legal document that guarantees the seller of the secured payment. As a part of the international trade agreement, in this LC, the buyer needs to pay advance payment to the sellers. Here, the buyers not only cover the production cost in advance, they are also responsible to cover the pre-shipment warehousing costs.
Differences from the red clause
| Aspect | Red Clause LC | Green Clause LC |
|---|---|---|
| Definition | Allows beneficiaries to receive advance payment for production | Allows beneficiaries to receive advance payment and pre-shipment warehousing |
| Purpose | Provide immediate funds to the sellers for production needs | Provide transportation costs and pre-shipment funds |
| Advance payment | Partial advance payment is required (25-30%) | Usually a larger amount (75-80%) |
| Document required | Only receipts of goods | More documentation of funding, insurance, and storage cost |
| Risk | Comparatively higher risk for sellers than Green Clause LC | Comparatively lower risk for sellers than Red Clause LC |
Applications in financing pre-shipment expenses
The Green Clause LC is used when goods must be handled and processed before shipment. This advance is often categorized as pre-shipment and storage costs. Here, the buyers pay the advance usually for the following reasons –
- Finance storage facilities for perishable goods like seafood, fruits, etc.
- Insurance cost and protection from the physical harm or any accidents of the products
- Quality assurance, packaging, and pre-shipment cost
- Transportation costs like loading & unloading containers and shipment.
Significance for local exporters
Green clause LC works best for the sectors with huge pre-shipment expenses and finances. For example, many Bangladeshi export sectors, like seafood and agricultural products, need special care in handling and storage. Without proper preserving facilities, the quality can’t be assured for international standards. In the market where products are carefully scrutinized and sorted, green clause LC is a savior.
Other than this, this type of letter of credit is also significantly beneficial for small and medium businesses. Often, they suffer from cashflow insufficiency and can’t undergo large productions due to financial constraints. Using green clause LC allows them to produce, do thorough quality checks, and control all the expenses up to the buyer’s expectations.
Transferable Letter of Credit
The transferable letter of credit allows the individual to transfer their credit to another party. This can be helpful when one party cannot process the entire production by themselves. However, this process can be complex, and may charge extra fees to issue this LC.
Definition
TLC or Transferable letter of credit allows a primary beneficiary (first seller) to transfer the credit to the secondary beneficiary (second seller). When the seller is unable to process the entire order or fails to complete the transaction, they can use this LC.
Mechanisms
Transferable letters of credit usually involve brokers or intermediaries who hand over the credit to the second beneficiary. Here, the secondary beneficiary is usually the local suppliers who are capable of doing large productions. Firstly, the buyer applies to the issuing bank for the TLC which assigns the rights to the secondary beneficiary. The partial part is fulfilled by the intermediaries while rest is contracted by the suppliers.
Benefits for intermediaries and brokers
Besides helping the buyers and sellers, TLC helps intermediaries and brokers in this complex process.
- Intermediaries can transfer and connect between sellers and buyers by handing a portion to them.
- They can handle multiple transactions without large investments and resell goods.
- Minimizes the non-payment risks.
- Helps to avoid volatile or untrusted buyers.
- Ensures profit margin without direct involvement in product handling.
- Helps intermediaries expand market reach and approach high-value clients.
Usage in Bangladesh’s trade
In Bangladesh, Transferable letters of credit are quite common in trading scenarios. The local trading houses or brokers often deal with international clients and regional suppliers. They often use TLC to transfer the credit to the secondary beneficiary to process the order.
There are many examples of such sectors. One is the garments sector, which is more concerned with this multi-party trading scheme. International buyers can use TLC, to work with intermediaries who process their orders with direct suppliers. The same scenario is prevalent in the trading of textile and leather goods. The intermediaries help to process the production by contacting the local suppliers. They do this indirectly without participating in the process.
Importance of Letters of Credit in Bangladesh
Letters of credit are an essential aspect of international trading, especially in Bangladesh. As a heavily export-driven country , it is exporting goods with a GDP of 12.88%. Most of the GDP of the country relies on RMG sectors, jute & agricultural exports.
However, even after being over-relied upon by international trading, the Bangladeshi suppliers often lack direct and long-term relationships with foreign buyers. Due to its geostrategic position and economic drawbacks, the regional sellers often have to suffer for secured trading.
Luckily, the use of letters of credit introduced new doors of secured payment opportunities for the regional sellers. All the LCs in Bangladesh follow the Uniform Customs & Documentary Credits (UCP 600) for international trading.
It is an internationally recognized set of guidelines for commerce. In addition to this, the Ministry of Commerce regulates and ensures compliance with the import of goods under the Import and Export Control Act (1950). This structure is prepared so that the parties can save themselves from fraud risk, and get transparent transactions.
This way, businesses can compete in the high-demand markets. They can also enjoy the following benefits.
- Mitigates non-payment risks for exporters.
- Assurance in payment when the stipulated conditions are fulfilled.
- Reduces risks of partial shipment for the importers.
- Smoother business operation.
- Cash flow and the operation cost can be managed.
Documentation and Processes
Issuing a letter of credit needs proper documentation and measured steps. Otherwise, there is a high chance that the application may not get approved.
Required documentation for each type of LCs
Usually, all the LC types require the same documents while applying. Some of the common documents that might need are –
- Trading license for the business
- Bank account details of the business
- Importers IRC certificate
- Income tax clearance certificate
- VAT certificate
- Purchase contract/ invoice
- Packing list
- Insurance certificate
- Application form of LC
Depending on the specific type of LC, one might need to add an extra document. Usually, the issuing bank informs on these specific documents. For example, for issuing a Green Clause type, you might need to submit extra documents about insurance and storage facilities. However, the above documents are enough for most of the LC types.
Steps involved in issuing and using an LC
As you have prepared the important documents, now it is time to apply for the LC. For that, go through the following steps as this will streamline the process even more.
- Application Process: It is the first step, where the applicant (buyer) must apply to the LC issuing bank. They need to submit the mentioned documents outlining the payment terms.
- Issuance of LC: If the application is accepted the LC is issued by the bank. This LC is then sent to the beneficiary’s bank account (advising bank) highlighting the payment terms and conditions.
- Shipment and Submitting Documents: Once the LC is issued and sent, the shipment procedures are started. In the meantime, the sellers need to prepare and submit the required documents along with commercial invoices to their bank. In turn, this is forwarded to the issuing bank.
- Payment Completion: If the seller’s documents satisfy the requirements, now the buyer can complete the payment. Simply, they can do this from the issuing bank. If the document does not align with their TOCs, the LC might get rejected delaying the payment.
- LC Closure: As the funds are transferred to the beneficiary’s account, the LC is closed. This means the transaction is completed and the entire process remains compliant with international trading law.
Tips for exporters and importers
Even after knowing all the steps by heart, and preparing all the documents, most of the LC applications fail. Due to negligence or lack of attention, the entire time & working is wasted. So, exporters and importers should take some extra precautionary steps –
- Ensure all the documents are accurate and updated.
- Cross-check the documents before submitting.
- Fill out the application form carefully without any misleading data.
- Understand the terms and conditions of LCs and ensure complete compliance.
- Use reliable issuing and advising banks that have experience dealing with LC.
- Choose the proper LC type as per your trading needs.
- Think properly about your payment security apart from budget and prepare your requirements thoroughly.
Challenges and Considerations
As letters of credit (LC) are essential components for international trading, they often come with various challenges. Especially in the context of Bangladesh, there are many regulatory and compliance-related issues that businesses often need to keep in mind. To solve these, businesses first need to get a detailed breakdown of these challenges.
Common issues faced with LCs in Bangladesh
Documentation errors, delayed payment terms, and currency exchange rates are some of the common issues that the LCs in Bangladesh faced.
Documentation errors
Unlike many governmental procedures, LC issuance is entirely dependent on documentation. Thus, minor flaws like incomplete information, backdated data, or missing documents can directly reject your LC. This may lead to no payment, and both the exporter and importer need to suffer from this.
Delayed Payment
Due to the bureaucratic processes and the several layered verification processes, the LC issuing can take a long time. Moreover, if the documents are not properly submitted, this time can increase a lot more. Which eventually affects cash flow management and can disrupt operational efficiency of businesses. For time-sensitive industries like RMG and agriculture, this delayed timeline can incur huge losses to the business.
Exchange rate
As LC transactions often involve foreign exchange, businesses suffer from the fluctuating exchange rates. These fluctuations can easily change the transaction amount. Sudden changes in large amounts of transactions can trap businesses in unexpected financial losses.
Regulatory challenges and compliance
Besides the general challenges, businesses need to suffer due to the regulatory challenges. They often struggle to adhere to international laws and local banking laws.
Adherence to International Standards
To get the LC approved, the businesses need to submit all the required documents adhering to international standards and UCP 600 terms and conditions. However, maintaining all these international standards can be challenging for small businesses. Often, they struggle to understand and provide all the documents required due to a lack of expertise and resources.
Compliance with Local Banking Laws
The LC procedures are strictly monitored and governed by the Ministry of Commerce and the Central Bank of Bangladesh. They have set up various rules and regulations to prevent fraudulent activities and maintain financial reserves. For beginners, it is quite normal to fail to understand all these criteria. Many complex documents like IRC and ERC certificates are required by the bank. Thus, businesses often struggle with this. As a result, issuing LC slows down the entire trading process.
Recommendations for minimizing risks
To avoid regulatory issues and complete the letter of credit, take the necessary steps before it is too late.
- Prepare the documents beforehand and get them checked by some experts.
- Take expert service to easily complete the entire LC issuance process.
- Use hedging tools to monitor currency fluctuations.
- Choose the appropriate bank that provides the facilities for faster LC approval.
- Consult with a banking specialist or official and understand their regulatory requirements and international standards for LC issuance.
Conclusion
The letter of credit is an important aspect in facilitating international trade. Various types of LC, like revocable, irrevocable, green & red clauses, and confirmed are present and applicable to different trading scenarios and industries. Understanding these types can help the business choose properly and secure its payment terms.
Especially in Bangladesh, where the entire economy is entirely dependent on exporting goods, LCs are crucial. This not only ensures secured payment but also helps the businesses to operate and expand smoothly in the international markets.
FAQs
What is the meaning of a Letter of Credit (LC)?
The letter of credit (LC) is a financial document issued by a bank on behalf of a buyer to secure payment of a seller. LC acts as a protection for both parties involved in a transaction. Here, the bank itself guarantees the payment to the seller while assuring the buyer receives the agreed-upon goods or services before any funds are released.
What is the difference between revocable and irrevocable Letters of Credit?
The Revocable letter of credit can be changed or canceled by the issuing bank at any time without informing the parties. On the other hand, the Irrevocable letters of credit can’t be changed or canceled. Any changes that need to be made require agreement of both parties.
What is a confirmed Letter of Credit?
The Confirmed letter of credit gives more security to the seller by adding a second bank to guarantee payment. This bank is known as the confirming bank. It helps the sellers get the payment even if the issuing bank fails to do so.
How does a standby Letter of Credit work?
A Standby letter of credit acts as a backup payment method and works when the buyer fails to fulfill the primary payment obligation. With this LC, the seller can submit the required proof and the amount of transaction to get the payment.
What challenges might businesses face when using LCs in Bangladesh?
When using LCs in Bangladesh, businesses might face challenges like documentation errors and currency fluctuations, which can lead to delayed payment. Besides, there are also regulatory complications from international laws and local banks.
