May 18, 2020
A most commonly used letter, the commercial letter of credit, is also very widely known in many areas as a regular letter of credit. Global trade is on the rise and poses its own challenges for all the parties concerned. Major difficulties include the different laws of each country, the different customs rules and the different languages. Also, not being able to identify a foreign buyer or seller personally is a big issue. Therefore, all of this contributes to the difficulty in judging credibility. It is now very essential to have a common tool between the buyer and vendor, further acting as a security to both parties. That’s where the role of a letter of credit comes in play.
An LC acts as a guarantee to the buyer of receiving their goods and the seller of receiving their payment. There are varied forms of this letter, but now we’ll focus specifically on the commercial LC.
How Would You Define the Commercial LC?
It’s a legal document that comes either from a bank or any financial institution, representing a guarantee to pay the holder, only if they fulfil their obligation. Vendors often need a guarantee of payment, especially in case of international transactions. It comes from the financial institution in the form of the commercial LC, where if the buyer fails to make a payment, the bank is responsible to cover the payments.
An Example of The Process of How It Works
This is the initial stage, where the buyer from UAE agrees to buy goods from a seller in India, which is worth AED 20,000. While negotiating, both parties agree that the payment will be done in the form of a commercial LC.
Request to Issue the Letter
The buyer in UAE puts in a request in their local issuing bank to open a letter of credit of AED 20,000 in favor of the Indian vendor. The bank will then check the buyer’s credit worthiness and complete the remaining formalities in order to issue the letter.
Release The LC
The local issuing bank releases the requested letter, which has an expiry date of three months from the date of issue. They will then forward it to the bank in India, which is the corresponding bank. we say India, as the bank will typically be located in the country in which the vendor resides. The bank will then authenticate the letter and have it sent to the buyer in UAE. Now, at this stage, it’s important for the buyer to have the goods exported and documents submitted before the letter expires. Failure to do so, will lead the buyer to make the payments and not their local bank.
Prepare the Documents Required for Shipping
The vendor in India will have the products shipped to UAE and prepare the shipping documents in compliance with the instructions stated on the LC. The typical documents would include the invoice, BoL, transport documents and insurance. While some banks would ask for additional docs, these are the mandatory ones.
Verification of Documents
The vendor then submits the documents to their Bank, where they will verify and check if everything is aligned with the instructions given. Once complete, they will then send the documents back to the bank in UAE to make the payment.
Payment to The Seller
The UAE bank again checks if everything is in place, then debits the amount agreed upon including the letter of credit and pays it to the seller in India. The bank in India will then deduct their fees and deposit the remaining amount.