What is Letter of Credit (LC)? Definition, Need, Process, Types

Letter of credit is a commitment/ undertaking in the form of written instrument by a bank on behalf of its customer (known as buyer/importer) to pay the "counter value" of goods/services within a given date to its supplier (known as seller/exporter) according to agreed stipulations and against presentation of specified documents as specified in the instrument. 
A "Letter of Credit" is used as an instrument for settlement of payment arising out of commercial transactions like sales/purchases. In such credit, payment obligation arises only upon fulfillment of specified conditions.

The letter of credit is one of the negotiable instrument. It is given by the bank, that guarantee’s buyer’s payment to the seller shall be received on time along with the proposed amount to be paid. In this instinct, if the buyer is unable to make the agreed payment to the seller, then the bank will cover the full or remaining amount of purchase.
Need of Letter of Credit:

In case of international dealings, many factors such as distance, duration, various law enforcing agencies and complexities in knowing the trading party in person and therefore, In international dealings letter of credit would be of great importance and key player in assurance to the beneficiary.
Standard Process of LC Transaction:
  1. Negotiations between buyer and seller and thus finalization of deal & Buyer approach its bank to open import LC.
  2. Issuing bank issues the LC through its advising bank & advising bank informs and advises the LC to the exporter.
  3. Exporter prepares the goods and makes the shipment through the carrier Exporter prepares the documents demanded in the credit and furnishes to its negotiating bank.
  4. Negotiating bank forwards the documents to issuing bank for payment.
  5. Issuing bank obtains payment from importer and provides the documents.
  6. Importer obtains the goods shipped by exporter through carrier (or its agent).
  7. Issuing bank releases the payment to negotiating bank through reimbursing bank.
  8. Exporter receives payment through negotiating bank.

Types of Letter of Credit:

  • Import/export letter of credit- In this the importer will be a buyer and exporter would be a beneficiary.
  • Revocable letter of credit -It can be changed anytime by buyer or issuing bank without any prior notification to the beneficiary.
  • Irrevocable letter of credit-Here the change can be done only by the issuing bank after approval given by the beneficiary alone.
  • Transferable letter of credit- It is used when beneficiary involved are one or more suppliers in which beneficiary will be presenting the documents for part of his payment.
  • Non-Transferable letter of credit- It is non-transferrable to the third parties/others who are not part of the payments.
A letter of credit is normally opened by the bank of the importer and not the exporter, hence it is known as import letter of credit.  However, the same import L/C is known as export L/C for the bank of exporter and the exporter himself.  This should be understood that importer as well exporter both do not open separate L/Cs for the trade of same commodity under one transaction.