QA Series 31 - Letters of Credit Part 1

 

The Banking Tutor

Question Answer Series 2025

S No 31                                                                   31-07-2025

Letters of Credit – Part 1 

01. What is a Letter of Credit ? 

A Letter of Credit is an undertaking by the bank issuing it to pay the beneficiary of the credit provided stipulated documents are presented and other terms and conditions of the LC are complied with. 

02. What are the two basic principles underlying the LC? 

Independence Principle: The letter of credit is independent of the underlying sales contract between the buyer and seller.

Rule of Strict Compliance: Documents presented under the LC must strictly comply with its terms. Any discrepancies can lead to rejection of the documents and non-payment. 

03. In LC transaction who is Applicant ? 

The buyer of the goods / services (Importer) is Applicant in LC transaction. On behalf of Buyer the letter of credit is issued. The applicant is the party who requests the issuing bank to issue the letter of credit.  

04. In LC transaction who is Beneficiary?           

The seller of the goods / services (exporter) in whose favour the credit is issued is the Beneficiary under LC and He obtains payment on presentation of documents complying with the terms and conditions of the LC. 

05. What is a Confirming Bank ?

A bank which adds its guarantee to the LC opened by another Bank and thereby undertakes responsibility for payment /acceptance/ negotiation/incurring deferred payment under the credit in addition to that of the Issuing Bank. It is normally a bank operating in the country of the beneficiary and hence it’s guarantee adds to the acceptability of the LC for the beneficiary. This is being done at the request / authorization of the Issuing Bank. 

06. What is a Revocable Letter of Credit ?

A revocable letter of credit (LC) can be changed or cancelled by the issuing bank at any time, without prior notice to the beneficiary (seller). Conversely, an irrevocable letter of credit cannot be changed or cancelled without the consent of all parties involved, including the issuing bank, the applicant (buyer), and the beneficiary.

07. What is an Irrevocable LC?

An Irrevocable Letter of Credit is one which cannot be cancelled or amended without the consent of all parties concerned. 

08. What is a Revolving Letter of Credit

A Revolving Letter of Credit is one where, under terms and conditions thereof, the amount is renewed or reinstated without specific amendments to the credit being needed. It can revolve in relation to time and value.

09. What is an Usance LC?

Usance LC is also known as Acceptance Letter of Credit. Acceptance Credit is similar to deferred payment credit except for the fact that in this credit drawing of a usance Bill of Exchange is a must. Under this credit, Bill of Exchange must be drawn on the specified bank for specified tenor, and the designated bank will accept and honour the same, by making payment on the due dates.

10. What is a Sight LC?

Sight LC is also known as Payment Letter of Credit. Payment credit is a sight credit which is available for payment at sight basis against presentation of requisite documents to the issuing bank or the nominated bank. In a payment credit, beneficiary may or may not be  called upon to draw a Bill of Exchange. In many countries, because of stamp duties even on sight bills, drawing Bill of Exchange is dispensed with.

11. What Protective Clause to be furnished in Revolving LC?

The following protective clause should invariably be incorporated in the Revolving LC - “The amount utilised under this credit shall be again available for utilisation only on receipt by the negotiating branch/bank of the advice that the draft already drawn by the beneficiary has been reimbursed by the opener”.

12. What is Unconfirmed LC ?

An unconfirmed letter of credit carries the obligation of the issuing bank to honour all drawings, provided that the terms and conditions of the letter of credit have been complied with. 

13. What is a Confirmed LC ?

A confirmed letter of credit also carries the obligation of another bank which is normally located in the beneficiary’s country, thereby giving the beneficiary the comfort of dealing with a bank known to him. 

14. What is the difference between Import LC and Export LC ?

The import LC is the instrument used by the importer to secure payment for their imports, while the export LC is the same instrument viewed from the exporter's perspective, assuring them of payment for their exports. Both import and export LCs are essentially the same document; the perspective of who initiates and receives it defines whether it's an import or export LC. 

15. What is the difference between an Inland and a Foreign Letters of Credit?

Inland and Foreign Letters of Credit (LCs) are both payment guarantees used in trade, but they differ based on the geographical scope of the transaction.

An inland LC is used for domestic trade within a country, while a foreign LC (also known as an import/export LC) is used for international trade between parties in different countries. 

16. What is a Clean LC ?

A clean LC is a bank's guarantee of payment to a beneficiary (usually a seller) upon presentation of the LC, without any additional documentation. 

17. What is a Documentary LC ?

A documentary LC is a bank's promise to pay the beneficiary (seller) upon  presentation of specified documents, as outlined in the LC. 

18. What is the difference between a Clean LC and a Documentary LC ?

The primary distinction between a clean LC and a documentary LC lies in the requirement for supporting documents to initiate payment. Clean LCs prioritize speed and simplicity for trusted, low-risk transactions, while documentary LCs offer more comprehensive security and risk mitigation for international trade through rigorous document verification processes. 

19. What is a Red Clause Letter of Credit ?

A red clause letter of credit incorporates a clause, traditionally written in red,  which authorizes the bank acting as the negotiating or paying bank to pay the beneficiary in advance of shipment. 

20. What is a Green Clause Letter of Credit ?

Green Clause LC  provides for advance not only for purchase of raw materials, processing and/or packing but also for warehousing and insurance charges at the port pending availability of shipping space. 

21. What is a Transferable Letter of Credit ?

A transferable letter of credit allows the beneficiary to act as a middleman and  transfer his rights under a letter of credit to another party or parties who may be suppliers of the goods. 

22. What is a Back-to-Back Letter of Credit (LC) ?

A Back-to-Back Letter of Credit (LC) is a financial instrument used in international trade where an intermediary (middleman) uses one LC as collateral to obtain a second LC. This is often employed when a buyer doesn't directly deal with the final supplier. Essentially, two LCs are created: one from the buyer to the intermediary, and a second from the intermediary's bank to the supplier. 

23. What is the difference between a Back to Back LC and Transferable LC ?

The difference between back-to-back letters of credit and transferable letters of credit, is such that in a transferable letter of credit, the rights under the existing letter of credit are transferred. In a back-to-back transaction, different letters of credit are actually issued. 

24. What is a Deferred Payment LC?

Under a Deferred Payment Letter of Credit, the applicant does not pay until a future date determined in accordance with the terms of the letter of credit. No drafts are called for, which avoids “stamp duties” charged by some countries on bills of exchange (drafts). 

25. What is a Straight LC?

A Straight LC or ‘Straight Credit’ is defined by the Bank only being allowed to make payment to the beneficiary named in the Letter. In short, they are not permitted to send any payment to any third parties or intermediaries. 

26. What is a Restricted LC ?

In the case of a Restricted LC only one nominated bank can be used for negotiation. Therefore, the authorization of the issuing bank to make payment to the beneficiary is restricted to a specific, nominated bank. 

27. What is an Unrestricted LC ?

An Unrestricted LC the bank is not specified, which means the Letter of Credit can be negotiated through any bank of the beneficiary’s choice. 

Next Issue  will be shared on 2^nd August  2025.

Sekhar Pariti

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