What is a letter of credit in simple words? This question can be found quite often on the World Wide Web. Many people believe that this word is used to refer to some complex term that is incomprehensible. ordinary person but it's actually easier than it looks. In our article today, we will tell you in detail what a letter of credit in a bank is. Interested? Then get started getting started!
We will not beat around the bush, but will immediately give an answer to your question. In the simplest terms, a letter of credit is one of the best and most reliable ways to protect your organization from the risks associated with prepayment for financial transactions. The letter of credit makes it possible to insure when cooperating with new partners. The bank in this situation is an intermediary that temporarily stores money in a special account. He also acts as a kind of guarantor, who takes responsibility for the payment of finances. It creates profitable terms for both the supplier and the recipient.
A letter of credit is a special bank account that gives the right to reserve the finances on it in the course of trade relations. If both parties comply with the terms of the contract, the bank must pay a certain amount of money to the recipient.
A letter of credit in a bank in simple words - what is it? We think this question is clear. Now let's find out where it is used. As a rule, these forms of calculation are most often used in the business sector: an entrepreneur who ordered a product can be sure that finances will be withdrawn from his working account only after shipment. The supplier, in turn, can be sure that he will receive his well-deserved monetary payment. Funds are transferred only when the bank receives the necessary documents. In addition, the letter of credit form of payment is quite often used when concluding large purchase-sale transactions.
In order to answer this question, you just need to familiarize yourself with the algorithm of actions of the parties who decided to use the form of calculation we are discussing:
Withdrawals can be made by both the paying bank and the receiving bank.
In addition to what a letter of credit is in simple terms, you also need to know what is needed to complete the transaction.
The document that regulates the relationship of the parties contains all the information necessary to complete the transaction. The contract specifies:
There are the following types of letters of credit in the bank:
| Covered (deposited) | The most commonly used. From the very beginning, funds are transferred to the account of the beneficiary bank |
| Uncovered | The executing bank is given the right to withhold finance from the correspondent account within the amount of money specified in the agreement |
| revocable | The issuer may cancel the transfer of funds if the payer makes a written order. Consent from the recipient is not required |
| irrevocable | The agreement is canceled only when the seller agrees to this |
| Confirmed (revocable/irrevocable) | Payments are made by the contractor even if there are no funds on the payer's account |
| Spare | The bank that opened the account may provide a written undertaking to the seller about the history of payments in the event that the buyer does not comply with the terms of the contract. In such a situation, the buyer will fulfill all obligations to the supplier |
| revolver | As a rule, they open for a part of the full amount of the payment, and after the accrual of funds by the buyer, it resumes to the previously specified amount. It is used in areas where goods are delivered according to a specific schedule. |
| Circular | Gives you the right to receive cash by letter of credit in all correspondents of the advising credit organization |
| With red clause | At the direction of the issuer, the advising banking organization credits the finance to the seller before he provides documents confirming the delivery |
Now let's take a closer look at the most popular ones.
Deposited and guaranteed operations are the most commonly used letters of credit. Types of contracts determine the specification of the operations themselves.
In second place in demand are revocable and irrevocable. They also have their own specific features.
The recipient of funds from a banking transaction may refuse to pay, but until the expiration of its term and provided that this was agreed in the agreement. By prior agreement, the acceptance of a third party who has the rights of the payer is also allowed.
In addition to what a letter of credit is in simple terms, many are also interested in the advantages and disadvantages of this phenomenon.
The clear pluses include:
If we consider letters of credit objectively, then it is also worth talking about their disadvantages:
When concluding a contract, the contract must necessarily indicate the form of mutual settlements, as well as the scheme for the provision of services or features of the delivery of goods. In addition, the planned types of letters of credit and their features are prescribed in the papers. To avoid problems in the future, the contract should contain the following information:
Letter of credit services can be implemented different ways It all depends on the lending institution. As a rule, banks carry out such operations:
What is a letter of credit in simple words, we have already discussed. In the end, we will pay attention to several important points.
In order for the partnership to be successful, the payer must, on his own or with the help of a professional, study this format banking operations. Letters of credit differ depending on the form of mutual settlements. For a particular case, you need to choose the optimal form of partnership.
A letter of credit is a conditional obligation of the bank to make payments to individuals and organizations at the client's request at his expense within the amount and conditions that were agreed in advance.
A letter of credit is a transaction that is made between one or more financial institutions in a non-cash form. The basis for the operation is a specialized application, which is issued according to prescribed form and is submitted by the buyer in favor of the supplier of the service or product. Participating parties can be only individuals, only legal entities, or both individuals and legal entities.
What is a letter of credit plain language? This is a very convenient form of interaction, which, however, is rarely used because of its complexity. A letter of credit is a form of payment that guarantees payment for the supplier and fulfillment of the terms of the contract for the buyer. After the delivery of the product or the provision of the service, the bank pays the seller its cost. The buyer, in turn, returns the funds to the bank, including interest.
The letter of credit form of payment can be used not only in domestic trade, but also in foreign trade. When applied in the field international trade procedure is governed by the Uniform Customs and Practice for documentary letters of credit, International Chamber of Commerce Publication No. 600, revised 2007.
Very often, a letter of credit is compared with a bank guarantee and factoring, however, these concepts are similar only at first glance. Learn more about letters of credit in the video below.
The use of this form of payments began to develop in Soviet times. Bashkir Soda Company OJSC, which produces caustic soda and is on the verge of bankruptcy, switched to a letter of credit form of interaction with customers in order to continue its activities.
The funds were credited only after the enterprise provided the bank with documents confirming the fulfillment of the terms of the contract, which were carefully checked. In this example, you can see that the letter of credit gave confidence to both parties.
Participants of calculations:
The letter of credit scheme is quite simple. It includes several required steps:
The service is provided by the issuing bank on the basis of an application, drawing up an agreement on the form 0401063. This document guarantees the supplier that the goods or services will be paid for within the agreed time frame. The buyer's funds may not be provided at the end of the algorithm, they may be deposited in advance.
A well-written contract includes the following points:
The standard list of conditions indicated above can be supplemented with additions regarding the procedure for making calculations. For example, not a full payment, but share payments may be used. A letter of credit can be issued for payment to one individual or organization. However, the person by whose means the payment will be made can be changed if it is specified in the contract - the possibility of acceptance.
When using this form of mutual settlements, it is very important point is the selection of a suitable type of letter of credit. Any varieties are opened by financial institutions, while the type is indicated in the agreement. The types are prescribed in the Regulation of the Central Bank of the Russian Federation:
The letter of credit agreement is clearly regulated by this legislation Russian Federation and is drawn up according to the rules prescribed in normative documents Central Bank Russian Federation in the event that the contract is drawn up between domestic organizations or residents of the Russian Federation.
into account in without fail the following regulations:
It should be borne in mind that the organization in favor of which a letter of credit is issued has the right to refuse such a form of payment.
If you are afraid to settle with counterparties on an advance payment, have started cooperation with a new supplier and want to insure yourself or plan to work with foreign partners, you should pay attention to such a form of payment as a letter of credit. This is one of the most profitable and reliable ways to pay under the contract, avoiding significant costs and risks. We will talk about him.
If you are afraid of banking terminology and it is difficult to figure out what a letter of credit is on your own, our material is just for you. In it, we tried to tell in simple terms what a letter of credit is, what types it is, what are its advantages and disadvantages.
To begin with, let's find out how the concept of "letter of credit" is deciphered in domestic legislation. And after that we will try to explain the essence of the phenomenon in simple words.
According to the Civil Code (Article 867), when making settlements under a letter of credit, the bank (issuer), on the basis of the payer's instruction, undertakes to pay the funds, pay the promissory note issued by the recipient, or perform other actions aimed at fulfilling the letter of credit, after the recipient presents certain documents.
Important: this is how a letter of credit is defined in professional language. If we state its interpretation in simpler words, then a letter of credit is an instruction to the bank to pay a certain amount, provided that its recipient provides certain documents. To put it even more simply: to open a letter of credit is to set aside money in a special bank account, which will wait there when they come with documents. In this case, you can use your own funds or borrow them from the bank.
After fulfilling the conditions of the letter of credit, the bank transfers the money to the recipient. This method of payment is used to make payments for the delivered goods, work performed and services rendered. The Bank participates in this process in the role of a guarantor that payments will be made in full and on time. Therefore, a letter of credit, in simple terms, can be called a guarantee of payment. It is also a special form bank lending because borrowed funds are often used.
Before opening a letter of credit, the parties must agree that payment will be made in this manner. The agreement is in the form of a contract. The next step is to contact the bank. The letter of credit is issued in paper form and must contain certain information:
The letter of credit can be executed by the bank in one of the following ways:
For clarity, we will demonstrate the use of a letter of credit for settlements using an example. Let's say you need to pay for a delivered product, but the required amount is not available. For this purpose, a letter of credit is opened with the attraction of credit funds, that is, in simple terms, you borrow money from the bank, but do not receive it yourself, but put it on a separate account and instruct the bank to pay them to the supplier when he fulfills certain conditions.
After the goods are delivered, the supplier submits supporting documents to the bank, and the agreed amount is transferred to his account. As such documents, as a rule, bills of lading are bills of lading. You just have to return the debt to the bank with interest, like a simple loan.
Important: when opening a letter of credit, it is not necessary to borrow funds - you can use your own money.
The person to whom the funds are to be paid applies to the bank with the documents stipulated by the terms of the letter of credit, and they can be drawn up in in electronic format. Further, within 5 working days, they can be checked, after which the bank makes a payment or refuses it. If within the period for which the letter of credit is issued, the necessary papers are not applied for, the funds are returned to the one who opened the letter of credit.
Important: a letter of credit is widely used not only in business, but also when paying for purchased apartments in new buildings. This method of payment allows both the buyer and the developer to insure against fraud. The client does not have to transfer money before registering the ownership of the apartment, and the company that sells the apartment may not be afraid that it will issue its transfer, but will not receive payment.
Depending on the possibility of cancellation and revision of conditions:
Based on the availability of coverage, that is, in simple words, the preliminary transfer of funds:
By mode of use:
Depending on the availability of additional warranties:
According to the payment procedure (form of execution):
Subject to other conditions, other types of letters of credit are also distinguished:
Like any other form of settlement, a letter of credit has both advantages and disadvantages that should be considered when choosing it as a payment method. Let's start with the positives.
Advantages of a letter of credit:
Cons of a letter of credit:
When working with counterparties, it is necessary to choose the best way to make settlements with them, which will allow you to make payments on time and insure yourself against dishonesty of the counterparty. One of the most profitable and safest forms of payment is the opening of a letter of credit. In simple terms, it can be defined as an instruction to the bank to pay funds to a certain person (company), provided that certain requirements are met. As a rule, in order to receive payment, it is necessary to provide documents confirming the fulfillment of obligations.
Depending on the terms of the letter of credit, in particular on the availability of coverage, confirmation and the possibility of revocation, there are various types of this form of payment. Its main advantages are savings and the ability to protect the parties to the contract from fraud. Among the shortcomings can be called a voluminous document exchange and the presence of restrictions on the use of a letter of credit.
15.10.2016 17 733 0 Reading time: 11 min.
Today we will continue talking about banking services and consider, what is a letter of credit where such a service can be used, why it is interesting. This service is more popular for representatives of large and medium-sized businesses, however, recently it has been increasingly extended to small entrepreneurs, and even to individuals who are not engaged in business. Therefore, knowing what a bank letter of credit is, what types of letters of credit are available will be useful to everyone, even just for general development.
A letter of credit is an obligation of the payer's bank to make a payment to the beneficiary's bank only after the payee provides his bank with certain documents stipulated by the conditions for opening a letter of credit.
Letters of credit belong to the so-called. documentary operations of the bank, that is, to operations based on document flow. Most often, documentary transactions, in particular letters of credit, are used by enterprises engaged in export-import activities, but this is not the only area of their application.
Why are letters of credit needed? In simple words, in order to exclude fraud between the parties to a particular transaction. The bank simply acts as a legal guarantor between the parties to the transaction, for which it receives its commission.
Consider the basic terms and concepts associated with the opening of letters of credit.
Letter of credit issuer- the bank to which the client applied, wishing to open a letter of credit.
Beneficiary bank- the bank in which the client is served, in whose favor the letter of credit is opened.
Beneficiary- beneficiary of payment under a letter of credit.
Deal- a certain sale and purchase operation, for the settlement of which a letter of credit is opened.
Letter of credit amount- the amount of the transaction, for the settlement of which a letter of credit is opened.
Letter of credit term— the limited period during which the letter of credit is valid.
Type of letter of credit– conditions for opening a letter of credit (I will consider the most common options below in more detail).
Commission for opening a letter of credit- the cost of opening a letter of credit, established by the bank's tariffs. Usually calculated as a percentage per annum of the amount of the letter of credit, it may also include some fixed or minimum payment. At the same time, the issuing bank pays part of the commission received to the beneficiary bank for its services.
Consider the scheme of the letter of credit on an example. Let's say we have a supplier and a buyer of a certain product who do not trust each other and want to make sure. The buyer is afraid to send money without seeing the goods, and the supplier is afraid to send goods without seeing the money.
In such a situation, opening a letter of credit can help. The buyer opens a letter of credit in his bank, pays the payment amount to a special account, and instructs the supplier to send it to his bank, but only after the supplier provides documents confirming the fact of sending the goods.
The buyer's bank sends the supplier's bank a notice of opening a letter of credit, and the supplier's bank informs the supplier about it. The supplier, knowing that the funds for payment for the goods have already been reserved and will be sent to him, sends the goods and provides his bank with documents confirming this fact. The supplier's bank checks the legality of these documents and, on the basis of this, makes the necessary payment, which is reported to the buyer's bank. After that, the buyer's bank transfers the reserved funds of its client to the supplier's bank. The supplier gets his money, the buyer gets the product, and the banks get their commission. Everyone is happy. This is the classic letter of credit scheme, and depending on the type of service, some actions may vary.
For clarity, an approximate scheme of the letter of credit can be presented in the following figure (numbers indicate the procedure):
Consider the most common types of letters of credit - they can be divided according to several criteria.
Based on whether it is possible to cancel the action of a letter of credit, there are revocable and irrevocable letters of credit.
Revocable letter of credit implies the possibility of the issuing bank to withdraw (cancel) its instruction to transfer funds before the moment of submission required documents by the opposite party, that is, cancel the operation, without notifying the beneficiary bank.
Irrevocable letter of credit does not imply the possibility of its cancellation without notifying the beneficiary bank and without the consent of the direct recipient of the payment. That is, it can also be canceled, but only with the consent of the two parties, and not in unilaterally as a revocable letter of credit.
Irrevocable letters of credit are used in practice much more often than revocable ones, since they satisfy the interests of both parties to the transaction more.
According to the degree of responsibility of both banks, confirmed and unconfirmed letters of credit are distinguished.
Confirmed letter of credit guarantees that the recipient's bank or another third bank will pay the recipient the amount due, even if the sender's bank does not transfer the money to him.
Unconfirmed letter of credit assumes that the payment will go to the recipient only if it is actually transferred by the issuing bank.
According to the possible source of funds for the execution of the payment, covered and uncovered letters of credit are distinguished.
Covered (deposited) letter of credit means that the issuing bank transfers the payment amount to the beneficiary's bank for the entire period of the letter of credit. This amount is a guaranteed cover, and is immediately at the disposal of the beneficiary's bank.
Uncovered (guaranteed) letter of credit means that the issuing bank allows the beneficiary's bank to write off the payment amount from its correspondent account, or stipulates some other conditions for receiving a refund. In practice, this type of letter of credit is most often used.
Consider some other well-known types of letters of credit.
Letter of credit with a red clause means that the issuing bank undertakes to make the agreed amount of advance payment to the beneficiary's bank even before the receipt of supporting documents from the beneficiary.
Revolving letter of credit opens when it is necessary to regularly perform homogeneous operations. Each time it acts on a certain batch of goods and then resumes its effect on the next batch.
Transferable (transferable) letter of credit implies the possibility of transferring part of it to another beneficiary, if necessary.
Standby letter of credit or stand-by letter of credit is a kind of symbiosis of a letter of credit and bank guarantee, under which the supplier receives payment for the goods, even if the buyer refuses to pay him, the payment is made by the bank at its own expense.
All the advantages and disadvantages of the letter of credit form of payment are reduced to one. The advantage is the bank guarantee that the client will receive the necessary product-service, his money will not be lost, the opposite side of the transaction is not a fraudster and will not deceive him. And the disadvantage is that opening a letter of credit costs money, as a rule, it is a few percent of the payment amount. Thus, for an increased level of security of the transaction, you just have to pay extra.
Consider the most common areas of application for letters of credit:
Now that you know the concept and essence of a letter of credit, let's summarize and highlight the most important thing.
A bank letter of credit is a kind of guarantee of the legal purity of a transaction, removing almost all the risks of fraud, because documents confirming the transfer of goods from the seller to the buyer are checked by experienced banking lawyers. Opening a letter of credit in the implementation of export-import operations is also interesting because, regardless of the countries where the supplier and buyer are located, such operations are regulated by a universal document - international Uniform Customs and Practice for Documentary Credits UCP-600, which eliminates the risk of non-compliance with legislation different countries carrying out a certain transaction. Opening a letter of credit will cost the buyer a certain amount, but this amount is significantly lower than, for example, when obtaining a loan, and a letter of credit of a certain type includes many parameters credit operation, but at the same time it also ensures a safe transaction. That is, this is a rather profitable service, but it requires additional costs.
Now you have an idea of what a letter of credit is, why it is needed, what types of letters of credit can be found in practice.
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Are you afraid of the risks associated with an advance payment for a transaction? Would you like to insure yourself as a client cooperating with a new supplier for the first time? Take advantage of a letter of credit - one of the most reliable and profitable banking instruments used when concluding contracts.
The letter of credit form of payment is beneficial for both the seller and the buyer. It can be used with equal success not only in domestic transactions, but also in foreign trade operations. Today, settlement services in the form of documentary letters of credit are provided by most major Russian banks.
In simple terms, a letter of credit is a special account opened with a bank, where you can reserve funds when conducting transactions for the sale of goods or the provision of services (performance of work). With full observance by both parties of the conditions specified in the contract, the bank pays the required amount to the account of the recipient (beneficiary).
Thus, the bank acts as a guarantor and assumes responsibility for making payments. The supplier is 100% sure that the product / service will be paid for, and the buyer knows that he can pay them on time and without debt.
It operates according to the following scheme.
One of the main and frequently used types of documentary calculations. Unlike a revocable letter of credit, a confirmed or unconfirmed irrevocable letter of credit is not revoked or changed by either party (including the bank) without the prior consent of the seller/supplier. It is considered the most reliable form of letters of credit, as it completely frees a trade and money transaction from all possible risks, primarily financial ones.
If during the course of the transaction the supplier and the buyer come to a mutual agreement, the terms of the irrevocable letter of credit may be changed.
Any information that can subsequently be used when making a trade and money transaction and paying for it is stipulated and strictly recorded in the agreement on the transaction, which provides for such a form of settlement:
Settlements by letters of credit provide for the transfer of funds to the seller's account only if all the conditions specified in the contract have been met. In particular, the transfer of money to the seller's account is made after the full shipment of the goods and the provision of all required documents to the bank. In the event that the terms of the letter of credit agreement have been violated, the payer (buyer) has the right to refuse payment and return the goods to the supplier.
Nuance: a letter of credit account is opened by the buyer for his own money or with the involvement of bank credit funds (if he has the right to lend).
To open a letter of credit account in banking organization a written application is submitted in the appropriate form. The statement states:
Comparison.ru advice: use a letter of credit form of payment if you need to conduct secure trade and money transactions with new and “problematic” business partners.
