Question

1. Explain how a letter of credit is used with an example for all 3 parties involved. Be Detailed in the process/ chain linking all parties

Answer 1

Letter of credit also known as letter of undertaking is used to provide an economic guarantee from creditworthy Bank to the seller of the goods, where in the the relationship between the seller and the buyer cannot easily be made and the seller wants guarantee for the payment. Herein the bank act as an underwriter. It discharges the legal obligation of the buyer to make payment to seller by making payment to seller directly. The seller rely upon the credit risk of the buyer.

Three main parties involved in letter of credit are: Buyer, Seller and the Bank.

The buyer, seller and the bank make contract with each other that if in case of default in the payment by the buyer, Bank shall make payment to the seller. Bank also charges some fees for this service from the buyer as the bank is taking the risk on behalf of the buyer.

When the contract is executed between buyer and seller for the purchase and sale of goods and the seller hands over the good to the carrier for delivery to the buyer, the carrier gives a bill of lading to the seller. The seller then present that bill to the bank for the payment. The bill of lading received by bank will act as security for the bank against the risk that the buyer defaults in making payment to the the bank. The bank ensures that the bill presented by the seller is eligible for payment and it complies with the terms of letter of credit after which bank make payment to the seller.

Now if the buyer defaults in making payment to the bank for the payment made to seller upon the instruction made by the buyer, Bank can seize those goods and can sell it to recover its payment.