Funding against Letter of Credit
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A letter of credit is a written promise by a bank to pay for goods a buyer purchases from a seller. Discounting is a way a seller gets paid immediately even if the buyer wants a longer term for payment.
Letter of Credit:
Sellers may request that a buyer obtain a letter of credit from a Bank / FI prior to shipping goods. This is done to protect the seller against non-payment for the merchandise. This letter states the bank will pay the seller if the buyer defaults. In simple terms, a Letter of Credit is a bank undertaking of payment separate from the sales or other contract on which it is based. It is a way of reducing the payment risks associated with movement of goods.
Expressed more fully, it is a written undertaking by a bank (issuing bank) given to the seller (beneficiary) at the request, and in accordance with buyer’s (applicant) instruction to effect payment- that is by making a payment or by accepting or negotiating bills of exchange (draft)- up to a stated amount, against stipulated documents and within a prescribed time limit.
Discounting of Letter of Credit:
Often a buyer does not want to pay for the goods immediately after receiving them. The seller may not like this idea and would rather receive payment immediately. In this case, the seller may work with the guaranteeing bank and ask for a discounted payment.
The discounting of a letter of credit is a short-term financing operation, consisting in the payment by the bank of the net value (nominal value minus discount and arrangement fee) of receivables aroused from irrevocable letters of credit with deferred payment. The receivable financing is made before the due date, against documents presented within the documentary credit and accepted for payment.
How It Works:
Parties Involved in Discounting Process:
2. The negotiating bank that negotiates the docs presented by beneficiary.
3. The discounting bank that discounts the value of LC.
4. The paying bank that pays the principal amount and interest at maturity
5. The beneficiary that has the right of assignment of proceeds under the letter of credit.
Different Steps of Discounting Process:
- The applicant refers to the counter of his bank and requests to issue a letter of credit to the favor of the beneficiary.
- Issuing bank issues the letter of credit and sends it to negotiating bank.
- The negotiating bank advises the letter of credit to the beneficiary for further review of the terms and conditions.
- The beneficiary consigns the goods and presents the relevant complying documents to the counter of negotiating bank.
- In case of compliancy of documents with terms and conditions of letter of credit, the beneficiary exercises his right and assigns the proceeds under the letter of credit by sending an assignment letter to discounting bank and requests to remit the discounting amount to the favor of him. Subsequently the negotiating bank sends a message to discounting bank requesting to accept the assignment of proceeds.
- Discounting Bank sends a message to the issuing bank enquiring for confirmation of the said bank to pay the principal and interest amount at maturity.
- After receiving the confirmation, discounting bank pays the discounting amount to the negotiating bank for further credit to account of beneficiary.
- The issuing bank reimburses the principal and interest amount at maturity.
Benefits:
CA Ravindra Jain RJ
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