The exchange of goods and services through international trade is a great way to boost a country’s economy. International trade has made it possible for countries to exchange goods and services that are not available in their own countries. It is also an alternative to importing goods internationally at ridiculously high prices.
Letter of Credit Vs. Letter of Undertaking
Though both these documents are important during international trading, they come with differences. A letter of credit is more reliable and does not entertain fraudulent activity. A letter of undertaking on the other hand is unsafe and is at risk of allowing fraudulent behavior.
Both letters are used to make the process of a transaction between the countries doing the transaction a seamless one. A letter of credit is the means through which the bank provides a guarantee to the seller and ensures correct payment is made at the right time. The bank has an obligation to clear the arrears in case the seller defaults.
A letter of undertaking on the other hand is an assurance made of payment completion but this is not bound by a contract.
Comparison between Letter of Credit and Letter of Undertaking
- A letter of credit is one provided by the bank that confirms the payment to be sent to the vendor by the buyer is done and on time. A letter of undertaking on the other hand is a guarantee statement but not formal, where the financial institution provides a short credit duration from the abroad entity of an Indian bank.
- The letter of credit only has two parties involved which are the credit and the seller. There are four parties involved in a letter of undertaking. The receiving bank, the importer, the overseas bank, and the issuing bank.
- It is safer to use a letter of credit as all the important details regarding the purchase are made present in the letter. There are no details regarding the purchase in a letter of undertaking making it prone to fraudulent activities and therefore an unsafe option.
- A letter of credit gives room for negotiation. That is, the bank can make payments directly to the recipients or any other bank that is a choice of the recipient. Letters of undertaking are only good for the importer who needs to quickly raise credit.
- A letter of credit is easy to trace while the undertaking’s letter cannot be traced.
What is a Letter of Credit?
This is a letter provided by the bank that guarantees the buyer’s payment made to a vendor will be made on time and will ensure the correct amount is made. A small fee is issued by the bank for them to give the credit letter. Should a buyer default in making payments to the vendor, the letter states that the bank must remit the remaining amount to ensure that the vendor is paid fully.
The provision is referred to in the finance sector as a ‘facility’.
The worldwide trade industry is commonly known to use letters of credit. You can negotiate terms using the credit letter whereby; the bank can make payments directly to the recipient, or to a bank nominated by the payment recipient.
Banks often demand a form of security or pledge to allot the credit letter. We can call this form of security a service charge.
There are several types of credit letters available for different purposes. They include;
- Commercial letter of credit: This letter states that the bank can make direct payments to the beneficiary.
- Standby letter of credit: This letter states that if the holder is unable to or defaults to make payment, the bank should remit the remaining payments to the vendor.
- Revolving Letter of Credit: A customer is allowed to make several withdrawals for a predetermined duration if he is the one in possession of the credit letter.
- Travelers credit letter: This is a credit letter for persons going abroad. It states that the issuing bank will honor the drafts made to the specific foreign bank.
- Confirmed letter of credit: If there is a possibility of default, the letter states that a second bank can confirm if payment has been done.
Letters of credit are a good alternative to use because different countries have their own different laws and distance.
What is a Letter of Undertaking?
This is a letter that guarantees the person a financial institution for a short duration. The issuing bank offers a guarantee to the foreign bank about customer repayment in foreign currencies.
The letter is mainly used to conduct transactions. A customer needs to make a margin payment to the bank, which is issuing this letter of undertaking.
A letter of undertaking follows the rules of the foreign trade policy. That governs the imports of services and goods.
Once the letter of undertaking has been produced, and the bank is sure of the security, the letter is shared with the foreign bank. Depending on the relationship between the customer and the bank, the margin payments could go higher.
It is a lengthy process because the next step is the bank releasing payment of the overseas branch of the Indian bank in the currency of the country transaction is being done. The amount credited to the banker’s account is referred to as the ‘Nostro Amount’ and a customer has the freedom to choose who gets to receive the payment.
Difference between a Letter of Credit and a Letter of Undertaking
- The letter of credit has all the transaction details while the undertaking letter does not need to be clear about the details of the transaction.
- The bank issues the letters of credit at a small fee.
- A letter of credit states that the bank is obliged to make payment in case there is a default made.
In conclusion, we understand that international trade is done between parties from different countries and is healthy for the economy.
It is also good to note that using a letter of credit for transactions is safer, as opposed to using a letter of undertaking.
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