Understanding Letters of Credit (LC) and their role in supporting MSMEs
Business21 Jan 2025
How letters of credit work
1. Parties involved:
a. Buyer (applicant): Requests the LC from their bank.
b. Seller (beneficiary): Receives payment once the terms of the LC are fulfilled.
c. Issuing bank: Issues the LC on behalf of the buyer.
d. Advising bank: Represents the seller and advises them on the LC terms.
2. Process:
a. The buyer and seller agree on a trade contract, specifying the use of an LC.
b. The buyer’s bank issues the LC and shares it with the advising bank.
c. The seller ships the goods and submits required documents (e.g., bill of lading, invoice) to the advising bank.
d. The advising bank verifies the documents and forwards them to the issuing bank.
e. Upon verification, the issuing bank releases payment to the seller.
Role of LCs in supporting MSMEs
1. Enhancing trust:
Many MSMEs face credibility challenges when dealing with new clients. An LC assures sellers of payment once terms are fulfilled, building trust with buyers.
2. Improving cash flow:
LCs provide sellers with a predictable payment timeline, enabling better cash flow management. This is especially crucial for MSMEs with tight working capital.
3. Minimising risk:
LCs mitigate risks such as buyer insolvency or non-payment, ensuring MSMEs can trade with confidence.
4. Facilitating credit access:
Many banks offer financing against LCs, allowing MSMEs to bridge gaps in their working capital needs without exhausting other credit lines.
5. Encouraging trade expansion:
With payment assurance, MSMEs can explore new markets domestically and internationally, scaling their operations without worrying about payment security.
Types of letters of credit
1. Revocable and irrevocable LCs:
Most LCs are irrevocable, meaning they cannot be changed without mutual agreement, providing added security to sellers.
2. Confirmed LCs:
These include an additional guarantee from the advising bank, offering extra security for sellers in high-risk markets.
3. Standby LCs:
Used as a backup payment guarantee if the buyer fails to fulfil their obligations.
4. Revolving LCs:
Useful for ongoing contracts, as they allow repeated use without the need for new documentation. Challenges and solutions
· Complex documentation: MSMEs often find the documentation for LCs cumbersome. Digital platforms and professional advisory services can simplify this process.
· Costs: Banks charge fees for issuing and confirming LCs. MSMEs can negotiate competitive rates or explore government schemes aimed at reducing trade finance costs.
· Banking relationships: Limited access to banks willing to issue LCs can hinder MSMEs. Building long-term relationships with financial institutions or using platforms like JSW One MSME can help.
Conclusion
Letters of credit are instrumental in empowering MSMEs by mitigating payment risks and providing liquidity. With growing digitalisation and platforms like JSW One MSME, Indian MSMEs can simplify the process of accessing LCs, streamline material procurement, and focus on scaling their operations confidently.