The exchange of goods and services through international trade plays a major role in the economic progress of a country. Through international trade, countries can exchange goods and services that are not available in their own country, or costly than imported goods.
Letter of Credit vs Letter of Undertaking
The main difference between a Letter of Credit and a Letter of Undertaking is that though both are useful in international trade, a letter of credit is more reliable and safer but a letter of undertaking carries chances for fraudulence.
A letter of credit and a letter of the undertaking are two methods to smoothen the transaction process that may occur between parties from two different countries. A letter of credit can be understood as a means to provide a guarantee by a bank to the seller against a correct payment made in due time. The bank is obligated to make the payment in the case of defaults.
A letter of undertaking is produced to offer assurance against payment of the previously agreed amount to the destination party but, there won’t be any formal contract.
Comparison Table Between Letter of Credit and Letter of Undertaking (in Tabular Form)
| Parameter of Comparison | Letter of Credit | Letter of Undertaking |
|---|---|---|
| Definition | A letter of credit is a letter given from a bank to guarantee a buyer’s payment to a vendor will be made on time and for the correct amount. | A letter of undertaking to offer a guarantee to a person by a financial institution for providing a short duration credit from the abroad branch of an Indian Bank. |
| Involved parties | The letter of credit involved only two parties viz the seller and the purchaser. | There are four parties involved in a letter of undertaking and they are a receiving bank, the importer, overseas bank, and the issuing bank. |
| Amount of safety | A letter of credit is safer as it has all the important details regarding a specific purchase. | Not as safe as a letter of credit since there won’t be many details about the purchase. |
| Major benefit | A letter of credit is negotiable. Therefore, an issuing bank can pay directly to the recipient or any bank nominated by the recipient. | Convenient and economical for an importer to raise credit fast. |
| Possibility for tracing | Can be traced | Cannot be traced |
What is Letter of Credit?
A letter of credit aka ‘credit letter’ is a letter given from a bank to guarantee a buyer’s payment to a vendor will be made on time and for the correct amount. Banks charge a small fee for providing a letter of credit. In case the buyer is not able to make the payment for a purchase, the bank that has given the letter of credit must remit the remaining amount of the purchase. This provision is known by the name ‘facility’ in the finance sector.
Letters of credit are frequently used in the worldwide trade industry. A letter of credit is negotiable. Hence, an issuing bank can pay directly to the recipient or any bank nominated by the recipient.
Banks will demand a pledge of securities or money as security for allotting a letter of credit as well as a service change, probably a percentage of the magnitude of the letter of credit.
Several types of letters of credit are available depending on the purpose of the issue.
- A commercial letter of credit: – Through a commercial letter of credit, the bank might make a direct payment to the beneficiary.
- A standby letter of credit: – By this type of letter of credit, if the holder is not able to issue the money, the bank is ought to make the payment.
- Revolving letter of credit: – A customer can make several withdrawals for a predetermined duration if he is the holder of a revolving letter of credit.
- Travelers letter of credit: – A traveler’s letter of credit is for the persons who are going abroad, to provide a guarantee from the issuing banks that they will honor the drafts made at a specific foreign bank.
- Confirmed letter of credit: – A second bank should confirm the payment when the possibility of default from the part of the customer and the bank that providing the letter of credit.
Letters of credit are a dependable payment mechanism in international trade because of the factors like distance and different laws of the country. Generally, the parties to a letter of credit are the applicant or the importer who appeals to the bank to issue the Letter of credit, the importer’s bank that issues the letter of credit as well as the exporter (beneficiary).
What is Letter of Undertaking?
A letter of undertaking offers a guarantee to a person by a financial institution providing a short duration credit from the abroad branch of an Indian Bank. The issuing bank is offering a guarantee to the foreign branch of the Indian Bank about the customer’s repayment in foreign currencies.
The letter of undertaking is issued and is used for making transactions in the business or trade areas. Usually, a letter of undertaking for ensuring a credit line is supported by margin money or a credit limit that is sanctioned by a bank. The customer needs to pay margin money to the bank which is issuing the letter of undertaking.
A letter of undertaking works according to the foreign trade policy that governs the import of services or goods.
After the primary steps for producing a letter of undertaking is done, and the bank is sure about the security received against the credit required from the foreign branch of the Indian Bank, the issuing bank will process the letter of undertaking to the overseas branch.
The margin money that supports the credit may go even higher than the applied credit amount depending upon the relationship between the customer and the bank.
Next, the amount is released from the part of the overseas branch of the Indian Bank in the form of foreign currency. The name of the amount that is credited to the Bankers’ account back home is called ‘Nostro Account’ and the customer has the freedom to choose the recipient to whom the payment has to be made.
Main Differences Between Letter of Credit and Letter of Undertaking
- The main difference between Letter of credit and Letter of Undertaking is, the letter of credit has all the details of the transaction, the letter of undertaking need not be clear about the details of the transaction.
- A letter of credit is issued from a bank for a small fee. In the case of a letter of undertaking, the customer needs to pay margin money to the bank which is issuing the letter.
- A transaction made by a letter of credit can be traced, in case a need arises. It is difficult to trace a transaction made with a letter of undertaking.
- A Letter of the undertaking is a guarantee from an Indian bank for a customer to receive credit from the foreign branch of an Indian Bank to pay the offshore suppliers of him/her in foreign currency.
- In a letter of credit, if the buyer is failed to make the payment of the purchase, the bank is obligated to cover the total amount or the remaining amount for the purchase.
Conclusion
International trade involves parties from different countries and required safer ways to make financial transactions that may provide some guarantee to the involved parties. Letters of credit provide such a guarantee, whereas a letter of undertaking provides a means to receive credit from the overseas branch of an Indian bank to pay to the supplier in foreign currencies.
A letter of credit is safer since it includes all the relevant details of the transaction. A letter of the undertaking does not carry such details and not at all easy to trace the transactions made through it. There are many limitations and more possibilities for fraudulence, in the case of letters of undertaking and they are now banned in India by the Reserve Bank.
References
- https://repository.law.umich.edu/cgi/viewcontent.cgi?article=2776&context=mlr
- https://digital.sandiego.edu/cgi/viewcontent.cgi?article=1244&context=ilj