The exchange of goods and services through international trade plays a significant role in the economic progress of a country. Through international trade, nations can exchange goods and services unavailable in their country or more costly than imported goods.
Key Takeaways
- A letter of credit is a financial instrument issued by a bank or financial institution that guarantees the payment of a specified amount to a beneficiary, provided that the beneficiary meets certain terms and conditions; a letter of undertaking is a formal, legally binding document in which a party commits to fulfill specific obligations or responsibilities.
- Letters of credit are primarily used in international trade transactions to ensure payment between buyers and sellers. In contrast, letters of undertaking can be used in various contexts, including financial transactions, contractual agreements, and legal disputes.
- Both letters of credit and letters of undertaking serve as assurances, but letters of credit focus on guaranteeing payment, while letters of undertaking involve broader commitments and obligations.
Letter of Credit vs. Letter of Undertaking
The 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. Still, a letter of undertaking carries chances for fraudulence.
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A letter of credit and a letter of undertaking are two methods to smoothen the transaction process between parties from two 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.
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
| Parameter of Comparison | Letter of Credit | Letter of Undertaking |
|---|---|---|
| Definition | A letter of credit is a letter given by 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: the seller and the purchaser. | Four parties are involved in a letter of undertaking: a receiving bank, the importer, the overseas bank, and the issuing bank. |
| Amount of safety | A letter of credit is safer as it has all the essential 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 | It cannot be traced |
What is Letter of Credit?
A letter of credit, aka ‘credit letter’ is a letter given by 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.
Letters of credit are frequently used in the worldwide trade industry. A letter of credit is negotiable.
Banks will demand a pledge of securities or money as security for allotting a letter of credit and a service change, probably a percentage of the magnitude of the letter of credit.
Several letters of credit are available depending on the purpose of the issue.
- A commercial letter of credit: – The bank might directly pay the beneficiary through a commercial letter of credit.
- A standby letter of credit: – With this type of letter of credit, if the holder cannot issue the money, the bank ought to make the payment.
- Revolving letter of credit: – A customer can make several withdrawals for a predetermined duration if he holds a revolving letter of credit.
- Travelers’ letter of credit: – A traveler’s letter of credit is for those going abroad to 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 verify the payment when the possibility of default on the pais on the customer’s part bank that provides 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, and 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 sanctioned by a bank.
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 the undertaking are 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 credited to the Bankers’ account back home is called the ‘Nostro Account,’ and the customer has the freedom to choose the recipient to whom the payment must be made.
Main Differences Between Letter of Credit and Letter of Undertaking
- The main difference between a Letter of credit and a Letter of Undertaking is that the letter of credit has all the transaction details. In contrast, the letter of undertaking need not be clear about the transaction details.
- 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 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 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 fails to pay for the purchase, the bank must cover the total or the remaining amount.
- https://repository.law.umich.edu/cgi/viewcontent.cgi?article=2776&context=mlr
- https://digital.sandiego.edu/cgi/viewcontent.cgi?article=1244&context=ilj
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Chara Yadav holds MBA in Finance. Her goal is to simplify finance-related topics. She has worked in finance for about 25 years. She has held multiple finance and banking classes for business schools and communities. Read more at her bio page.
