Letters of credit accomplish their purpose by substituting the credit of the bank for that of the customer, for the purpose of facilitating trade. The rise of Islamic Banking now there are two option : Islamic and Convensional letter of credit. The function are similar where a Letter of Credit act as a contractual payment mechanism between a bank, known as the issuing bank, on behalf of one of its customers, authorizing another bank, known as the advising or confirming bank, to make payment to the beneficiary.

Convensional Letter of Credit

Letters of credit used in international transactions are governed by the International Chamber of Commerce Uniform Customs and Practice for Documentary Credits. The general provisions and definitions of the International Chamber of Commerce are binding on all parties.

The issuing bank, on the request of its customer, opens the letter of credit. The issuing bank makes a commitment to honor drawings made under the credit. The beneficiary is normally the provider of goods and/or services. Essentially, the issuing bank replaces the bank’s customer as the payee.

Elements of a Letter of Credit

• A payment undertaking given by a bank (issuing bank) On behalf of a buyer (applicant) 
• To pay a seller (beneficiary) for a given amount of money 
• On presentation of specified documents representing the supply of goods  Within specified time limits 
• Documents must conform to terms and conditions set out in the letter of credit 
• Documents to be presented at a specified place

Letters of credit safeguards both the Seller and the Buyer and act as a tool to reduce risk. Letters of credit accomplish their purpose by substituting the credit of the bank for that of the customer, for the purpose of facilitating trade.

Islamic Letter Of Credit

An Islamic Letter Of Credit is no different from a convensional Letter of Credit, it is a written undertaking by an Islamic Bank at the request of the Buyer/Applicant to pay the Seller/Beneficiary a certain sum of money as stipulated in the Letter of Credit, provided that the Seller/Beneficiary complies with the terms and conditions of the Letter of Credit.

The Letter of Credit can be issued under two condition ; The Wakalah contract (agency relationship) and the Murabahah contract (cost plus).

WAKALAH CONTRACT

• The participating Islamic Bank will act as an agent on behalf of the Buyer/Applicant 
• Buyer/Applicant will place deposit to the full amount of goods to be purchased 
• The Islamic Bank establishes the Letter of Credit and remits the payment to the Seller/Beneficiary utilising the customers’ deposit.

MURABAHAH CONTRACT

• The Islamic Bank will act as the financier for the Buyer/Applicant for the purchase of the goods 
• The Islamic Bank will establish the Letter of Credit and remit the payment to the Seller/Beneficiary utilising its own funds 
•  The Islamic Bank sell the goods to the Buyer/Applicant at a sale price comprising its cost and a profit margin 
•  Buyer/Applicant is given a deferred payment term for the settlement of the purchase

Tips for Exporters

The risk to an Exporter not being paid can be mitigated through the used of Letter of Credit, however it is your own responsibilities to always ;

• Communicate with your customers in detail before they apply for letters of credit. 
• Consider whether a confirmed letter of credit is needed. 
• Ask for a copy of the application to be fax to you, so you can check for terms or conditions that may cause you problems in compliance. 
• Upon first advice of the letter of credit, check that all its terms and conditions can be complied with within the prescribed time limits. 
• Many presentations of documents run into problems with time-limits. You must be aware of at least three time constraints - the expiration date of the credit, the latest shipping date and the maximum time allowed between dispatch and presentation. 
• If the letter of credit calls for documents supplied by third parties, make reasonable allowance for the time this may take to complete. 
• After dispatch of the goods, check all the documents both against the terms of the credit and against each other for internal consistency.