Debt is a currency

Instruments that let you pay without actually paying:

Having debt is using money one doesn't have for one's needs. This presumes a transfer of funds
from the lender to the borrower and the borrower's subsequent usage of the money. However, that is
not the case in reality. Businesses often consummate the transaction before transferring money from
the lender to the borrower. They do this by ‘transferring the promise’ to the borrower to whosoever
the borrower must pay.

Essentially, a transaction is completed without the transfer of funds between the lender and the
borrower. In these kinds of ‘non-fund’ based transactions, the recipient of such a promise receives
the money directly from the lender. The instruments that allow such a promise to be transferred are
often called ‘non-fund-based’ debt instruments.

For individuals, Credit Cards are this kind of instrument where the supplier gets paid by the transfer
of a promise from the borrower - Whatever the amount that the borrower owes the supplier, they
can get paid by using the credit card provided by the Bank to the borrower. After the transaction is
completed, i.e. after the supplier is paid, the Bank will create a charge on the borrower’s account,
which needs to be cleared on/before a particular day.

For Companies, besides having their own credit cards, Letters of Credit, Banker's Assurance/Bills
of exchange/Bill Finance, Bank Guarantees & overdrafts are some non-fund-based debt instruments
that are often used by to pay without actually transferring money from their accounts.

Letter of Credit:

Letter of Credit is a contractual arrangement between a company and its Supplier stating that the
Company's bank will pay the Supplier as soon as the Supplier supplies the goods to the Company. It
is predominantly used in transactions between different enterprises in different parts of the world.

This is how they work:

- The Company (referred to as the importer) enters into a sale agreement with the Supplier
(referred to as the exporter), under which they agree that the mode of payment is through the
Letter of Credit drafted by the Importer's Bank. This is done either because the Exporter has little
confidence in the ability of the Importer to pay the amounts that are due (i.e. if the Importer's
credit rating - one which credit rating agencies provide - is unacceptable or not available to do
the business) or if the Exporter is dealing with a relatively new entry in the relevant market.
- The Importer's Bank drafts the contractual terms of the Letter of Credit (LC), which state all the
terms and conditions that need to be complied with by the Exporter before claiming payment and
the duties that need to be performed by the Importer.
- While drafting the Letter of Credit (LC), the Importer's Bank appoints a Negotiating Bank (An
enterprise whose primary job is to check whether the documentation that is required to be
provided by the Exporter for claiming money is in order) and a Reimbursement Bank (An
enterprise that holds the funds that the Importer Bank has to transfer after the Negotiating Bank
has given a green signal vis-à-vis the documentation provided).
- While creating the LC, the Importer’s Bank also creates a Bill of exchange in favour of the
Exporter. Bill of exchange is an instrument that essentially directs a certain person to pay the
bearer of the Bill the amount that is mentioned in the Bill. In the process of LC, a bill of
exchange is created so that the exporter can demand the Importer’s Bank to pay the money.
- After finalising the LC, the Negotiating Bank & the Reimbursement Bank are transferred to the
Exporter's Bank for verification. The Exporter's Bank (also called Advisory Bank) verifies the
documentation and the entities that are providing the Letter of Credit and advises the Exporter on
the reliability of the documentation. If, at this stage, the Exporter requires more assurance, ask
for another Bank (Confirmation Bank) to authenticate the L.C. and ask the Bank to provide a
guarantee in case the Importer Bank fails to pay the Exporter once they perform their obligations.
- After the Advisory Bank/Exporter's Bank finalises the documentation, it sends the LC to the
Exporter, who performs the obligations laid down in the LC & the sale agreement.
- After producing/manufacturing the goods under the sale agreement and are shipped, the exporter
takes the Commercial Invoice (which consists of details like value, quantity, weights, importer's
name, address, LC number, shipping marks, etc.), the transportation documents and Bill of
Exchange to the Exporter’s Bank for the sake of payment.
- Transportation documents are documents that evidence the movement of goods from one place to
the other like a Bill of lading - issued when goods are moved from one shipping port to another
shipping port, an Airways receipt - issued when goods are moved from one Airport to another,
 Railway Receipts - given when goods are moved from one Railway station to another & Lorry
Receipts - given when goods are moved from one destination to another via roadways.
- After receiving the transportation documents, the Commercial invoice and any other document
required to be produced under LC, the Exporter's Bank verifies them and transfers those
documents to the Negotiating Bank.
- The Negotiating Bank, after reviewing the documents, informed the Importer's Bank, who will
then instruct the Reimbursement Bank to release the funds.
- In some cases, the Funds are received by the Negotiating Bank and are transferred to the
Exporter. In other cases, they are directly transferred from the Reimbursement Bank to the
Exporter. Sometimes, it can also happen that the Negotiating Bank transfers the money and then
collects it from the Reimbursement Bank/Importer's Bank. Who transfers the money and how is
the money is transferred is governed by the terms and conditions laid down in the LC.
- The Advisory Banks can undertake to provide funds to the Exporter as and when the Exporter
provides the documents the Advisory Banks verify them, but that is a duty that they are not
required to take.
- All the Banks involved in the process are paid through commissions from the Importer/Exporter
for being involved in the process and taking the risks.

Essentially, the Exporter is exporting the goods with the assurance from the Importer that, once they
ship the goods, the Importer's Bank will pay them promptly. The mechanism facilitating this
transaction between the parties is named ‘Letter of Credit’.

Types of Letters of Credit:

Several types of Letters of Credit facilitate business between companies in different areas. They are:

1. Sight Letter of Credit: This LC requires the Importer's Bank to provide the money to the
Exporter when the documentation required under the LC is produced and verified.
2. Usance Letter of Credit: This LC requires the Importer's Bank to provide the money to the
Exporter within a specific period from the day the documentation required under the LC is
produced and verified.
3. Time Letter of Credit: This LC requires the Importer's Bank to provide the money to the
Exporter on a specific day after the documentation required under the LC is produced and
verified.
4. Red Clause Letter of Credit: This LC requires the Importer's Bank to pay the Exporter to
procure the raw materials needed to produce the goods that need to be shipped as per the sale
agreement.
5. Green Clause Letter of Credit: This LC requires the Importer's Bank to pay the Exporter after
the production of goods but before they are shipped out of the Exporter's port.
6. Revocable Letter of Credit: This LC allows the Importer's Bank to either revoke the LC or
amend its terms as & when the Importer's Bank wishes. If the Negotiating Bank pays the
amounts and if the revocation happens after the Negotiating Bank pays the money, then the
Importer's Bank is liable to pay the money the Negotiating Bank.
7. Irrevocable Letter of Credit: This LC allows the Importer's Bank to only amend the terms and
conditions of the LC after obtaining approval from the Importer. In so far as the Importer's
Bank is concerned, the LC is irrevocable.
8. Confirmation Letter of Credit: This LC involves a confirmation Bank, and the Confirmation
Bank agrees to pay the Exporter if the Importer Bank fails to pay the amounts due to be paid
after verifying the documents. The Confirmation Bank, along with the Negotiating Bank, also
verifies the documents as it has bound itself for payment that is supposed to be coming from the
Importer's Bank.
9. Back-to-Back Letter of Credit: This LC doesn't just involve an Exporter and an Importer. It
involves a brokering party/parties who broker a deal between an Exporter and an Importer. This
is how it works: if there is one broker, The Importer's Bank draws the first LC with the Broker
being the beneficiary. The Second LC is drawn by the Broker's Bank with the Exporter being
the beneficiary. As & when the Exporter performs their obligations, the Broker's Bank is
required to transfer the funds, and they will be required to receive the money from the
Importer’s Bank.
10. Transferable Letter of Credit: This LC allows the Supplier to transfer the rights (to demand
payment) in LC, either partly / entirely, in favour of any. Such a transfer can only happen once;
the LC must be specified as Transferable.
11. Revolving Letter of Credit: Those businesses who are expected to do business regularly enter
into this type LC, which allows the Exporter to gain funds on a revolving basis from the
Importer's Bank for about a year.
12. Stand-by Letter of Credit: According to this LC, it is not the Importer's Bank who should pay
the Exporter, but it is in fact, the Importer who is required to pay and only in case of default, the
Importer’s Bank (the one who is standing by) will have to complete the transaction by
transferring the funds.

Usually, a LC drafted by the Importer’s Bank will have more than one feature included in it.
Depending on the Exporter’s requirements and the Importer's ability to meet the requirements, the
LC drafted can have be a mix of any no. of types of LCs mentioned above.

Difference between Letters of Credit and Letters of Undertaking:

Letter of Credit (LC) involves businesses (supplier and buyer) using the buyer’s Bank as an
intermediary to complete the transaction between themselves. On the other hand, Letter of
Undertaking is one business getting an assurance from a bank and going to the bank's sister
company located in another location and asking them to pay the business. The assurance states that
the Bank will pay the sister company for transferring the funds to the Business.

In the infamous Nirav Modi's case, Letters of Undertaking were taken from Punjab National Bank
(PNB), locted in India and were used to take money from the PNB located in the United Kingdom.
The problem there was that Mr. Nirav Modi had forged those Letters of Undertaking to gain money
from PNB UK.

To Write: Bills of exchange (&promissory notes) / Bank guarantees (from slides) and the
difference between the letter of credit and bank guarantee.

Bank Guarantees:

Bank guarantees are a form of non-fund-based issued by the Banks on behalf of their clients. They
act as commitments to third parties by assuring payment in case of default by the clients. Three
types of Bank Guarantees are often issued to businesses:

1. Financial Bank Guarantees:

Financial Bank Guarantees are assurances by third parties (banks) to back the debt of the second
party (the company / the client). Essentially, if a debt issuer faces difficulties