Table of Contents
What is a Letter of Credit?
A letter of credit is a financial document issued by a bank or financial institution that guarantees payment to a seller on behalf of the buyer, as long as specific conditions outlined in the document are met. It serves as a safeguard in international and domestic trade, ensuring both parties fulfill their obligations.
In an LC arrangement, the bank acts as a neutral intermediary. The buyer assures the seller of payment, while the seller is required to provide proof (such as shipping documents) that the agreed-upon goods or services have been delivered.
LCs are especially useful in international trade, where distance and differing laws may make it difficult for two parties to establish trust in a transaction. In such deals, a letter of credit is an important guarantee.
There are many types of LCs, each designed to cater to specific trade scenarios. For example, a revolving letter of credit enables ongoing transactions between the same buyer and seller without the need to issue a new LC for each trade.
How Does a Letter of Credit Work?
A Letter of Credit (LC) is a step-by-step process that ensures secure payment in trade transactions.
First, the buyer and seller agree on the terms of the transaction, including the use of an LC for payment security. According to the terms of the deal, the selling party requests a letter of credit from the buyer’s bank.
The buyer then applies to their bank (the issuing bank) to issue an LC in favor of the seller. Once the issuing bank evaluates the buyer’s creditworthiness, it issues the LC outlining the conditions for payment and sends it to the seller’s bank (the advising bank). The bank may sometimes require collateral to be pledged.
Upon receiving the LC, the seller ships the goods or provides the services as agreed and prepares the required documentation, such as the bill of lading, invoice, and insurance certificate. These documents are submitted to the advising bank, which verifies them and forwards them to the issuing bank for further verification.
If all conditions outlined in the LC are met, the issuing bank releases the payment to the seller and collects the payment from the buyer. Finally, the buyer receives the shipment along with the necessary documents to claim the goods, completing the transaction.
This streamlined process reduces risks for both buyers and sellers, fostering trust in trade transactions, especially in international markets where parties may be unfamiliar with each other.
Letter of credit transactions are overseen by bodies like International Chamber of Commerce’s Uniform Customs and Practice for Documentary Credits.
Cost of Letter of Credit
The cost of a Letter of Credit (LC) depends on several factors, including the type of LC, the transaction amount, the issuing bank’s policies, and the duration of the LC. Typically, banks charge various fees for processing, guaranteeing, and maintaining an LC, which can include:
- Issuance Fee: Charged by the issuing bank to create the LC, usually calculated as a percentage of the LC value.
- Advising Fee: Paid to the advising bank for notifying the seller about the LC.
- Confirmation Fee: If a confirming bank adds its guarantee, an additional fee applies, often based on the creditworthiness of the buyer and the risk involved.
- Negotiation Fee: Charged when the seller’s bank verifies the documents and forwards them for payment.
- Amendment Charges: Applied if the terms of the LC need to be modified after issuance.
- Discrepancy Fees: Incurred when submitted documents do not meet the LC’s terms, requiring corrections.
The total cost of a Letter of Credit typically ranges between 0.25% to 2% of the LC amount, depending on the complexity and the risk involved in the transaction. While these fees may seem significant, they provide security and reduce risks, making them a worthwhile investment for businesses engaged in high-value or international trade.
Importance of Letter of Credit
A Letter of Credit (LC) is a crucial financial tool in international trade, offering assurance and security to both buyers and sellers. It serves as a binding agreement, issued by a bank, guaranteeing that the seller will receive payment once the terms and conditions outlined in the LC are fulfilled.
Eliminates payment risks
For sellers, the LC reduces the risk of non-payment, especially in cross-border transactions where trust and creditworthiness can be hard to establish. By involving a financial institution, sellers are assured of payment upon presenting the required documents.
Facilitates international trade
Global trade often involves dealing with unfamiliar parties from different countries, currencies, and legal systems. An LC bridges these gaps, providing confidence to exporters and importers to engage in business without fear of default.
Acts as a guarantee
An LC acts as a bank’s commitment to honor payment on behalf of the buyer. This backing often makes it easier for businesses to secure deals, particularly with suppliers who require assurances for large or high-risk transactions.
Legal and regulatory compliance
An LC also helps businesses comply with international trade laws and regulations. It standardizes processes and ensures transparency, reducing potential legal disputes.
Types of LCs
Letters of Credit (LCs) come in various types, each designed to cater to specific business needs and trade scenarios. Understanding these types helps businesses choose the right LC to minimize risk and streamline transactions.
Revocable Letter of Credit
A revocable LC can be modified or canceled by the issuing bank without prior notice to the beneficiary (seller). This type offers flexibility to the buyer but poses a higher risk to the seller, as payment is not guaranteed if the terms are changed.
Irrevocable Letter of Credit
An irrevocable LC cannot be altered or canceled without the consent of all parties involved—buyer, seller, and issuing bank. This type provides greater security to the seller, as the issuing bank must honor the payment if all conditions are met. Irrevocable LCs are the most commonly used type in international trade.
Confirmed Letter of Credit
In a confirmed LC, a second bank (confirming bank), usually in the seller’s country, adds its guarantee to the LC issued by the buyer’s bank. This is particularly useful in high-risk transactions or when the issuing bank’s reliability is uncertain. It provides the seller with an additional layer of security.
Transferable Letter of Credit
A transferable LC allows the original beneficiary (usually a middleman) to transfer part or all of the credit to one or more secondary beneficiaries (e.g., suppliers). This is ideal for intermediaries who do not supply the goods themselves but act as facilitators in the trade.
Revolving Letter of Credit
A revolving LC is used for recurring transactions between the same buyer and seller, eliminating the need to issue a new LC for each trade. It can be set up for a fixed time period or for a specific cumulative amount, making it convenient for long-term business relationships.
Back-to-Back Letter of Credit
This involves two separate LCs. The first LC is issued by the buyer’s bank in favor of an intermediary, who then uses it to obtain a second LC from another bank in favor of the supplier. Back-to-back LCs are commonly used in transactions involving intermediaries or traders.
Standby Letter of Credit
A standby LC serves as a guarantee rather than a primary payment method. It is only invoked if the buyer fails to fulfill their payment obligations. This type acts as a safety net and is often used in construction projects, service contracts, or performance guarantees.
Sight Letter of Credit
A sight LC requires the issuing bank to make payment immediately upon presentation and verification of the required documents. It is ideal for sellers who need quick access to funds after fulfilling the trade terms.
Usance Letter of Credit (Deferred Payment LC)
A usance LC allows payment to be made at a future date after the required documents are presented and verified. This provides the buyer with a credit period, helping them manage cash flow while assuring the seller of payment.
Red Clause Letter of Credit
A red clause LC allows the seller to receive an advance payment before shipping the goods. This is particularly useful for sellers who need funds to procure materials or start production. The advance is deducted from the final payment upon completion of the trade.
Green Clause Letter of Credit
An extension of the red clause LC, the green clause LC includes provisions for pre-shipment financing and additional support for storage, warehousing, or insurance. It offers sellers greater flexibility in managing their logistics and operations.
Clean Letter of Credit
A clean LC does not require the seller to present shipping or other trade documents. The payment is based solely on the buyer’s ability to fulfill their obligations, making it a higher-risk option.
Each type of LC is tailored to specific trade needs, offering varying levels of flexibility, security, and convenience. Choosing the right type ensures a seamless trade experience while mitigating risks for both buyers and sellers.
Letter of Credit Glossary
Here are some essential terms related to a letter of credit:
- Issuing Bank: The bank that issues the letter of credit on behalf of the buyer, and is responsible for ensuring that the terms and conditions of the letter of credit are met.
- Applicant: The buyer who applies for the letter of credit and agrees to pay the amount specified in the letter of credit.
- Beneficiary: The seller or exporter who receives the payment from the issuing bank upon fulfilling the terms and conditions of the letter of credit.
- Confirmed Letter of Credit: A letter of credit that is guaranteed by a second bank, known as the confirming bank, in addition to the issuing bank. This provides an extra layer of security for the seller.
- Irrevocable Letter of Credit: A letter of credit that cannot be cancelled or modified without the consent of all parties involved.
- Standby Letter of Credit: A letter of credit that is used as a backup payment method, in case the buyer fails to fulfil their obligations under the contract.
- Uniform Customs and Practice for Documentary Credits (UCP): A set of international rules governing the use of letters of credit in international trade.
Example of a Letter of Credit
Let’s have a look at a letter of credit sample:
How to apply for a letter of credit
A letter of credit is prepared by bank officials on behalf of the buying party in a trade. Before approaching the bank for a LC, it is important to make sure the terms of the deal are agreed upon by both parties, including the type of LC, the value, shipment deadlines, and documentation required.
Once this is done, ehe buyer contacts their bank (the issuing bank) to initiate the LC application. The buyer must have an established credit relationship with the bank or provide collateral as security for the LC.
At this stage, the buyer submits a formal application to the issuing bank, along with details such as:
- Beneficiary (seller) details.
- Transaction amount.
- Shipment details (e.g., mode, date, and port of loading/destination).
- Required supporting documents (e.g., invoice, bill of lading, insurance certificate).
- Type of LC (e.g., irrevocable, transferable).
- Any special conditions for payment.
The issuing bank evaluates the buyer’s creditworthiness, verifies the details, and ensures compliance with regulatory requirements. If the buyer’s credentials are satisfactory, the bank drafts and issues the LC.
The seller and the seller’s bank carefully review the LC terms to ensure they align with the agreed-upon trade conditions. If there are any discrepancies, amendments can be requested through the banks.
Advantages & Disadvantages of Letter of Credit
Let’s have a closer look at the pros and cons of a Letter Of Credit.
| Advantage | Disadvantage |
| It provides protection to both the buyer and the seller. The buyer is protected from non-delivery of goods, while the seller is protected from non-payment. | Obtaining this can be time-consuming and costly, as additional fees may be required. |
| It can help reduce the risk of doing business with unfamiliar buyers since all the payment and delivery terms are clearly defined and agreed to upfront. | The terms and conditions of it must be very specific and must be followed precisely in order for the buyer to receive payment from the issuing bank. |
| It is an accepted form of payment in international trade, allowing buyers and sellers from different countries to do business with each other. | If the buyer does not pay the issuing bank on time, the issuing bank may be forced to pay the seller, even if the buyer has not received the goods or services. |
| It can help to expedite transactions and make them more efficient. | The seller may be subject to significant financial risk if the terms of the letter of credit are not followed precisely. |
A letter of credit is an important tool for businesses to ensure safe transactions between parties. It is a guarantee from a bank that the buyer will pay the seller for the goods and services purchased. It is a secure way for businesses to trade as it offers protection for both parties involved in the transaction.
Despite its benefits, there are also some drawbacks to using a letter of credit. These include the cost of issuing the letter of credit, the time required to process the letter of credit, and the potential for fraud. Overall, a letter of credit is an important tool for businesses to use when trading and its benefits outweigh the drawbacks.
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