Letters of Credit Explained: A Practical Guide for Businesses

/ Blog / By

Letters of Credit Explained: A Practical Guide for Businesses

letters-of-credit-explained-practical-guide

Introduction:

In the world of international trade, trust is the highest form of currency. When a seller in one country agrees to ship a container of textiles to a buyer in another country, each party has a Catch-22 on their hands. The seller does not want to ship the goods without receiving payment, while the buyer does not want to pay for the goods without receiving them. The Letter of Credit is the strongest answer to this Catch-22 in the world of international finance. 

 

What is a Letter of Credit?

A Letter of Credit is a commitment by a bank (the issuing bank) on behalf of the buyer (the applicant) to pay the seller (the beneficiary) a certain amount of money in exchange for certain documents that conform strictly to the terms set in the LC. 

The Architecture of a Letter of Credit Transaction :

A Letter of Credit transaction is not a two-way street but rather a coordinated effort between four key players in the world of international trade: 

 

  • The Applicant (Buyer): The party that requests the LC from his or her bank to pay for the goods or services. 

  • The Issuing Bank: The buyer’s bank that examines the buyer’s creditworthiness and issues the actual LC document.

  •  The Beneficiary (Seller): The party that receives the payment after proving that he or she has met the shipping requirements. 

  • The Advising/Confirming Bank: A bank in the seller’s country that validates the authenticity of the LC and, in some instances, adds its guarantee of payment (confirmation). 

Why Use a Letter of Credit?

Despite the rise of “Open Account” trade (i.e., pay after delivery), the traditional LC remains the best option in high-risk or high-value transactions for the following reasons: 

 

  • Risk Transfer: The risk of non-payment is transferred from the buyer to the issuing bank. The risk of non-payment no longer rests with the buyer but with the bank that issues the credit, as it is legally obligated to pay. 

  • Strict Compliance: Payments are based on documents received, not goods. This provides security for the buyer since the bank will only make payments after receiving a Bill of Lading, insurance certificates, and inspection reports from the seller that prove goods were dispatched. 
  •  Financing Opportunities: The LC may be used as collateral. The seller, having received an LC from a reputable bank, may be able to obtain “pre-shipment financing” for the cost of manufacturing the goods. 

  • Global Standardization: The LCs are standardized and governed by the UCP 600 (Uniform Customs and Practice for Documentary Credits). This means that a Letter of Credit from Bangkok will be interpreted the same way as one from New York. 

The Lifecycle of an LC: Step-by-Step :

It is important to grasp the process of an LC so that delays and costs do not occur: 

  • The Sales Contract: The buyer and seller agree on the purchase and sale of goods and stipulate that payment will be made through a Letter of Credit. 
  • LC Application: The buyer asks the bank to issue the LC, specifying the documents needed (e.g., Commercial Invoice, Packing List, Certificate of Origin). 
  • Issuance and Advising: The issuing bank informs the seller through the advising bank of the LC. 
  • Shipment: The seller checks the terms of the LC. If the seller can comply with the conditions, the seller manufactures and ships the goods. 
  • Presentation of Documents: The seller presents all the needed documents to ship the goods to the bank. 
  • Examination and Payment: The bank examines the documents to see if there are “discrepancies.” If all the documents match the exact terms of the LC, the issuing bank will pay the seller, and the buyer will receive the documents to collect the goods at the port. 

Common Pitfalls and How to Avoid Them:

The greatest danger in the transaction of Letters of Credit is non-compliance. The bank will only deal with documents, not merchandise. Even a small typographical error in an invoice will cause a “discrepancy,” giving the bank the right to withhold payment. 

  • Inconsistent Descriptions: The description of the goods on the Commercial Invoice must be exactly the same as that on the LC. If the LC says “100% Blue Silk Ties” and the Commercial Invoice says “Blue Silk Neckties,” the bank may reject the LC. 
  • Late Shipment: LCs have an expiry date and a last date of shipment. If the Bill of Lading indicates a date one day after the deadline, technically the LC is invalid. 
  • Complexity: Be cautious of over-complicating the LC. If there are too many third-party certificate requirements, there is a greater risk of something going wrong in the documentation process. 

Selecting the Type of LC :

Based on the nature of the business relationship, different LC forms may be applicable. 

These are: 

  • Irrevocable LC: This is the most common type. It cannot be canceled or changed without mutual consent. 
  • Confirmed LC: This is an additional security measure. If the seller is concerned about the financial stability of the buyer’s country, a second bank (usually in the seller’s home country) adds an additional guarantee. 
  • Transferable LC: Most common with middlemen or traders. It is used to transfer part of the credit to a second supplier by the first beneficiary. 
  • Standby LC (SBLC): It is more like an insurance mechanism. It is drawn down only when the buyer fails to pay through other means. 

Final Thoughts for Businesses :

A Letter of Credit is not just a means of payment but a sophisticated tool that manages risks. It is the ultimate assurance of payment for exporters in new markets. It is a tool that ensures that capital is not invested unless there is documentary evidence of shipment. By understanding the finer points of Letter of Credit documentation, businesses can conquer the complexities of global trade with confidence.