Letter Of Credit

Introduction to
Letters of Credit

International trade and transactions are not only meticulous but they heavily rely on trust and clear communication and trade agreements. It is a global business that you need security for, A Letter of Credit (LC) acts as a vital tool for a risk free, smooth transaction between buyers and sellers.

Let us break down what is this letter of credit, its benefits, type and use for a clear understanding.

What is a Letter of Credit?

Simply said, it is a financial document that is issued by a bank guarantee of  payment to a particular seller as long as all the conditions that are agreed upon are met. It acts as a safety net that assures legal transactions in exchange of goods as promised.

If the buyer fails to pay, the bank covers the cost to protect both the parties involved.

Advantages of Letters of Credit

A letter of Credit is beneficial for the buyer and the seller alike.

A buyer receives his goods as stipulated in the letter and they do not need to pay for the goods upfront.

For a seller, they are ultimately protected against the possibility of refusal to pay from a buyer. There are many different types of LCs but frequently people get confused between  commercial letters of credit and LCs.

Commercial letters of Credit act as a primary payment assurance for any transaction and a standby letter of credit acts as a fail safe guarantee and a secondary payment mechanism.

Depending on the buyer or seller, they are additional import and export letters of credit which help in safeguarding the terms of their agreements respectfully.

How does a Letter of Credit work?

After an international trade transaction is finalised between two parties, the buyer’s bank (issuing bank) promises to pay the seller an agreed- upon amount. The letter of credit is issued by the buyer’s bank or sometimes another advisor bank is involved in this process.

All this while, the seller ships the goods as agreed upon in the contract while the advisory bank sends the documents to the issuing bank for payment and completion of transaction.

Why are Letters of Credit used?

  1. Safety: Letters of Credit are legally binding and ensure that all parties are committed to the transaction.
  2. Clarity: They specify the exact details of the goods and terms of payment, reducing misunderstandings between parties.
  3. Risk Reduction: They protect sellers from non-payment situations and ensure that buyers receive the agreed upon goods.
  4. Facilitates Safe Trading: They are crucial for trading with unfamiliar suppliers in new markets.
  5. Efficiency: Modern trade banking services allow for electronic issuance of Letters of Credit.

Types of Letters of Credit

  1. Irrevocable LC cannot be changed or cancelled without the seller’s consent. The bank is fully liable
  2. Revocable LC can be altered or cancelled by the issuing bank without the seller’s consent, and the bank has no liability after cancellation.
  3. Stand-by LC acts as a backup payment method if the buyer fails to pay. It’s similar to a bank guarantee.
  4. Confirmed LC it Involves a second bank (the confirming bank) guaranteeing payment, even if the issuing bank fails.
  5. Unconfirmed LC is used when the responsibility for payment lies solely with the issuing bank
  6. Transferable LC allows the seller to transfer part of the LC to another party, useful when goods are sourced from multiple suppliers.
  7. Back-to-Back LC involves issuing a second LC based on the first one, often used when intermediaries are involved.
  8. Payment at Sight LC requires immediate payment upon submission of the required documents (typically within 7 days)...
  9. Deferred Payment LC is made at a later date, often after the buyer receives the goods.
  10. Red Clause LC allows the seller to receive an advance payment before shipping the goods, highlighted in red on the document.