Letter Of Credit

Introduction to
Letters of Credit

International trade is a global business that relies heavily on trust and clear agreements between buyers and sellers. A Letter of Credit (LC) is a vital tool in this context, reducing risk and ensuring smoother transactions. Here’s an easy-to-understand overview of Letters of Credit, their benefits, and types.

What is a Letter of Credit?

A Letter of Credit is a financial document issued by a bank that guarantees payment to a seller as long as specific conditions are met. It acts as a safety net in international trade, ensuring that sellers receive payment and buyers get the goods as promised. If the buyer fails to pay, the bank covers the cost, protecting both parties involved.

Advantages of Letters of Credit

For the buyer, they are certain to receive the goods as stipulated in the letter of credit, and they do not need to pay for the goods upfront. For the seller, they’re somewhat protected against non-payment from the buyer. There are many different types of LCs, and I’ll cover most of them today. Often people get confused between commercial letters of credit, which acts as the primary payment mechanism for a transaction, and a standby letter of credit, the secondary payment mechanism, a fail safe guarantee. Depending on the perspective of the buyer or the seller, there are also import Letters of Credit, set up by the importer or buyer of goods or services, and export Letters of Credit, which are set up by the exporter or seller.

How does a Letter of Credit work?

1. Issuance: The buyer’s bank (the issuing bank) promises to pay the seller

2. Advising Bank: Sometimes, another bank (advising bank) helps the seller by providing the LC details.

3. Payment: The advising bank receives and processes payment once it verifies the required documents

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.
  3. Risk Reduction: They protect sellers from non-payment and ensure buyers receive the agreed 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: Involves a second bank (the confirming bank) guaranteeing payment, even if the issuing bank fails.
  5. Unconfirmed LC: 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: Payment 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.