Letter of credit

3 key takeaways

• A letter of credit mitigates the risk in international trade by ensuring that the seller receives payment as long as they meet the terms specified in the LC.
• There are various types of letters of credit, including commercial, standby, and revolving, each serving different purposes and conditions.
• The process of obtaining and using a letter of credit involves multiple parties, including the buyer, seller, issuing bank, and advising (or confirming) bank.

What is a letter of credit?

A letter of credit is a financial instrument issued by a bank on behalf of a buyer, providing the seller with a guarantee that they will receive payment for the goods or services provided, assuming they comply with the terms and conditions outlined in the LC. This instrument is commonly used in international trade to reduce the risk associated with cross-border transactions, where the buyer and seller may be in different countries with different legal systems and financial regulations.

Example

A U.S. importer wants to buy goods from a Chinese exporter. The importer’s bank issues a letter of credit guaranteeing payment to the exporter upon receipt of shipping documents that comply with the terms of the LC. The exporter can then ship the goods with confidence, knowing that payment is secured.

Types of letters of credit

Commercial letter of credit

A commercial letter of credit, also known as a documentary credit, is used primarily in international trade. It guarantees payment to the seller upon the presentation of specified documents, such as a bill of lading, commercial invoice, and packing list.

Standby letter of credit

A standby letter of credit serves as a secondary payment method, acting as a guarantee of payment if the buyer fails to fulfill their contractual obligations. It is often used in situations where there is a high degree of trust between the parties but an additional guarantee is needed.

Revolving letter of credit

A revolving letter of credit allows for multiple payments within a specified period under the same LC. It is useful for ongoing transactions between the same buyer and seller, reducing the need to issue a new LC for each transaction.

Transferable letter of credit

A transferable letter of credit permits the beneficiary (usually the seller) to transfer some or all of the credit to another party, such as a supplier. This type is often used when the seller is not the original producer of the goods.

Confirmed letter of credit

In a confirmed letter of credit, a second bank, usually in the seller’s country, adds its guarantee to the LC issued by the buyer’s bank. This provides additional security to the seller, especially in situations where the seller has concerns about the creditworthiness of the buyer’s bank.

How a letter of credit works

1. Agreement: The buyer and seller agree on the terms of the sale, including the use of a letter of credit.
2. Issuance: The buyer applies for a letter of credit from their bank (issuing bank), which issues the LC in favor of the seller.
3. Notification: The issuing bank sends the LC to the advising bank, usually located in the seller’s country, which verifies its authenticity and informs the seller.
4. Shipment: The seller ships the goods and presents the required documents to the advising bank.
5. Verification: The advising bank verifies the documents to ensure they meet the terms of the LC and then forwards them to the issuing bank.
6. Payment: Upon verification, the issuing bank releases the payment to the advising bank, which then pays the seller.

Advantages and disadvantages

Advantages

• Risk mitigation: Provides assurance to both parties that payment and delivery conditions will be met.
• Security: Reduces the risk of non-payment for the seller and ensures that the buyer only pays for goods received as agreed.
• Facilitates trade: Encourages international trade by providing a reliable payment mechanism.

Disadvantages

• Cost: Obtaining a letter of credit can be expensive due to bank fees and charges.
• Complexity: The process involves multiple steps and documentation, which can be time-consuming and require careful attention to detail.
• Stringent conditions: The seller must comply with all terms and conditions specified in the LC to receive payment, which can sometimes be stringent and restrictive.

Related topics

• International trade: Explore the mechanisms and principles governing trade between countries, including the use of letters of credit.
• Trade finance: Understand the various financial instruments and products that facilitate international trade.
• Documentary collection: Learn about an alternative trade finance method where banks act as intermediaries without providing a payment guarantee.

A letter of credit is a crucial tool in international trade, providing a secure and reliable means of ensuring that sellers receive payment while buyers receive the goods or services they ordered. By understanding its types, processes, and implications, businesses can effectively manage their trade transactions and mitigate risks.