Letter of Credit: What It Is

In essence, a letter of credit constitutes a financial agreement among the bank, the bank's clients, and the beneficiaries involved. The letter of credit, usually provided by the importer's bank, assures that the beneficiary will receive payment as long as the conditions outlined in the letter of credit are fulfilled.

What is a Letter of Credit?

A letter of credit, also known as a documentary credit, is a document issued by a bank to ensure that the seller will receive payment for their goods or services on time and in the correct amount. In the event that the buyer is unable to pay, the bank will cover all or part of the purchase price. Given the challenges of international transactions, such as geographic distance, varying legal frameworks, and lack of familiarity between parties, letters of credit have become a critical tool for facilitating international trade.

What is it used for?

Letters of credit play a crucial role in mitigating risk in international trade transactions, particularly in cases where buyers and sellers lack familiarity with each other. As an importer, a letter of credit offers a means of ensuring payment to the supplier only after proof of shipment has been provided, thus preserving cash flow and avoiding the need for prepayment or deposit. Additionally, the use of a letter of credit can enhance the credibility of the importer, demonstrating their creditworthiness to the exporter.

For exporters, a letter of credit serves as insurance against the risk of non-payment by the buyer. In the event of non-payment, the outstanding amount is covered by the financial institution. Moreover, the use of a letter of credit protects exporters from legal risks by guaranteeing payment provided that delivery conditions are met. Exporters can also use the letter of credit as collateral for a working capital loan to fulfill the order.

How does a letter of credit work?

In international trade, buyers making significant purchases may require a letter of credit to provide assurance to the seller that payment will be made. The bank issues the letter of credit, guaranteeing payment to the seller, and assumes responsibility for payment by default. However, before guaranteeing payment, the bank must ensure that the buyer has sufficient assets or credit limit to cover the payment.

Letters of credit are generally negotiable instruments, and the issuing bank pays the payee or any bank designated by the payee. If the letter of credit is transferable, the beneficiary can transfer the rights of issue to another company, such as a corporate management company or a third party.

The International Chamber of Commerce's Uniform Customs and Practice for Documentary Credits (UCP 600) governs the use of letters of credit in international transactions, providing standardized guidelines and procedures for their use.

Understanding the workings of a letter of credit is essential. Typically, a letter of credit process begins when both parties have a transaction requirement, and one party requests the addressee for a letter of credit. Since it is a document obtained from a bank or financial institution, the applicant must collaborate with the lender to secure the letter of credit. This process is akin to applying for a loan, with the applicant submitting an application that usually includes a copy of the sales contract, purchase order, export agreement, and other documents, depending on the issuing bank. Once submitted, the applicant awaits approval, similar to the loan process.

Applicants often work with specific bank branches, such as the Department of International Trade or the Department of Commerce, to obtain a letter of credit. A letter of credit fee, usually a percentage of the letter of credit's amount, is charged to the business applying for it.

After obtaining a letter of credit successfully, companies confirm that the financial institution agrees to guarantee the transaction's amount. This establishes confidence in the transaction since the buyer is guaranteed to receive the full amount of the transaction. Depending on the bank or financial institution that purchased the letter of credit, it can be transferred. While letters of credit are commonly used in international trade, especially for imports and exports, companies can also obtain them for domestic transactions.

Type of Letter of Credit

Correct, there are different types of letters of credit that can be used for different purposes. Commercial letters of credit are the most common and are used for international trade transactions. Standby letters of credit are a secondary method of payment that provides assurance to the beneficiary that they will be paid if the bank is unable to receive a promise from the seller. 

Revolving letters of credit are useful when two parties are expected to make several transactions together, while road letters of credit are used when the issuing bank guarantees compliance with other credit notes signed by foreign banks. 

Finally, confirmed letters of credit offer additional assurance to the beneficiary by having a second bank, the confirming bank, guarantee payment in case the issuing bank and the buyer default. Understanding the different types of letters of credit and their advantages and considerations can help businesses make informed decisions about whether to use them in their transactions.