Letter of Credit

A Letter of Credit (LC) is a financial instrument used in international trade to provide an assurance of payment from a buyer to a seller. It is issued by a bank on behalf of the buyer (importer) and guarantees that the seller (exporter) will receive payment for the goods or services provided, as long as the specified terms and conditions in the LC are met.

Key Features of a Letter of Credit:

1.Bank Guarantee: The buyer’s bank (the issuing bank) guarantees payment to the seller, provided the seller submits the required documents proving that they have met the terms of the sale.
2.Document-Based: Payment is made based on the presentation of specific documents (e.g., bill of lading, invoice, inspection certificate), not on the actual delivery of goods.
3.Reduces Risk: It minimizes the risk for both parties—sellers are assured of payment as long as they meet the terms, and buyers ensure that they won’t pay unless the seller fulfills their contractual obligations.

Parties Involved:

1.Applicant: The buyer or importer who requests the letter of credit from their bank.
2.Beneficiary: The seller or exporter who is the recipient of the payment guaranteed by the letter of credit.
3.Issuing Bank: The buyer’s bank that issues the letter of credit and guarantees payment.
4.Advising Bank: The bank, usually in the seller’s country, that advises or informs the seller about the letter of credit.
5.Confirming Bank (optional): A bank that adds its own guarantee to the letter of credit, further assuring the seller that payment will be made.

Types of Letters of Credit:

1.Revocable Letter of Credit: Can be amended or canceled by the issuing bank without prior notice to the seller.
2.Irrevocable Letter of Credit: Cannot be altered or canceled without the agreement of all parties involved. This is the most common type of LC in international trade.
3.Confirmed Letter of Credit: A second bank (usually in the seller’s country) guarantees payment in addition to the issuing bank, providing extra security to the seller.
4.Sight Letter of Credit: Payment is made as soon as the required documents are presented and verified.
5.Deferred Payment Letter of Credit: Payment is made at a future date, even if the documents are presented earlier.

How a Letter of Credit Works:

1.The buyer and seller agree on the terms of the sale and decide to use a letter of credit.
2.The buyer applies for the letter of credit from their bank (the issuing bank).
3.The issuing bank sends the LC to a bank in the seller’s country (the advising bank).
4.The seller ships the goods and submits the required documents (like a bill of lading, commercial invoice, insurance certificate) to the advising bank.
5.The advising bank reviews the documents and forwards them to the issuing bank for verification.
6.If the documents are in order, the issuing bank releases payment to the seller.
7.The issuing bank collects payment from the buyer, and the buyer takes possession of the goods.

Benefits of a Letter of Credit:

•For the Seller: Guarantees payment, as long as the terms and conditions are met, reducing the risk of non-payment.
•For the Buyer: Ensures that payment will only be made once the seller has fulfilled their contractual obligations and provided the necessary documents.
•For Both Parties: Provides a reliable method of payment in international transactions, where trust and enforcement of contracts across borders may be difficult.

Example:

A company in Germany sells machinery to a company in Brazil. To ensure payment, the Brazilian buyer requests a letter of credit from their bank, which guarantees that the German seller will receive payment once they ship the machinery and submit the necessary documents (such as a shipping bill, invoice, and insurance certificate). The seller’s bank in Germany receives the letter of credit, and once the terms are met, the bank releases the payment to the seller.

Conclusion:

A Letter of Credit is a critical tool in international trade that mitigates the financial risks involved for both buyers and sellers. It provides assurance of payment to the exporter while ensuring the importer that payment will only be made once the goods or services are delivered according to the agreed terms.