Letter of Credit

Introduction to Letters of Credit

Most trade in the world is done internationally. In order to facilitate this, a business needs to have trade agreements with their partners and counterparts.

Trust is incredibly important when agreeing payment terms. Putting this on a scale, at the riskier end, trade can be done on open account terms – where the seller bears the risk of not being paid. A Letter of Credit, or LC is less risky.

A Letter of Credit is relevant where there is an exporter and an importer; and there needs to be prepayment or a confirmation of payment in order for goods to be shipped. A letter of credit is an instrument from a bank, which guarantees a buyer’s payment to a seller if certain criteria are met. If the buyer can’t pay up, due to the agreed contract through the Letter of Credit, the bank will cover the remaining price.

Letters of Credit are fundamental components of international trade. They’re governed universally by a set of guidelines called the UCP 600, which are issued by the International Chamber of Commerce.

So what is a Letter of Credit?

An LC is a promise written on a legal document that comes from a bank with a promise to pay the holder if the holder fulfills certain obligations. Obligations include payment when the goods are shipped if certain criteria are met. A Letter of Credit is usually used when the buyer and seller do not know each other well and this is why it is used so frequently in international trade. Letters of Credit are incredibly specific and close attention to detail is required. If there is a misspelling in the contract, for example, the name of the goods is incorrectly spelled, there may be non-payment until a new, corrected LC is issued and accepted.

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?

On behalf of a buyer, the issuing bank promises payment to a seller or beneficiary. An advising bank may act on behalf of the seller. The advising bank will receive payment, normally when they’ve been presented with specified documents representing the supply of goods.

Why are Letters of Credit used?
  • Safe – Letters of Credit are usually legally binding and so all parties need to agree to cancel them.
  • Clarity – The goods defined in an LC are specific and well defined so the details of a transaction are generally very transparent.
  • Risk reduction – Exporter or payment to the seller is guaranteed providing the terms of the LC are met.
  • Allows Safe Trading – Letters of Credit are a focus of international trade, and allow companies to trade safely in unfamiliar markets with unfamiliar suppliers.
  • Efficiency – Letters of Credit can be raised electronically using an online trade banking service.
Different types of Letters of Credit
  • Irrevocable LC:
    This LC cannot be canceled or modified without the consent of the beneficiary (Seller). This LC reflects the absolute liability of the Bank (issuer) to the other party.
  • Revocable LC:
    This LC type can be canceled or modified by the Bank (issuer) at the customer’s instructions without the prior agreement of the beneficiary (Seller). The Bank will not have any liabilities to the beneficiary after revocation of the LC.
  • Stand-by LC:
    This LC is closer to the bank guarantee and gives more flexible collaboration opportunities to the Seller and Buyer. The Bank will honor the LC when the Buyer fails to fulfill payment liabilities to the Seller.
  • Confirmed LC:
    In addition to the Bank guarantee of the LC issuer, this LC type is confirmed by the Seller’s bank or any other bank. Irrespective of the payment by the Bank issuing the LC (issuer), the Bank confirms the LC is liable for the performance of obligations.
  • Unconfirmed LC:
    Only the Bank issuing the LC will be liable for payment of this LC.
  • Transferable LC:
    This LC enables the Seller to assign part of the letter of credit to another party (ies). This LC is especially beneficial in those cases when the Seller is not a sole manufacturer of the goods and purchases some parts from other parties, as it eliminates the necessity of opening several LC’s for other parties.
  • Back-to-Back LC:
    This LC type considers issuing the second LC on the basis of the first letter of credit. LC is opened in favor of intermediary as per the Buyer’s instructions and on the basis of this LC and instructions of the intermediary, a new LC is opened in favor of Seller of the goods.
  • Payment at Sight LC:
    According to this LC, payment is made to the seller immediately (maximum within 7 days) after the required documents have been submitted.
  • Deferred Payment LC:
    According to this LC the payment to the seller is not made when the documents are submitted, but instead at a later period defined in the letter of credit. In most cases, the payment in favor of the Seller under this LC is made upon receipt of goods by the Buyer.
  • Red Clause LC:
    The seller can request an advance for an agreed amount of the LC before shipment of goods and submittal of required documents. This red clause is so termed because it is usually printed in red on the document to draw attention to the “advance payment” term of the credit.