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Letter of Credit
Introduction to Letters of Credit
Letter of Credit Solutions for Safer International Trade
Most trade in the world is done internationally. To facilitate this, businesses need trade agreements with partners and counterparts.
Trust is critical when agreeing payment terms. 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 (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 confirmation of payment for goods to be shipped. It is an instrument from a bank that guarantees a buyer's payment to a seller if agreed criteria are met. If the buyer cannot pay, the bank covers the remaining amount in line with the LC terms.
Letters of Credit are fundamental components of international trade and are governed by UCP 600 guidelines issued by the International Chamber of Commerce.
Key Value
- Trusted global trade assurance
- Secure payment commitments by banks
- Reduced non-payment risk across borders
Parties Commonly Involved
- Applicant (buyer/importer)
- Beneficiary (seller/exporter)
- Issuing bank and advising bank
So what is a Letter of Credit?
An LC is a promise on a legal document from a bank to pay the holder if defined obligations are fulfilled. It is often used when buyer and seller do not know each other well, especially in international trade.
Letters of Credit are highly specific. Even minor errors in wording, including misspellings in goods descriptions, may delay payment until the LC is corrected and accepted.
Advantages of Letters of Credit
For buyers, LCs support receipt of goods as stipulated without always paying upfront. For sellers, LCs provide stronger protection against non-payment by shifting payment assurance to a bank.
Commercial LCs are primary payment mechanisms for transactions, while standby LCs are secondary fail-safe guarantees.
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 for the seller and typically receives payment once the required trade documents are presented as specified in the LC.
Why are Letters of Credit used?
- Safe: Usually legally binding and not easily canceled unilaterally.
- Clarity: Goods and terms are specific and transparent.
- Risk reduction: Payment is tied to fulfillment of LC terms.
- Safe trading: Supports trade in unfamiliar markets.
- Efficiency: Can be raised electronically through trade banking systems.
Different Types of Letters of Credit
LC Structures for Different Trade and Risk Profiles
Irrevocable LC
Cannot be canceled or modified without consent of the beneficiary (seller). Reflects absolute liability of the issuing bank.
Revocable LC
Can be canceled or modified by the issuing bank at the customer's instructions without prior beneficiary agreement.
Stand-by LC
Functions similarly to a bank guarantee. The bank honors payment when the buyer fails to meet payment obligations.
Confirmed LC
In addition to the issuer's guarantee, another bank confirms the LC and is liable for performance of obligations.
Unconfirmed LC
Only the issuing bank is liable for payment under the LC.
Transferable LC
Allows the seller to assign part of the credit to one or more third parties.
Back-to-Back LC
A second LC is issued based on the first LC, commonly used when an intermediary is involved in the trade flow.
Payment at Sight LC
Payment is made to the seller immediately, typically within seven days after required documents are submitted.
Deferred Payment LC
Payment is made at a later period defined in the LC instead of at document submission.
Red Clause LC
Allows the seller to request an agreed advance before shipment and document submission.