Demystifying the Letter of Credit: Definition, Example, and Usage

Last updated 03/20/2024 by

Edited by

Summary:

A Letter of Credit (LC) is a financial instrument used in international trade to guarantee payment between two parties. It is a written document issued by a bank or financial institution on behalf of the importer to the exporter in which the bank hopes to pay some amount of money to the exporter upon the presentation of certain documents specified in the LC. There are several types of LCs, each made to meet the specific needs and requirements of buyers and sellers in different trade scenarios. LCs are commonly used in international trade because they offer a reliable and secure method of payment that helps to reduce the risks associated with cross-border transactions.

Get Competing Personal Loan Offers In Minutes

Compare rates from multiple vetted lenders. Discover your lowest eligible rate.

Get Personalized Rates

It's quick, free and won’t hurt your credit score

What is Letter of Credit

A Letter of Credit (LC) is a financial document that guarantees payment between two parties in an international trade transaction. It is a written instrument issued by a bank or financial institution on behalf of the importer (buyer) to the exporter (seller) in which the bank promises to pay a certain amount of money to the exporter upon the presentation of certain documents specified in the LC.

The LC serves as a means of protection for both parties in the transaction. For the exporter, it provides assurance that they will receive payment for their goods or services as long as they fulfill the requirements outlined in the LC. For the importer, it provides a level of comfort knowing that the payment will not be released until the goods have been shipped or the services have been performed to their satisfaction.

LCs are commonly used in international trade because they offer a reliable and secure method of payment that helps to reduce the risks associated with cross-border transactions. They also help to facilitate trade by providing a mechanism for financing and ensuring that goods are delivered as agreed upon.

How does letter of credit work?

The are the steps expected for the process of how a Letter of Credit (LC) works:

The buyer and seller accept to make use of an LC as the method of payment for their transaction.
The buyer applies to their bank (the issuing bank) for an LC in favor of the seller (the beneficiary).
The issuing bank evaluates the buyer’s creditworthiness and, if approved, issues an LC in favor of the beneficiary.
The LC specifies the terms and conditions of the transaction, including the amount of money to be paid, the date of payment, and the documents required for payment.
The beneficiary ships the goods to the buyer and presents the required documents to their bank (the advising bank) within a specified timeframe.
The advising bank reviews the documents to ensure they comply with the terms and conditions of the LC and forwards them to the issuing bank.
The issuing bank reviews the documents and, if they comply with the terms and conditions of the LC, releases payment to the beneficiary.
The advising bank informs the beneficiary that the documents have been accepted and that payment has been made.
The buyer receives the goods and provides evidence to the issuing bank that the goods have been received.
The issuing bank debits the buyer’s account for the amount of the LC.

Types of letter of credit

There are different types of Letters of Credit (LCs), each designed to meet the specific needs and requirements of buyers and sellers in different trade scenarios. Some of the types of LCs are:

1. Revocable letter of credit

This type of LC can be modified or canceled by the issuing bank at any time without prior notice to the beneficiary.

2. Irrevocable letter of credit

This type of LC cannot be modified or canceled without the agreement of all parties involved, including the beneficiary, the issuing bank, and the applicant.

3. Confirmed letter of credit

This type of LC is guaranteed by a second bank (the confirming bank) and the issuing bank. The confirming bank undertakes to pay the beneficiary if the issuing bank defaults.

4. Unconfirmed letter of credit

This type of LC is not guaranteed by a second bank. The beneficiary relies solely on the creditworthiness of the issuing bank.

5. Standby letter of credit

This type of LC is used as a backup payment method if the buyer fails to fulfill their payment obligations. It is often used for construction projects or other long-term contracts.

6. Red clause letter of credit

This type of LC includes a clause that allows the beneficiary to collect an advance payment from the issuing bank before the shipment of goods. This helps to finance the production and shipment of the goods.

7. Green clause letter of credit

This type of LC includes a clause that allows the beneficiary to receive an advance payment from the issuing bank to purchase raw materials for the production of goods.

8. Transferable letter of credit

This type of LC allows the beneficiary to transfer their rights to receive payment to a third party (usually a supplier or manufacturer) as a means of financing the production of goods.

9. Back-to-back letter of credit

This type of LC involves two separate LCs. The first LC is issued by the buyer’s bank in favor of an intermediary, who then uses it to obtain a second LC from their bank in favor of the seller. The seller then ships the goods to the buyer, and the intermediary pays the seller using the second LC.

Example of letter of credit

Citibank offers letters of credit to customers in Latin America, Africa, Eastern Europe, Asia, and the Middle East who might find it difficult to obtain overseas credit on their own.

Exporters can reduce the country risk of the importer and the commercial credit risk of the issuing bank by using letters of credit from Citibank.

Letters of credit, which guarantee payment by the confirming Citibank branch, are normally delivered within two working days.

How letter of credit is used

Let’s say a company in the United States wants to purchase goods from a supplier in China. The buyer can arrange for an LC with their bank, which will guarantee payment to the seller in China once certain conditions are met. The buyer’s bank will issue an LC to the seller’s bank in China, which serves as a guarantee that the buyer will pay for the goods once they are delivered.

The LC specifies the terms and conditions that must be met before the seller can receive payment. These terms might include requirements for the shipment of the goods, such as the date of shipment, the method of transportation, and the port of discharge. The LC might also require the seller to provide certain documents, such as a commercial invoice, (a bill of lading, a certificate of origin) or an insurance certificate, to prove that the goods have been shipped and are in compliance with the terms of the LC.

Once the seller has fulfilled the requirements of the LC, they can present the necessary documents to their bank in China, which will then forward them to the buyer’s bank in the United States for payment. The buyer’s bank will examine the documents to ensure that they agree with the terms of the LC, and if everything checks out, they will release payment to the seller’s bank.

There are several types of LCs available, including revocable and irrevocable LCs, confirmed and unconfirmed LCs, standby LCs, transferable and back-to-back LCs, and green and red clause LCs. The specific type of LC used will depend on the needs of the buyer and seller and the nature of the transaction.

Advantages of a letter of credit

1. Reduced risk

A letter of credit reduces the risk for both the buyer and seller. The buyer is assured that the seller will only receive payment once the goods or services have been provided in accordance with the agreed terms, while the seller is guaranteed payment as long as they comply with the terms of the LC.

2. Increased trust

The use of an LC builds trust between the buyer and seller, as it provides a third-party guarantee that payment will be made once the agreed conditions have been met.

3. Access to finance

An LC can be used as collateral for financing, which can provide the seller with access to working capital while waiting for payment from the buyer.

4. International trade facilitation

LCs facilitate international trade by providing a universally accepted payment method that is recognized by banks worldwide.

Disadvantages of a letter of credit

1. Cost

An LC can be expensive, as banks charge fees for issuing and processing them. These fees are different depending on the complexity of the LC.

2. Time-consuming

The process of issuing and processing an LC can be time-consuming, as it involves multiple parties and requires the verification of various documents.

3. Strict compliance requirements

LCs have strict compliance requirements that must be done in order for funds to be paid. If the seller does not agree with the terms and conditions of the LC, they may not receive payment.

4. Risk of fraud

LCs can be vulnerable to fraud, as criminals may attempt to produce fake documents or manipulate the terms of the LC in order to receive payment without providing the agreed goods or services.

Conclusion

A letter of credit is a financial means that provides security and trust in international trade transactions. It serves as a payment method that ensures the seller receives payment for their shipment or work while also protecting the buyer by ensuring that the seller complies with the terms and conditions of the LC before receiving payment.

There are various types of LCs available, and the specific type used will depend on the needs of the buyer and seller and the nature of the transaction. While LCs can provide benefits such as reduced risk and increased trust, they also come with associated costs and strict compliance requirements that must be carefully considered. Overall, LCs can be a valuable tool for facilitating international trade, but they require careful planning and execution to ensure success.

Key takeaways

A letter of credit is a written guarantee that a buyer will pay a seller quickly and in full. It comes from a bank or other financial institution.
Letters of credit are commonly used in the field of global trade.
There are numerous kinds of letters of credit, one of which is referred to as a revolving letter of credit.
A fee is charged by banks to issue a letter of credit.

Share this post: