A Letter of Credit (LC) is a financial instrument issued by a bank or financial institution that guarantees the payment of a buyer’s obligations to a seller. The issuing bank promises to pay the seller a specified amount as long as the seller meets the terms and conditions outlined in the LC. Letters of Credit are primarily used in international trade to mitigate risks associated with cross-border transactions, such as credit risk, legal risk, and foreign exchange risk.
Types of Letters of Credit
1. Commercial Letter of Credit
A commercial LC, also known as an import/export LC, is the most common type and facilitates the payment for goods in international trade.
2. Standby Letter of Credit
A standby LC serves as a secondary payment mechanism. It functions as a guarantee from the bank that the buyer will fulfill payment obligations, and steps in if the buyer defaults.
3. Revocable and Irrevocable Letters of Credit
- Revocable LC: Can be modified or cancelled by the issuing bank without prior notice to the beneficiary.
- Irrevocable LC: Cannot be amended or cancelled without the agreement of all parties involved (issuing bank, buyer, and seller).
4. Confirmed Letter of Credit
A confirmed LC involves a second bank (usually in the seller’s country) that adds its own guarantee of payment to that of the issuing bank.
5. Transferable Letter of Credit
A transferable LC allows the beneficiary to transfer credit to another party, facilitating intermediary trade.
6. Revolving Letter of Credit
A revolving LC covers multiple transactions over a set period of time under the same requirements.
Key Elements of a Letter of Credit
- Issuing Bank: The bank that issues the LC on behalf of the buyer.
- Beneficiary: The seller in the transaction who receives payment.
- Applicant: The buyer or importer who requests the LC.
- Documents Required: Specifies the documents (such as bill of lading, invoice, packing list) that the seller must present to receive payment.
- Expiry Date: The date beyond which the LC is no longer valid.
- Terms and Conditions: Specific criteria that must be met for payment to be released.
Historical Context
The use of letters of credit dates back to the Middle Ages, originating as a tool for merchants to facilitate trade across Europe. Over time, their utility has expanded to modern-day international trade, playing a crucial role in global commerce by providing a secure method of financing and payment assurance.
Applicability
LCs are particularly useful in international trade due to:
- Distance and different legal jurisdictions between buyer and seller.
- Lack of trust between new trade partners.
- Need for mitigation of risks related to payment and delivery.
Comparisons with Similar Terms
- Bank Guarantee: Like an LC, a bank guarantee is a promise from the bank to cover a debtor’s obligations, but it is primarily used for domestic transactions, while LCs are more common in international trade.
- Documentary Collection: Unlike an LC, which provides a payment guarantee, a documentary collection involves banks handling the exchange of documents but does not inherently guarantee payment.
FAQs
1. How does a Letter of Credit work?
The buyer’s bank issues an LC guaranteeing payment to the seller if pre-agreed conditions are met. The seller ships goods and submits required documents to their bank, which forwards them to the issuing bank for review. Upon verifying the documents, the issuing bank releases payment to the seller.
2. What costs are associated with a Letter of Credit?
Costs include issuance fees, amendment fees, and confirmation fees if a confirming bank is involved. These fees vary depending on the transaction and banks.
3. Can a Letter of Credit be revoked?
A revocable LC can be modified or cancelled by the issuing bank at any time without prior notice. However, most LCs in modern trade are irrevocable and cannot be cancelled or altered without mutual agreement.
4. Is an LC used only for goods?
While predominantly used for goods, LCs can also be issued for services, though this is less common.
References
- International Chamber of Commerce (ICC). Uniform Customs and Practice for Documentary Credits (UCP 600).
- “Understanding Letters of Credit” by Charles H. Green.
- British Bankers’ Association’s Guide on Letters of Credit.
Summary
A Letter of Credit (LC) serves as a crucial tool in international trade, ensuring that sellers receive payment and buyers receive goods as per agreed conditions. By involving banks, LCs mitigate various risks and facilitate trust between unknown trading partners across borders. Various types, including commercial, standby, revocable, and irrevocable LCs, cater to specific needs, enhancing flexibility and security in global commerce.
