A Letter of Credit (L/C) is a financial instrument or document issued by a bank on behalf of a buyer, guaranteeing the seller’s payment for goods or services, up to a stated amount and within a specified period. This banking tool is designed to mitigate the risk associated with international trade, where the seller’s and buyer’s geographical and cultural differences might impair trust.
Types of Letters of Credit
Revocable Letter of Credit
A revocable letter of credit can be amended or canceled by the issuing bank at any time without prior notice to the beneficiary (seller).
Irrevocable Letter of Credit
An irrevocable letter of credit cannot be altered or canceled without the consent of both the buyer (applicant), seller (beneficiary), and the issuing bank.
Confirmed Letter of Credit
In addition to the issuing bank’s guarantee, a second bank (confirming bank) guarantees payment. Typically used in scenarios where the seller does not completely trust the issuing bank’s promise.
Unconfirmed Letter of Credit
Only the issuing bank guarantees payment. The responsibility is solely with the issuing bank, not involving another bank.
Standby Letter of Credit
Primarily used as a backup or failsafe, providing a financial guarantee to the beneficiary in case the applicant fails to meet obligations.
Transferable Letter of Credit
Allows the beneficiary to transfer some or all of the credit to another party, often used when the beneficiary is not the actual supplier of the goods, acting as an intermediary.
Key Components of a Letter of Credit
Applicant
The buyer or party requesting the issuance of the L/C, responsible for the goods’ payment.
Beneficiary
The seller or party in whose favor the L/C is issued; the one who will receive the payment.
Issuing Bank
The bank that issues the L/C at the request of the applicant, guaranteeing the payment.
Advising Bank
The bank, usually in the seller’s country, that advises the beneficiary of the issued L/C. It confirms the authenticity of the L/C.
Terms and Conditions
Specific requirements, such as required documents and timelines, which the beneficiary must meet to claim the payment.
Process of a Letter of Credit in International Trade
- Contract Agreement: Buyer and seller agree on terms and conditions.
- Application: Buyer applies for L/C from their bank.
- Issuance: Issuing bank evaluates the application and issues the L/C, sending it to the advising bank.
- Advising: Advising bank informs the beneficiary and verifies the L/C’s authenticity.
- Shipment: Seller ships the goods and submits required documents to the advising bank.
- Verification: Advising bank checks documents and forwards them to the issuing bank.
- Payment: Issuing bank verifies documents and, if in order, makes the payment to the advising bank, which credits the seller.
Historical Context
The concept of letters of credit can be traced back to the medieval times of the Byzantine Empire, where merchants began to use similar instruments to mitigate risks associated with long-distance trade.
Special Considerations
- Cost: Issuing and advising banks charge fees, which must be factored into the total cost of the transaction.
- Terms Compliance: The L/C is document-driven, meaning payment is conditioned upon the presentation of specified, compliant documents.
- Jurisdiction: International regulations, such as the Uniform Customs and Practice for Documentary Credits (UCP 600), govern the operation of L/Cs.
Comparison with Other Financial Instruments
- Open Account: Higher risk for sellers as payment is made after shipment.
- Advance Payment: Riskier for buyers who pay before shipment.
- Consignment: Seller sends goods to the buyer without payment until sale, holding higher risk for the seller.
Related Terms
- Trade Credit: A business agreement where the buyer can purchase goods on account without paying cash upfront.
- Bill of Exchange: A written, unconditional order directing one party to pay a fixed sum of money to another.
FAQs
What is the main purpose of a Letter of Credit?
How much does a Letter of Credit cost?
Can a Letter of Credit be canceled?
What is required to claim payment under an L/C?
Summary
A Letter of Credit (L/C) is a vital tool in international trade, offering payment assurance to sellers and reducing transaction risks for both parties. The L/C can be configured in various forms to suit different transactional needs and security preferences. Regulated by international bodies, it adheres to standardized practices to facilitate smooth and trustworthy global trade.
References
- Uniform Customs and Practice for Documentary Credits, International Chamber of Commerce (UCP 600)
- Introduction to Letters of Credit, Charles E. McCarthy
- Documentary Credits: UCP 600 & Beyond, Shyam Venkat
