A Letter of Credit (L/C) is a financial instrument prominently used in international trade. It represents a commitment by a bank to pay the seller a specified amount of money on behalf of the buyer, provided that the terms outlined in the L/C are met through the presentation of compliant documents.
Types of Letters of Credit
Commercial Letters of Credit
These are the most common type of L/C, used primarily for the sale of goods across international borders.
Standby Letters of Credit
A standby L/C functions as a secondary payment method. It’s usually invoked only if the buyer defaults on their payment obligation.
Revolving Letters of Credit
A revolving L/C is used for multiple transactions over a specified period, typically involving ongoing, regular shipments.
Transferable Letters of Credit
A transferable L/C allows the initial beneficiary to transfer part or all of the credit to another party, useful in cases where intermediaries are involved.
How Letters of Credit Work
- Agreement & Application: Buyer and seller agree on a transaction requiring an L/C, and the buyer applies for the L/C from their bank.
- Issuance: The issuing bank creates the L/C and sends it to the advising bank of the seller.
- Shipment and Documentation: The seller ships the goods and provides the required documents to the advising bank.
- Review and Payment: The advising bank checks the documents against the L/C requirements. If compliant, they forward them to the issuing bank, which then releases payment to the seller.
- Reimbursement and Delivery: The issuing bank reimburses the advising bank, and the buyer eventually receives the goods.
Historical Context
The concept of credit letters dates back to ancient Greek and Roman times. However, modern usage in trade finance began to flourish in the 19th and 20th centuries with the rise of global trade and the need for secure payment methods.
Applicability in International Trade
Letters of Credit are vital in mitigating risks for both buyers and sellers in international transactions. They ensure sellers receive payment provided they meet the stipulated terms and guarantee buyers that payment will not be made unless the terms are fulfilled.
Comparisons with Other Payment Methods
Letters of Credit vs. Bank Guarantees
While both serve as assurance instruments, an L/C is primarily centered around payment for goods and services, whereas a bank guarantee covers a broader range of guarantees, often including performance.
Letters of Credit vs. Open Account
Open account transactions are riskier for the seller but involve lower costs and simpler processes. An L/C provides more security but comes with higher fees and complexity.
Related Terms
- Advising Bank: The bank that receives the L/C from the issuing bank and informs the beneficiary.
- Issuing Bank: The bank that issues the L/C on behalf of the buyer.
- Applicant: The buyer in the transaction, who applies for the L/C.
- Beneficiary: The seller in the transaction, who is designated to receive payment under the L/C.
FAQs
What documents are typically required for a Letter of Credit?
Are Letters of Credit expensive?
Can Letters of Credit be revoked?
References
- International Chamber of Commerce (ICC). “Uniform Customs and Practice for Documentary Credits (UCP 600).”
- Federal Reserve Bank. “Understanding Letters of Credit.”
- Bank of International Settlements. “Trade Finance and Economic Development.”
Summary
A Letter of Credit is a secure, bank-guaranteed method of payment used chiefly in international trade to ensure that payments are made only if specific documentary requirements are met. While offering high security, it involves considerable costs and complex procedures, making it essential for high-value transactions and trades where trust between parties is nascent or limited.
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