Letters of Credit: Definition & Uses

What is a Letter of Credit?

Letters of credit (L/C) are documents which facilitates international trade. They are sometimes known as international letters of credit. On rare occasions, they can be used for trade within a single country, but that is unusual as there are other cheaper methods for ensuring security of payment and delivery within one’s own country.

Letters of Credit have been in existence for centuries and the basic format has barely changed, although the mode of delivery has moved with the times.

A letter of credit is defined by guaranteeing that if the seller complies with all terms of the document as to delivery time, mode of delivery, quality/quantity of goods, and certain other conditions he will be paid by the issuing bank without further reference to the buyer.

A bank letter of credit is far and away the most common type of guarantee of payment although they can be issued by trading houses and finance companies. It is synonymous with the move away from treating banks as the only supplier of banking products like credit cards, treasury services and trade finance. It is also showing banks that the interest in issuance of letters of credit by non-bank institutions is growing.

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While letters of credit are primarily used to facilitate the movement of goods, there is another form of L/C; a standby letter of credit. This differs from a commercial letter of credit in that it relates to the performance of a service and generally requires a simple invoice confirmation to be settled. A standby L/C often relates to the payment for ongoing services like a maintenance contract.

For example, a supplier may ship a piece of equipment to his customer under a commercial letter of credit. Once the equipment has been delivered and installed the terms of the commercial letter of credit will have been complied with. However, there may be an agreement under which the supplier provides, say, three years maintenance. To ensure payment for the maintenance and since there is no further movement of goods, the supplier may require a standby L/C to be issued in his favour that pays him upon presentation of a document that confirms the maintenance has been carried out. In this instance, a standby letter of credit is simply a different form of guarantee.

What are the Costs Involved in a Letter of Credit?

Letter of credit costs are a constant area of contention between banks and their customers, often leading to disputes about the level of risk banks are prepared to accept for contingent liabilities (a contingent liability is a credit risk which doesn’t involve the payment of funds as in a loan). The issuing banks liability is contingent upon the importer being able to pay and the confirming bank’s liability is contingent upon the issuing bank being able to pay.

When a letter of credit is issued by a bank, it is generally sent to a bank in the country of the exporter to be advised (forwarded by the bank in the exporters country without accepting any payment liability) to the beneficiary (exporter). If the importer is in a country that has experienced payment problems in the past, or either the country or the issuing bank has a low credit rating, the importer may ask for the L/C to be confirmed in his own country. This means that the bank will “confirm” the payment to the importer, taking on the obligation of the issuing bank. There is a fee charged by the confirming bank and depending upon the circumstances, this may be for the account of the exporter.

The payment terms under a letter of credit may be at sight or usance. Under a sight L/C, the beneficiary (exporter) is paid as soon as he presents a conforming set of documents to the confirming or issuing bank. A usance L/C is used when, under the terms of the commercial agreement, the exporter is allowing the importer extended terms of payment. The risk involved in a usance letter of credit is greater than for a sight payment, so the banks’ fees will be higher. All these issues need to be taken into consideration at the negotiation stage between the two commercial parties.

In summary, a letter of credit (L/C) is a vital document which not only guarantees payment from buyer to seller but ensures quality, shipping dates and other parts of the sales contract are complied with. L/C’s are the most used conduit for exchange of goods for payment in international trade.

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