A letter of credit is a financial instrument that is used in international trade and is a well-known form of payment security. In simple terms, it is a type of contract which makes sure that a trade will be completed by using a bank as a neutral third party.
It is one of the oldest and most secure payment instruments available, as it is a way to ensure that the seller will be paid in full and on time and the buyer will receive everything they requested, which is crucial for a good trade.
A letter of credit is often abbreviated to LC.
When is a letter of credit used?
A letter of credit is used during an international trade, between a buyer and a seller or an importer and exporter. As trust is central to a successful trade, if the buyer cannot be assured of the goods or services being sent, then they may be reluctant to trade. On the flipside, a seller may be hesitant if they cannot be certain that they will receive payment on time, or at all.
This is where a letter of credit comes in. A buyer will approach their bank and request a letter of credit. If everything is in order, the bank will issue the letter of credit to the seller, as a guarantee of payment to them. The seller can now be certain that once they meet their conditions, they will receive payment. The buyer owes the bank for the money instead of the seller.
Letters of credit are incredibly useful for ensuring that business and trade runs smoothly. There are many potential hiccups that can happen, and with the magnitude and frequency of international trade, this must be avoided at all costs, otherwise huge losses can be incurred.
A letter of credit could be needed when…
- The buyer’s credit is unacceptable or cannot be found
This is a common reason which can justify a letter of credit, as it means that a seller can be assured that they will receive payment, despite a poor or non-existent credit rating. This may not be the fault of the buyer, but a letter of credit will ensure the trade is completed.
- The buyer doesn’t have enough money
Some trades can be huge, and in many cases the buyer may not have enough money to cover the costs today, but will do in the future. By using a letter of credit, the transaction can go ahead safely and the payment can be settled at a later date.
- Trading with a new buyer
Sometimes by default, a company will begin a brand-new trade with a letter of credit, to ensure that business is running well, before switching to direct payments.
- The terms of an existing trade are changing
Terms of a trade may need changing or need to be renewed. This is where a letter of credit can be useful, as it can ensure that the individual trade can still happen, regardless of any outside disagreement about business.
How does the process work?
There are variants of letters of credit, but this is the following procedure for a standard or commercial letter of credit:
- The buyer and seller will have already agreed on the trade details. The buyer will begin the trade by approaching their bank, either on their own terms or by request of the seller.
- The buyer will provide the details of the transaction. The letter of credit will specify the terms of the payment, including the date of payment, the amount, and any other necessary details.
It will also, most importantly, detail the conditions that must be met before the seller can receive payment. These conditions may include the presentation of shipping documents, proof of delivery, or other evidence that the goods or services provided have been received and accepted by the buyer.
- Once the letter of credit has been approved, the buyer’s bank supplies the letter of credit to the seller. The seller will then accept the terms on the letter of credit and the trade can go ahead.
- When the buyer receives the goods, and the conditions are met, the seller’s payment will be released by the bank. The buyer will then settle the payment with the bank.
This whole process means that: the buyer can be assured that they will receive their goods or services (as the seller must deliver on this in order to receive payment), and the seller can be assured that payment will arrive (as it comes from the bank, guaranteed upon delivery of the goods or services).
Disadvantages of a letter of credit
A letter of credit may seem ideal for every trade, but there are some disadvantages. The main disadvantage of a letter of credit is that it is cheaper overall to trade without one. If a buyer and seller can be trusted and there are no hiccups, then a trade can be completed without any need for one.
Letters of credit are also labour-intensive, and if they are not handled by professionals then the trade may suffer even further delays. Any discrepancies can cause delays or even a cancelling of the trade. It is crucial that all of the correct documents and evidence are provided to the bank or financial institution, and that the requirements of the trade are met.
Letters of credit can also be fairly expensive, adding further costs to a transaction.
Are there different types of LCs?
Inevitably, no two trades are the same, and there will need to be a different type of letter of credit for certain situations. Here is a short list of some of the variants and their uses.
- Standby Letter of Credit
A standby letter of credit means that there are funds payable when there has been a failure in the transaction. The buyer must prove that they didn’t receive what was agreed, so this variant acts as a form of insurance against riskier situations.
- Confirmed (and Unconfirmed) Letters of Credit
The buyer or seller may not even trust the bank of either party, so a confirmed letter of credit may be of use here. This will require that a bank in their home country confirms the letter, and therefore acting as insurance for a failed payment from the bank.
- Red Clause Letter of Credit
With this variant, the buyer must pay cash up front which acts as an advance payment. This is useful for sellers because they can then use this loan to buy supplies or transport for the buyer’s request.
- Revolving Letters of Credit
For multiple payments, a revolving letter of credit can be used. If business is expected to be recurring, but a letter of credit is still required for each trade, then this will prevent creating a new letter of credit each time.
Talk to an expert at CurrencyTransfer for your import/export business and we’ll be happy to help.
You can also read more on the topic:
- Letters of Credit: The Risks, Processes and Responsibilities
- What are revocable and irrevocable Letters of Credit?
- What happens if my LC doesn’t agree with the shipping terms?
- Why is it more secure to have a Letter of Credit confirmed?
Caleb is a writer specialising in financial copy. He has a background in copywriting, banking, digital wallets, and SEO – and enjoys writing in his spare time too, as well as language learning, chess and investing.