A Letter of Credit (LC) is a financial document issued by a bank on behalf of a buyer, guaranteeing payment to the seller, provided that the terms and conditions stipulated in the LC are met. LCs are commonly used in international trade to reduce the risk of non-payment and ensure that the seller is compensated for goods or services once the required documentation is provided.
Various types of LCs:
- · Revocable Letter of Credit:Can be modified or canceled by the buyer (or applicant) or the issuing bank at any time before payment is made. Offers less security to the seller as the terms are not fixed.
- · Irrevocable Letter of Credit: Cannot be changed or canceled without the consent of all parties involved (the buyer, seller, and bank). Provides more security for the seller compared to a revocable LC.
- · Confirmed Letter of Credit :Involves a second bank (usually the seller’s bank) confirming the LC. The confirming bank guarantees payment, even if the issuing bank defaults. It adds an extra layer of security for the seller.
- · Unconfirmed Letter of Credit: A Letter of Credit where only the issuing bank is responsible for payment, without any confirmation from another bank. Offers less security for the seller.
- · Sight Letter of Credit: Payment is made immediately when the required documents are presented to the bank and verified. Commonly used in cases where the buyer and seller have a high level of trust.
- · Time or Usance Letter of Credit: Payment is made after a specified period, typically 30, 60, or 90 days from the date of shipment or presentation of documents. Used when the buyer requires time to make the payment.
- · Standby Letter of Credit: Acts as a guarantee of payment in case the buyer defaults on their contractual obligations. It is often used as a backup payment method.
Benefits of Using a Letter of Credit
- Security for Sellers: Provides assurance of payment once the terms are met, reducing the risk of non-payment.
- Risk Mitigation for Buyers: Buyers can ensure that payment is only made when the seller fulfills their obligations, such as shipping the goods.
- Facilitates International Trade: Helps establish trust between parties who may not know each other, especially in cross-border transactions.
Key Features of a Letter of Credit
1. Parties Involved:
- Applicant: The buyer (importer) who requests the LC from their bank.
- Beneficiary: The seller (exporter) who receives the payment.
- Issuing Bank: The bank that issues the LC on behalf of the buyer.
- Advising Bank: The bank that advises the beneficiary about the LC, usually located in the beneficiary’s country.
2. Documents Required: To receive payment, the beneficiary must present specific documents, which may include:
- Bill of lading
- Commercial invoice
- Insurance certificate
- Packing list
- Any additional documents specified in the LC.
3. Payment Guarantee: The LC guarantees that as long as the beneficiary presents the required documents that comply with the terms of the LC, the issuing bank will make the payment.
4. Conditions and Terms: The LC will specify the conditions under which the payment will be made, including the timeframe for document submission and any specific requirements related to the shipment of goods.
LCs are bank-backed guarantees that secure international trade. They mitigate risk for both buyers and sellers by ensuring payment upon fulfillment of agreed-upon conditions, fostering trust and facilitating cross-border transactions.
