What is a Letter of Credit?

Letter of credit, also known as documentary credit, is a financial instrument commonly used in international trade to provide a guarantee of payment to the seller (beneficiary) from a buyer’s bank (issuer). It is a commitment by the issuer to pay the beneficiary a certain amount of money, as long as the beneficiary presents specified documents such as a bill of lading, invoice, and insurance policy.

In simple terms, a letter of credit serves as a guarantee that the buyer will honour their payment obligations to the seller, even if the buyer is unable to do so themselves. This can provide peace of mind for the seller, as they know that they will receive payment even if the buyer is unable to pay.

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Parties to a Letter of Credit

There are several entities involved in a letter of credit like the buyer, the seller, the issuing bank, the advising bank etc. However when we refer to the term “party”, there are only two parties in a letter of credit – the issuing bank and the beneficiary. It is because an LC, once issued, cannot be amended or cancelled without the consent of both the parties – issuing bank and the beneficiary.

Types of Letter of Credit

There are several types of letters of credit, including:

Revocable letters of credit: A revocable LC can be amended or cancelled by the issuing bank without the consent of the beneficiary. This type of LC is not commonly used in international trade as it does not provide a strong guarantee of payment to the seller.

Irrevocable letters of credit: An irrevocable LC cannot be amended or cancelled without the consent of all parties involved in the transaction. This type of LC provides a strong guarantee of payment to the seller and is the most commonly used type of LC in international trade.

Confirmed letters of credit: A confirmed LC is an LC in which a second bank, known as the confirming bank, adds its guarantee of payment to the LC issued by the buyer’s bank. This type of LC provides an additional layer of security to the seller and is commonly used in transactions between two parties located in different countries. A confirmed LC guarantees payment to the seller even if the issuing bank defaults on the payment.

Standby letters of credit: A standby LC is similar to a guarantee and is used to provide a secondary source of payment if the buyer fails to pay the seller. This type of LC is commonly used in construction or other projects where the completion of the work is dependent on the receipt of payment.

Red Clause LC: A red clause LC allows the seller to receive an advance payment from the buyer’s bank before shipment of the goods. This type of LC is used to finance the production or purchase of the goods being shipped.

Back-to-Back LC: A back-to-back LC is used when the seller of goods does not have a direct relationship with the buyer’s bank and requires a second LC to be issued by their own bank in order to receive payment.

Revolving LC: A “Revolving Letter of Credit” (RLOC) is a type of Letter of Credit (LC) that allows the buyer to repeatedly draw on a pre-approved credit line for a specified period of time. The credit line can be used for multiple transactions, and the amount available for borrowing will be replenished as payments are made.

Letter of Credit at sight

A “Letter of Credit at Sight” (also known as a “Documentary LC at Sight” or simply an “at sight LC”) is a type of Letter of Credit (LC) that requires the issuing bank to pay the beneficiary (seller) as soon as the required shipping documents have been presented and found to be in compliance with the terms of the LC.

In other words, with an at sight LC, the issuing bank must make payment to the seller within a very short time frame (often within a few days) of the presentation of the shipping documents, rather than waiting for a predetermined period of time to elapse.

At sight LCs are commonly used in international trade when the buyer and seller have a strong relationship and trust each other, or when the goods being purchased are highly perishable or time-sensitive. The advantage of an at sight LC is that it provides the seller with quick access to funds and reduces the risk of non-payment. However, at sight LCs also come with some added risk for the buyer, as they must be prepared to make payment as soon as the shipping documents are presented.

Letter of Credit usance

A “Letter of Credit Usance” or a “Usance LC” is a type of Letter of Credit (LC) that provides for payment to be made to the beneficiary (seller) at a specified future date, rather than at the time the shipping documents are presented.

In a usance LC, the issuing bank promises to pay the seller a specified amount of money at a specified future date, typically ranging from 30 to 180 days after the shipment of goods. The usance period allows the buyer time to sell the goods and generate the funds needed to pay for them.

Usance LCs are commonly used in international trade when the buyer does not have the funds available to pay for the goods at the time of shipment, or when the goods being purchased are not immediately marketable. The advantage of a usance LC is that it provides the buyer with time to generate the funds needed to pay for the goods, while still providing the seller with the security of a guarantee of payment from the buyer’s bank.

However, usance LCs also come with some added risk for the seller, as they must wait for a longer period of time to receive payment, and the buyer’s bank may require additional security, such as a financial statement or a collateral deposit, to guarantee payment.

How Letter of Credit works

A Letter of Credit (LC) provides assurance to the seller that the seller will be paid for the goods or services if the terms and conditions of the LC are met. It is essentially a promise from a buyer’s bank to pay the seller a specified amount even if the buyer fails to do so.

Here’s how a typical LC works:

Agreement between buyer and seller: The buyer and seller agree on the terms of the sale, including the price, shipping details, and payment terms. The buyer typically requests the LC from their bank. The main document specifying these details is called the “sales contract”.
Issuance of LC by buyer’s bank: The buyer’s bank or the issuing bank issues the LC after reviewing the request. The LC includes all the details of the transaction and the conditions that must be met by the seller for the payment to be made.
Shipping and presentation of documents: The seller ships the goods and provides the required documents, such as the commercial invoice, bill of lading, insurance and other documents specified in the LC, to the buyer’s bank either directly or through the nominated bank.
Examination of documents: The buyer’s bank examines the documents to ensure they meet the conditions specified in the LC. If the documents are in order, the bank releases the payment to the seller.
Payment to the seller: If the LC conditions are met, the buyer’s bank pays the seller the agreed-upon amount. If the conditions are not met, the buyer’s bank may reject the documents, and the seller may need to renegotiate the terms of the transaction with the buyer.

Advantages of Letter of Credit

One of the main benefits of using a letter of credit is the reduced risk for both the buyer and the seller. For the buyer, a letter of credit can provide assurance that the goods or services they are paying for will be delivered as specified in the contract. For the seller, a letter of credit can provide assurance that they will receive payment for the goods or services they have delivered.

Another benefit of using a letter of credit is that it can help to facilitate international trade by reducing the need for trust between the buyer and seller. In some cases, a letter of credit may be a requirement for the seller to do business with a buyer from a different country, as it provides a level of security that may not otherwise be available

Disadvantages of Letter of Credit

There are also some drawbacks to using a letter of credit. One issue is the cost, as banks will typically charge fees for issuing and processing a letter of credit. Additionally, the process of obtaining and processing a letter of credit can be time-consuming, which can delay the shipment of goods or services.

Letter of Credit vs Bank Guarantee

A Letter of Credit (LC) and a Bank Guarantee (BG) are two financial instruments used in international trade finance to provide security to the seller in the event of non-payment by the buyer. While they are similar in some ways, there are also several key differences between an LC and a BG.

Purpose: The main purpose of an LC is to provide a guarantee of payment from the buyer’s bank to the seller, while the main purpose of a BG is to provide a guarantee of performance from the buyer to the seller. In other words, an LC is a payment guarantee, while a BG is a performance guarantee.

Payment: An LC provides for payment to the seller upon presentation of the required documents, while a BG only provides for payment in the event of a specific default by the buyer.

Involvement of the beneficiary: In an LC transaction, the seller is not directly involved with the buyer’s bank. The seller’s bank verifies the authenticity of the LC and facilitates payment. In a BG transaction, the seller is directly involved with the buyer’s bank and may need to take legal action to recover payment in the event of default.

Reimbursement: In an LC transaction, the buyer’s bank is reimbursed by the buyer once the LC conditions have been met. In a BG transaction, the issuing bank is typically responsible for payment to the seller in the event of default by the buyer, and may seek reimbursement from the buyer.

Cost: LCs can be more expensive than BGs due to the added complexity of the transaction and the involvement of multiple parties.

In summary, while both LCs and BGs provide security to the seller in the event of non-payment by the buyer, they serve different purposes and have different mechanics. The choice between an LC and a BG will depend on the specifics of the transaction and the needs of the parties involved.

Conclusion

A letter of credit is a valuable financial instrument in international trade, providing a guarantee of payment for the seller and assurance of delivery for the buyer. While there may be some drawbacks such as cost and time required for processing, the benefits of reduced risk and facilitation of international trade make it a worthwhile consideration for businesses engaging in international trade.

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