What is a Letter of Credit?

Minimizing financial risk between exporters and importers in international trade depends mostly on a letter of credit. Knowing how this financial instrument operates is crucial whether your business is a customer worried about timely delivery and payment or a supplier exporting items across borders. Let's explore the letter of credit definition, its types, process, and benefits in global commerce.

What Is the Purpose of Letter of Credit?

The primary purpose of a letter of credit in international trade is to ensure letter of credit payment between buyers and sellers who may not know each other personally but want to engage in safe, secure trade. A bank issues it on behalf of the buyer (applicant), therefore ensuring that the seller (beneficiary) will get paid as long as the terms and conditions stated in the letter are complied with.

In essence, a letter of credit in banking serves as a bridge of trust, backed by a financial institution. It substitutes providing bank credit risk for buyer credit risk.

What is Letter of Credit Process?

The letter of credit process consists of several important stages:

• Agreement: The buyer and seller agree on using a letter of credit payment method in their sales contract.
• Application: The buyer applies to their bank for a letter of credit application.
• Issuance: The issuing bank sends the LC to the seller’s (beneficiary’s) bank.
• Shipment: The seller ships the goods and prepares required documents like a letter of credit bill of lading.
• Document Presentation: The seller submits these documents to their bank.
• Verification: The issuing bank verifies if the documents comply with the letter of credit terms.
• Payment: If compliant, the bank releases the funds to the seller.

For both exporters and importers, this organized approach makes letters of credit in international trade transactions more consistent and safe.

Moreover, the letter of credit application process has become quicker thanks to internet banking systems as digital transformation grows. Many banks today provide digital tools where customers may start and oversee the letter of credit format, therefore enabling electronic document submission. This change accelerates the whole transaction time and helps to lower paperwork mistakes.

In addition, the letter of credit in banking differs somewhat based on internal procedures, rules, and required documentation for every bank. Before starting any transaction, importers and exporters must interact openly with their respective banks. Regarding a documentary letter of credit, document timing and accuracy are absolutely important. Any differences could cause postponed or denied payments.

What are the Requirements of LC?

A documentary letter of credit needs to be issued and processed under numerous criteria:

• Commercial Invoice
• Bill of Lading
• Packing List
• Certificate of Origin
• Insurance Documents (if applicable)
• Inspection Certificate (if required)

Every document must exactly match the specified terms and letter of credit format; else, the issuing bank could refuse payment.

What are the Types of Letters of Credit?

There are several kinds of letter of credit used in global transactions. Let’s explore the different types of letter of credit one by one.

Irrevocable Letter of Credit

Unless both sides agree, this kind cannot be amended or canceled. It provides the seller the most security.

Revocable Letter of Credit

The issuing bank might change or terminate this without warning to the seller. Its instability makes it hardly used.

 

Confirmed Letter of Credit

Usually from the seller's nation, a second bank guarantees the LC and adds still another degree of security. The document is also referred to as a letter of credit confirmation.

Unconfirmed Letter of Credit

Only the issuing bank has a payment obligation.

Standby Letter of Credit

Used more like a guarantee, it’s activated if the buyer defaults.

Transferable Letter of Credit

Allows the beneficiary to transfer part or all of the LC to another party, commonly used in supply chains.

Revolving Letter of Credit

Used for repetitive transactions, this LC renews itself for a specified period.

Red Clause Letter of Credit

Includes a clause allowing the seller to receive an advance before shipping.

Each of these letter of credit types serves different business needs depending on the nature of trade and level of trust between parties.

What Is an Example of a Letter of Credit?

Consider a German exporter of industrial tools selling to a Brazilian company. Applying for an export letter of credit, the Brazilian buyer uses their bank. The bank issues it for the German exporter's benefit. After the products are shipped, the exporter supplies insurance, a letter of credit, a bill of lading, and an invoice. Payment is released once the paperwork is confirmed and follows the format of a letter of credit.

This is a typical letter of credit example showing its function in global trade.

What are Advantages and Disadvantages of a Letter of Credit?

Although a trade letter of credit presents a methodical approach to handling foreign business, it is advisable to weigh its advantages and disadvantages before depending on it.

What are Advantages of Letter of Credit?

• Payment Security: Ensures the seller gets paid if terms are met.
• Import Assurance: Buyer only pays when compliant documents are presented.
• Bank Credibility: Reduces risk of fraud.
• Flexible Formats: There are various formats of letter of credit to suit different trade scenarios.
• Global Acceptance: Works in many jurisdictions, supporting international letter of credit practices.

These points highlight key benefits of letter of credit in cross-border transactions.

What are Disadvantages of Letter of Credit?

• Cost: Letter of credit cost includes issuance, advising, and confirmation fees.
• Documentation Errors: Small errors can delay payment.
• Time-Consuming: Preparing and checking documents is labor-intensive.

 

What is the Risk of Using Letter of Credit?

The primary risk arises from discrepancies in the documentation. Should terms fall short of perfection, banks could withhold payment. Furthermore influencing performance are geopolitical concerns or financial collapse.

What is Difference Between Bank Guarantee and Letter of Credit?

The key distinction between letter of credit vs bank guarantee lies in function:

• Letter of Credit: Ensures payment upon performance.
• Bank Guarantee: Covers loss if performance fails.

LCs are proactive tools in trade finance, while guarantees are reactive and triggered by non-performance.

OPCA Members Handle Letter of Credit with Confidence

Trustworthy international shipping companies that regularly handle sensitive and high-value shipments are gathered by Overseas Project Cargo Association (OPCA). Deep expertise of letter of credit in shipping, including complicated documentation and compliance procedures, these professionals possess.

OPCA's trustworthy agents guarantee your transaction is expertly handled whether your goal is to manage an import letter of credit or set up an export letter of credit. Our freight forwarders directory worldwide allows you to peruse a complete list of professionals.