Letter Of Credit
Definition of Letter of Credit
Letters of Credit (LC) are financial guarantees provided by banking associations to assure payment to a seller once specific conditions are fulfilled.
The LC minimises risks for both parties by making sure the seller gets paid when they provide documentation proving that the goods have been shipped (as agreed), while the buyer’s payment is only made when those conditions are fulfilled.
The Letter of Credit effectively shifts the risk from the buyer to the bank.
How does a Letter of Credit work?
The process begins when a buyer requests an LC from their bank, typically after finalising a purchase agreement. The issuing bank then guarantees payment to the seller, provided the seller submits documents meeting the terms outlined in the LC.
Once verified, the bank releases the payment to the seller (however, they will make sure the buyer receives the agreed goods before funds are transferred).
Why use a Letter of Credit?
Letters of Credit are crucial in scenarios where there is a lack of trust between trading parties, especially in international deals where regulations, legal systems, and trading practices differ.
By involving a bank as a neutral third party, both buyers and sellers can mitigate risks such as non-payment or fraud.
What are the types of Letters of Credit?
Different types of LCs cater to specific business needs. The most common are:
- Commercial LC: Typically used for direct transactions between a buyer and a seller.
- Standby LC: These serve as a backup payment method and are only activated if the buyer defaults.
- Confirmed LC: Offers an extra layer of security where a second bank guarantees payment in addition to the issuing bank.
- Revolving LC: Useful for businesses involved in multiple transactions over time, covering ongoing shipments under one agreement.
When should you use a Letter of Credit?
A Letter of Credit is particularly beneficial when engaging in cross-border trade where the parties are unfamiliar with each other or where local regulations pose a risk.
It is often employed when dealing with new suppliers, in high-risk markets, or where the buyer and seller operate under different legal systems.
What are the advantages of using a Letter of Credit?
The key advantages include:
- Payment assurance: Sellers receive guaranteed payment as long as they fulfil the LC’s terms.
- Risk mitigation: Both parties reduce the risk of default or fraud by relying on a trusted financial intermediary.
- Facilitated trade: Letters of Credit facilitate transactions between unfamiliar or distant parties by offering financial security and trust.
What are the disadvantages of using a Letter of Credit?
Despite their benefits, Letters of Credit have some downsides:
- Costs: The process involves various fees for issuing, confirming, and processing the LC.
- Time-Consuming: The documentation and verification process can be detailed and time-intensive.
- Inflexibility: Each LC is tied to a single transaction, meaning a new one is required for each order (which is not ideal for businesses with recurring trade relationships).
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