A letter of credit (sometimes known as a “credit letter”) is a letter from a bank that guarantees payment. They can assure a seller that payment will be received on time and in the exact amount. If the buyer is unable to make such a payment, the bank pays the whole or outstanding sum on the buyer’s behalf.

A letter of credit is issued in exchange for a commitment of cash or securities. Banks often charge a fee, calculated as a percentage of the letter of credit’s size/amount.

Letters of credit are widely utilized in international trade. The bank provides financial guarantees to businesses involved in the import and export of goods. Enterprises doing business overseas must deal with foreign suppliers, who require payment certainty before proceeding with any transaction. As a result, a letter of credit is required to offer payment assurance to suppliers or exporters.

How does a Letter of Credit Work?

Because a letter of credit is usually a negotiable instrument. If a letter of credit is transferable, the recipient may delegate the right to draw to another entity, such as a corporate parent or a third party.

Banks also charge a service fee, which is normally a percentage of the letter of credit amount. The International Chamber of Commerce’s Uniform Customs and Practices for Documentary Credits regulates letters of credit used in international transactions.

• The buyer must first approach the bank and request that it provide a letter of credit.
• The issuing bank, typically an international bank, pays the beneficiary or any bank designated by the recipient. The advising bank’s responsibility is to authenticate and verify the information in the letter of credit.
• After verifying, the advising bank reassures the seller that his funds will be processed.
• After the customer ships the acquired items, the seller receives a bill of lading.
• From here, the banks take over, since the landing bill is submitted to the bank in charge of negotiations, which then checks the exported items.
• The shipping paperwork are then provided to the issuing bank.

Types of Letters of Credit

1. Commercial Letter of Credit

This is a direct payment mechanism in which the issuing bank transfers funds to the beneficiary. In contrast, a standby letter of credit is a secondary payment method in which the bank pays the beneficiary only when the holder is unable.

2. Revolving Letter of Credit

This type of letter lets a consumer to create as many sketches as they want within a set time frame.

3. Traveler’s Letter of Credit

For those traveling overseas, this letter ensures that issuing banks will honour drafts issued at specific foreign banks.

4. Confirmed Letter of Credit

A confirmed letter of credit requires a bank other than the issuing bank to guarantee the letter of credit. The second bank is the confirming bank, which is often the seller’s. If the holder and issuing bank fail to meet their obligations under the letter of credit, the confirming bank will ensure payment.

5. Transferable credit

Transferable credit, as the name implies, is a sort of LC in which the recipient may transfer his or her rights to third parties. The terms and conditions may differ depending on the trade and industry.

Conclusion

To sum up, the letter of credit is an essential tool for risk reduction, trade facilitation, and building confidence in cross-border commercial dealings. Businesses can efficiently use this financial tool to increase their worldwide reach, reduce payment risks, and seize new market opportunities in today’s connected world by knowing the forms, functions, and advantages of long-term contracts (LCs).