What Is a Letter of Credit (LC) and How Does It Work?

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A Letter of Credit (LC) is a widely used financial instrument in international trade that provides payment assurance to the seller (exporter) and guarantees the fulfillment of contractual obligations by the buyer (importer). Issued by a bank on behalf of the buyer, an LC acts as a promise to pay the seller once the required documents and conditions outlined in the credit are fulfilled.

Key Features of a Letter of Credit

  1. Payment Assurance: Ensures the seller is paid as long as the agreed conditions are met.
  2. Conditional Payment: Payment depends on the presentation of compliant trade documents.
  3. Neutral Party: The bank acts as an intermediary to reduce trust issues between the buyer and seller.
  4. Customizable Terms: Tailored to the needs of the buyer and seller, specifying documents, timelines, and conditions.

Types of Letters of Credit

  1. Sight LC: Payment is made immediately upon presentation of compliant documents.
  2. Usance LC: Payment is deferred, typically 30, 60, or 90 days after acceptance.
  3. Confirmed LC: A second bank guarantees payment, reducing risk for the seller.
  4. Back-to-Back LC: Used for intermediaries, where two LCs are issued to facilitate the trade.
  5. Red Clause LC: Allows the seller to receive an advance payment before shipment.
  6. Green Clause LC: Includes provisions for pre-shipment storage or warehousing.
  7. Standby LC: Acts as a payment guarantee if the buyer defaults on their obligations.

How Does a Letter of Credit Work?

  1. Buyer and Seller Agreement:
    • The buyer and seller finalize a trade agreement, specifying the use of an LC for payment.
  2. LC Issuance:
    • The buyer requests their bank (issuing bank) to issue an LC in favor of the seller.
  3. LC Notification:
    • The LC is transmitted to the seller’s bank (advising bank), which informs the seller.
  4. Shipment and Documentation:
    • The seller ships the goods and submits the required trade documents (e.g., bill of lading, invoice) to their bank.
  5. Document Verification:
    • The advising bank verifies the documents and sends them to the issuing bank for confirmation.
  6. Payment Processing:
    • If all conditions are met, the issuing bank releases payment to the seller.
  7. Reimbursement:
    • The buyer reimburses the issuing bank as per the terms of the LC.

Documents Commonly Required in an LC

  1. Commercial Invoice
  2. Bill of Lading
  3. Packing List
  4. Certificate of Origin
  5. Insurance Certificate
  6. Inspection Certificate

Advantages of Letters of Credit

  1. For Sellers:
    • Reduces the risk of non-payment.
    • Guarantees timely payment upon fulfilling conditions.
  2. For Buyers:
    • Ensures goods are shipped as per the agreement.
    • Offers confidence in cross-border trade transactions.

Challenges and Costs

  1. Complex Documentation: Errors in documents can lead to delays or non-payment.
  2. High Fees: Banks charge fees for issuing, amending, and confirming LCs.
  3. Time-Consuming: Multiple verifications and compliance checks take time.

A Letter of Credit is an essential tool in trade finance, providing security and facilitating trust between buyers and sellers in international trade. By understanding how it works, businesses can leverage LCs to mitigate payment risks and streamline global trade operations.

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3 thoughts on “What Is a Letter of Credit (LC) and How Does It Work?”

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