A Letter of Credit (LC) is one of the most widely used financial instruments in international trade. It is a written guarantee issued by a bank on behalf of the buyer (importer) to the seller (exporter). The LC ensures that the seller will receive payment, provided they meet specific terms and conditions outlined in the trade agreement.
By providing security and trust, Letters of Credit bridge the gap between buyers and sellers, especially in cross-border transactions where parties may not know each other well.
How Does a Letter of Credit Work?
The process of a Letter of Credit can be broken down into these key steps:
- Agreement Between Buyer and Seller
- The buyer and seller agree on the terms of the trade, including the use of an LC as the payment method.
- Buyer Requests the LC
- The buyer (applicant) approaches their bank (issuing bank) to issue a Letter of Credit in favor of the seller (beneficiary). The buyer provides details of the transaction, including the agreed terms, documents required, and timeline.
- Issuance of the LC
- The issuing bank evaluates the buyer’s creditworthiness and issues the LC. This document outlines the conditions under which the payment will be made. The LC is sent to the seller through the advising bank (usually the seller’s bank).
- Seller Ships the Goods
- The seller ships the goods as per the agreed terms and prepares the required documents (e.g., bill of lading, commercial invoice, certificate of origin).
- Seller Presents Documents
- The seller submits the documents to their advising bank. These documents are forwarded to the issuing bank for verification.
- Bank Reviews Documents
- The issuing bank checks whether the documents comply with the LC terms. If all conditions are met, the payment is released to the seller.
- Payment to the Seller
- Once the documents are approved, the seller receives payment as specified in the LC (e.g., immediately for sight LCs or after a set period for usance LCs).
- Buyer Receives Goods
- The buyer gets access to the documents required to take delivery of the goods.
Types of Letters of Credit
- Sight LC
- Payment is made immediately upon verification of documents.
- Usance LC (Deferred Payment LC)
- Payment is made after a specified period, providing the buyer additional time to pay.
- Red Clause LC
- Allows the seller to receive an advance payment before shipping the goods.
- Green Clause LC
- Includes provisions for pre-shipment financing and storage-related expenses.
- Standby LC
- Acts as a backup payment method if the buyer fails to meet their obligations.
- Transferable LC
- Allows the seller to transfer part or all of the credit to another party, such as a supplier.
- Back-to-Back LC
- A second LC is issued based on the original LC, often used in intermediary transactions.
Advantages of Letters of Credit
- For Exporters (Sellers):
- Ensures payment if terms are met.
- Minimizes the risk of buyer default.
- Helps secure financing from banks.
- For Importers (Buyers):
- Ensures goods are shipped as agreed.
- Builds trust with international suppliers.
- Provides a structured payment process.
Challenges in Letters of Credit
While LCs are secure, they involve some challenges:
- Documentation Errors: Small mistakes in documents can delay payments.
- High Costs: LCs involve bank fees, which can be significant.
- Complex Processes: Requires knowledge of trade finance and compliance with international regulations.