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Understanding the Letter of Credit: Examples and Working Mechanism

Published on Feb 2, 2024Updated on Jul 22, 2024

Understanding the Letter of Credit: Examples and Working Mechanism

Ever heard of the term "letter of credit"? It's like a backstage pass to the world of trade, ensuring transactions go off without a hitch. Imagine it as your financial fairy godmother, magically smoothing the way for international business deals. In this guide, we'll unravel the mystery of letters of credit, exploring what they are and how they work

What Is a Letter of Credit?

A Letter of Credit (LC) serves as a financial safety net in the world of international trade, providing assurance to both buyers and sellers. In essence, it's a written commitment from a bank to facilitate a payment on behalf of the buyer once specific conditions are met. The LC outlines the terms, ensuring the seller ships the goods as agreed and the buyer fulfills their payment obligations. This financial instrument comes in handy when trust needs a little boost in global dealings. It acts as a win-win for all parties involved, reducing the risk of non-payment for the seller and ensuring the buyer receives what was promised. A letter of credit plays a vital role in harmonizing the steps, fostering trust, and facilitating smoother transactions across borders.

How a Letter of Credit Works

Understanding how a Letter of Credit (LC) works involves delving into the intricate choreography of international trade.

Let's break it down: The buyer and seller agree to use an LC as a financial intermediary. The buyer instructs their bank (issuing bank) to issue the LC in favor of the seller, specifying terms and conditions. Upon receiving the LC, the seller can confidently ship the goods, knowing that as long as they comply with the agreed-upon terms, they will receive payment. The LC acts as a guarantee from the issuing bank to make the payment on behalf of the buyer. Upon shipment and presentation of the necessary documents, the seller's bank (advising bank) reviews the compliance. If everything aligns, the advising bank forwards the documents to the issuing bank, and the buyer's account is debited. The issuing bank then pays the advising bank, and the transaction is completed. This intricate process ensures that both parties fulfill their obligations, fostering trust and enabling secure global transactions. The Letter of Credit, with its systematic steps, adds a layer of reliability to the complex world of international trade.

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When to Use a Letter of Credit

Knowing when to use a Letter of Credit (LC) is crucial for businesses engaging in international trade. This financial instrument becomes particularly beneficial when there is uncertainty or a lack of trust between the buyer and the seller. It offers a secure payment method, ensuring that the seller receives payment as agreed upon and the buyer obtains the promised goods. LCs are commonly used in transactions involving large sums of money, complex agreements, or when dealing with unfamiliar trading partners. Additionally, they are favored in situations where the buyer's creditworthiness may be in question or when the seller operates in a region with a less stable financial environment. Essentially, an LC acts as a risk mitigator, providing a structured framework for transactions and fostering confidence in cross-border business dealings.

How Much a Letter of Credit Costs

Determining the cost of a Letter of Credit (LC) involves understanding the various charges associated with this financial instrument. The primary fees include issuance fees, advising fees, and confirmation fees. The issuing bank typically charges an upfront issuance fee for preparing and issuing the LC. Additionally, if the buyer's bank seeks the expertise of another bank (confirming bank) to add confirmation, an additional confirmation fee may apply. Advising fees are charged by the advising bank for verifying and forwarding the LC to the seller. Furthermore, there are amendment fees if any changes are made to the original LC terms. It's essential to consider negotiation fees, which the seller's bank may charge for reviewing and negotiating the documents. The buyer bears these costs, but they are essential for ensuring a smooth and secure transaction process. Additionally, the parties involved should be aware of discrepancy fees if the presented documents do not align with the LC terms. While these costs contribute to the overall expense, the reliability and security provided by an LC often justify the investment, especially in complex international trade scenarios.

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Types of Letters of Credit

  • Commercial Letter of Credit
  • Revolving Letter of Credit
  • Traveler’s Letter of Credit
  • Confirmed Letter of Credit

Let's explore the distinctive features that make each type a valuable tool in the world of finance and trade, offering businesses and individuals tailored solutions for their unique requirements

Commercial Letter of Credit

A commercial LC facilitates smooth transactions in trade, assuring the seller of payment once delivery conditions are met. It acts as a secure payment method, fostering trust between buyers and sellers.

Revolving Letter of Credit

In a revolving LC, the credit amount is replenished after each transaction, offering ongoing financial support for recurring transactions and providing flexibility for continuous trade relationships.

Traveler's Letter of Credit

Ideal for globetrotters, a traveler's LC ensures a secure and convenient means of payment during international travel, facilitating seamless transactions while abroad.

Confirmed Letter of Credit

Adding an extra layer of security, a confirmed LC involves a third-party confirming bank, mitigating risk and instilling confidence in the transaction, particularly when dealing with unfamiliar trading partners.

Example of a Letter of Credit

An example of a Letter of Credit (LC) involves a buyer and seller engaging in an international trade transaction. The buyer, wanting to ensure the timely delivery of goods, requests that their bank issue an LC in favor of the seller. The LC outlines specific conditions, such as shipping documents and quality certifications, that the seller must fulfill to receive payment. Upon shipment, the seller presents the required documents to their bank, which, in turn, forwards them to the buyer's bank. If the documents comply with the LC terms, the buyer's bank makes the payment to the seller. This example showcases how an LC acts as a secure bridge, facilitating trust and ensuring a smooth transaction in the complex realm of global commerce.

Letter of Credit Key Terms Glossary

  1. Applicant
  2. Beneficiary
  3. Issuing bank
  4. Negotiating bank
  5. Advising bank
  6. Confirming bank
  7. Intermediary

Understanding the following key terms is essential for all parties involved in Letter of Credit transactions to ensure smooth and secure international trade transactions.

Applicant: The party initiating the Letter of Credit (LC), often the buyer, requesting their bank's involvement to facilitate a secure transaction.

Beneficiary: The recipient of the LC, typically the seller, who will receive payment upon fulfilling the specified conditions outlined in the LC.

Issuing Bank: The bank that issues the LC on behalf of the buyer, assuming the responsibility of payment.

Negotiating Bank: The bank that reviews and negotiates the documents presented by the beneficiary, ensuring compliance with the LC terms.

Advising Bank: The bank that receives and verifies the LC before advising the beneficiary of its existence.

Confirming Bank: An optional third-party bank that adds its confirmation to the LC, providing an additional layer of assurance for the beneficiary.

Intermediary: A financial institution that facilitates communication between banks involved in the LC process, ensuring a smooth and secure transaction.

Advantages and Disadvantages of a Letter of Credit

Advantages of Letter of Credit (LC) 

Disadvantages of Letter of Credit (LC) 

Secure Payments: Ensures secure and timely payments. 

Costly: Involves fees like issuance and advisory fees. 

Trust Building: Fosters trust in international trade. 

Complexity: Involves intricate documentation and steps. 

Risk Mitigation: Reduces the risk of non-payment. 

Time-consuming: Processing can be lengthy. 

Flexibility: Various types cater to different needs. 

Amendment Charges: Changes may incur additional fees. 

Global Trade Facilitator: Supports cross-border trade. 

Inflexible Terms: Strict adherence to LC terms is required. 

How to Apply for a Letter of Credit

Initiate Request: The buyer (applicant) initiates the request for an LC with their bank.

Provide Transaction Details: Specify transaction details, terms, and conditions to the issuing bank.

Creditworthiness Assessment: The issuing bank assesses the buyer's creditworthiness.

LC Issuance: Upon approval, the issuing bank issues the LC.

Transmission to Advising Bank: LC details are transmitted to the advising bank.

Verification by Advising Bank: The advising bank verifies and informs the beneficiary about the LC.

Confirmation (if applicable): A confirming bank may add its confirmation for additional assurance.

Goods Shipment: The beneficiary ships the goods.

Document Presentation: The beneficiary presents the required documents to the negotiating or confirming bank.

Payment Processing: The negotiating or confirming bank processes payments based on compliant documents.

Communication and Coordination: Effective communication among banks is crucial throughout the process.

Precision and Adherence: Adherence to international trade norms and precise documentation are emphasized.

Why Should My Business Use a Letter of Credit?

Utilizing a Letter of Credit (LC) offers several advantages for businesses engaged in international trade. Firstly, it provides a secure and standardized method for payment, mitigating the risk of non-payment and building trust between buyers and sellers. LCs also act as a financial tool, facilitating smoother transactions by specifying terms and conditions that must be met before payment is made. For businesses dealing with unfamiliar partners or in regions with volatile financial environments, an LC adds an extra layer of assurance. It fosters a more predictable and structured approach to global transactions, reducing uncertainties and potential disputes. In essence, incorporating an LC into your business practices enhances financial security, streamlines international trade, and contributes to the overall efficiency and reliability of cross-border transactions.

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Conclusion

In conclusion, the Letter of Credit (LC) stands as a powerful instrument in the realm of international trade, offering businesses a secure and structured approach to transactions. Its role in fostering trust, mitigating risks, and providing a standardized payment method cannot be overstated. In the world of international trade, having the necessary financial support is paramount.

SMFG India Credit understands the challenges businesses face and offers tailored solutions, including business loans designed to meet the unique needs of enterprises engaged in global transactions. Whether you are expanding your operations, optimizing your supply chain, or pursuing new opportunities, SMFG India Credit business loan can provide the financial backing you need. 

* Please note that this article is for your knowledge only. Loans are disbursed at the sole discretion of SMFG India Credit. Final approval, loan terms, disbursal process, foreclosure charges and foreclosure process will be subject to SMFG India Credit's policy at the time of loan application. If you wish to know more about our products and services, please contact us

FAQs

What is a Letter of Credit (LC)?

A Letter of Credit (LC) is a financial instrument issued by a bank that guarantees payment to a seller (beneficiary) on behalf of a buyer (applicant) once specific conditions are met. It serves as a secure method of facilitating international trade transactions, providing assurance to both parties.

How Does a Letter of Credit Facilitate International Trade?

An LC facilitates international trade by acting as a mediator, ensuring that the buyer fulfills payment obligations and the seller meets specified conditions, fostering trust and reducing the risk of non-payment in cross-border transactions.

What Are the Main Types of Letters of Credit?

The main types of LCs include Commercial Letter of Credit, Revolving Letter of Credit, Traveler's Letter of Credit, and Confirmed Letter of Credit, each tailored to different trade and financial needs.

What Information is Included in a Letter of Credit?

A Letter of Credit typically includes details such as the names and addresses of the buyer and seller, the amount of the credit, a description of the goods or services, and the terms and conditions that must be met for payment.

How Does the Issuing Bank Verify Compliance in a Letter of Credit?

The issuing bank verifies compliance by thoroughly examining the documents presented by the seller (beneficiary) to ensure they align with the terms and conditions stipulated in the LC.

What Are the Risks Associated with Letters of Credit?

Risks include discrepancies in document presentation, non-compliance with LC terms, and potential delays or disputes. Unfamiliarity with the process can also pose challenges, emphasizing the need for careful consideration.

How Can Businesses Benefit from Standby Letters of Credit?

Standby Letters of Credit act as financial backup, providing assurance to the beneficiary that, in case of default or non-payment by the applicant, the issuing bank will fulfill the obligation. This financial tool is often used in various business scenarios, including contract performance and payment security.

Can a Letter of Credit Be Amended After Issuance?

Yes, a Letter of Credit can be amended after issuance if both the buyer and the seller agree to modify certain terms. However, amendments may incur additional charges and should be carefully negotiated to ensure the smooth continuation of the transaction.

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