A letter of credit, commonly known as LC or credit letter, is an assurance from a bank that a buyer will make the proper payment to a seller on time and in full. The bank will be obligated to pay the entire or remaining transaction balance if the Buyer has yet to pay in full. It might be provided as a service.
A credit letter is a written guarantee that a buyer will pay a seller quickly and in total from a bank or other financial institution. Letters of credit are commonly used in the field of global trade. Banks demand a fee to issue a letter of credit.
Importance of an LC
Due to the nature of such negotiations, which includes factors like distance, dissimilar laws in each country, and difficulty getting to know each partner personally, the use and awareness of letters of credit have grown to be an essential part of International Trade. The “International Chamber of Commerce for Uniformed Customs and Practices” regulates letters of credit.
Parties in an LC
1. Claimant (importer) requests the bank to issue the LC.
2. Issuing bank (importer’s bank, sometimes referred to as the LC’s opening banker), which issues the LC.
3. The recipient (exporter).
Working of an LC
Buyers usually require a letter of credit for significant purchases to guarantee the payment will be forthcoming. In effect, the bank assumes responsibility for the Seller’s expense by issuing a letter of credit as a guarantee. Even before the bank ensures the Seller’s payment, a buyer must demonstrate to the bank that they have adequate assets or an adequate line of credit to pay. The issuing bank pays the beneficiary or any bank the beneficiary designates because a letter of credit is usually a negotiable instrument. If a letter of credit is conveyable, the recipient may transfer the right to draw to a different organization, such as a corporate parent or a third party.
Cost of an LC
For a letter of credit, banks typically charge a fee that may be based on the total amount of credit that they are guaranteeing. A letter of credit’s price will differ depending on the bank and its size. For instance, they can demand 0.70%-0.80% of the sum they guarantee.
Kinds of Letter of Credit
Commercial/Business Letter of Credit
This is a straightforward payment mechanism where the beneficiary gets paid by the issuing bank. A standby letter of credit simultaneously is a backup form of payment in which the bank only pays the beneficiary when the holder is unable to.
Revolving Letter of Credit
This type of letter enables customers to conduct as many draws as they desire within a predetermined limit and a given time frame.
Traveller’s Letter of Credit
This letter assures travellers that issuing banks would accept draughts made at specific foreign banks.
Confirmed Letter of Credit
A letter of credit that has been confirmed includes a bank beyond the one that issued it, guaranteeing the document. The second bank is the verifying bank, which is frequently the Seller’s bank. If the holder and the issuing bank falter, the confirming bank guarantees payment under the letter of credit. In foreign transactions, this arrangement is often requested by the issuing bank.
Transferable Letter of Credit
The Seller can transfer a portion of the LC to the other party. This eliminates the need to extend several letters of credit to other players, which is especially advantageous when the Seller is not the sole creator of the items and purchases some components from other players.
Back-to-Back Letter of Credit
This considers providing the second LC in light of the first one. According to the instructions of the Buyer, it is opened in the intermediary’s favour. An LC is created in the name of the product seller, depending on this LC and the intermediary’s instructions.
Payment at sight Letter of Credit
After the required records have been turned over in this sort of LC, the money settlement is completed to the Vendor immediately (or at most within seven days).
Deferred Payment Letter of Credit
The payment to the Seller is made at a later period than when the documents are filed. Most of the time, the payment in the Seller’s favour happens after the Buyer receives the products.
Illustration of an LC by an institution
A) For buyers in various continents like Latin America, Africa, Eastern Europe, Asia, and the Middle East who might struggle to secure foreign credit on their own, institutions such as Citibank offer letters of credit. Exporters can reduce the importer’s country risk and the issuing bank’s commercial credit risk by using letters of credit from Citibank. Letters of credit guarantee payment by verifying deliveries to Citibank branches typically take two working days. This benefit is significant if a client lives in a region with potentially erratic economic conditions.
B) Consider an exporter working in an unsteady economic climate where securing financing would be more difficult. This Buyer would receive a letter of credit from Bank of America that would include a guarantee from a Bank of America branch for the purchase and be available in two business days. Due to the prior connection between the exporter and the bank, the bank is aware of the Buyer’s creditworthiness, resources, and financial situation. In case you need one-on-one help with understanding what Letter of Credit is, please reach out to us on Legamart, and we will be thrilled to assist you.
Pros and Cons of a Letter of Credit:
Pros of an LC
1. Can give sellers and buyers security and mutual trust in commercial transactions.
2. It makes it simpler to specify when and how transactions between relevant parties are to be performed.
3. The terms of letters of credit can be customized to the particulars of each transaction.
4. Can streamline and increase the efficiency of money transfers.
Cons of an LC
1. Typically, a letter of credit is obtained at the Buyer’s expense.
2. There may be gaps in the coverage provided by letters of credit, which could lead to mistakes.
3. For all parties involved, creating a letter of credit could be laborious or time-consuming.
4. Unexpected changes to the economic or political climate may not be covered by the letter of credit’s provisions.
The Conclusion
Letters of credit can be crucial in business dealings. Depending on the situation, numerous letters of credit may be utilized. Your existing bank might be the ideal location to start your search if you need to get a letter of credit for a commercial transaction. If you have accounts with a smaller financial institution, you might need to cast a broader net to include them. Letter of credit might be more complex than they sound, and professionals might be needed to draft it. Let Legamart.com guide you through the fine print.