Definition
A Letter of Credit is a financial document issued by a bank, or other financial institution, ensuring payment to a seller on behalf of the buyer as long as certain delivery conditions outlined in the letter have been met. It acts as an essential international trade tool that minimizes risk by providing a bridge of trust between traders. Essentially, it’s a guarantee that the buyer will pay the seller by a specified date if the delivery conditions are fulfilled.
Phonetic
The phonetics of the keyword “Letter of Credit” is “ˈlɛtər ɒv ˈkrɛdɪt”.
Key Takeaways
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- Security: Letter of Credit offers a form of guarantee to the seller that payment will be made when the agreed conditions are met. This is backed by the buyer’s bank, thereby providing trust and security in international business transactions.
- Documentary Proof: It requires a seller to provide specific documents to the buyer’s bank. These documents might include bills of lading, invoices, insurance documents, etc. which prove that the agreed obligations have been met.
- Intermediary: Banks work as an intermediary and perform various roles. Banks not only assure that payment will be made but also check and verify that transactions meet specified requirements. If the conditions are not met, payment might not be released even if goods have been shipped.
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Importance
A Letter of Credit is crucial in international trade as it provides financial security for both the buyer (importer) and the seller (exporter). It serves as a promise from a bank on behalf of the buyer assuring the seller that they will receive payment in accordance with the terms of the contract. This arrangement mitigates the risk of non-payment or delayed payment for the seller. For the buyer, it ensures that payments are only made upon receipt of necessary documentation proving that the goods have been shipped or delivered as agreed. It essentially acts as an instrument to build trust in transactions, especially those involving parties from different countries, and enhances smoother, secure, and efficient business dealings.
Explanation
The primary purpose of a Letter of Credit (LC) is to facilitate global and local trade, particularly for transactions involving substantial amounts where the buyer and seller may not know each other well. It serves as a guarantee to the seller (also known as the beneficiary) that they will be paid the correct amount and on time by the buyer (also referred to as the applicant) for the goods or services provided. It reduces the risk of non-payment after the seller has fulfilled their part of the transaction deal. The letter of credit is issued by the buyer’s bank (issuing bank) and is a commitment that the bank will make the payment to the seller upon the presentation of agreed-upon documents, such as a bill of lading, commercial invoice, etc., that proves the seller has fulfilled their contractual responsibilities. The Letter of Credit is used as a tool to mitigate the risk involved in international trade transactions, as one party may be unsure of the other’s creditworthiness or ability to meet contract obligations. Moreover, in global dealings, there may be differences in law and trading customs, cultural barriers, or language barriers that enhance the likelihood of misunderstandings or dispute. The Letter of Credit aids in bridging this gap by setting concrete terms that need to be met before payment is released. It effectively substitutes the creditworthiness of the banks involved for that of the buyer, ensuring the seller that payment will indeed be made if all specified conditions are met, thereby encouraging a more fluid and reliable international trade system.
Examples
1. International Trade: A company based in the US is looking to import goods from a supplier based in China. This is their first transaction, so a letter of credit is issued by the US company’s bank and sent to the supplier’s bank in China, providing a guarantee that the US company will pay the Chinese supplier once they meet the terms specified in the letter – typically the shipment of goods.2. Construction Projects: A construction company is hired to build an office complex. Before starting the project, the company requests a letter of credit from the project owner. This provides assurance that the company will receive payment for the project, giving them financial security to proceed with the construction.3. Real Estate Transactions: A builder wants to purchase a plot of land to develop a residential project. The seller may ask for a letter of credit to ensure that they will get the agreed amount after the transfer of the property, reducing the risk of the deal falling through due to insufficient funds.
Frequently Asked Questions(FAQ)
What is a Letter of Credit?
A Letter of Credit (LC) is a legally binding document issued by a bank guaranteeing a buyer’s payment to a seller within a specific timeframe, for a particular amount. It is widely used in international trade to ensure that payment will be received.
Why is a Letter of Credit used?
LCs are used in international transactions to reduce the risk of non-payment after the seller has provided the goods or services. This gives the seller more confidence to proceed with transactions as the payment is assured by the issuer of the LC.
Who are the parties involved in a Letter of Credit?
Four main parties are involved: buyer (applicant), issuing bank, seller (beneficiary), and advising bank. Sometimes, a confirming bank may be involved.
What are the different types of Letter of Credit?
Some types of LCs include a Sight LC, where payment is made as soon as complying documents are presented; a Time or Usance LC, which allows for a deferred payment; a Restricted LC, that specifies the presenting bank; and an Unrestricted LC, which doesn’t specify the presenting bank.
Is a Letter of Credit secure?
Yes, an LC is a secure payment method as it is backed by the bank’s creditworthiness and not the buyer’s. However, the beneficiary (seller) must comply with the terms and conditions specified in the LC to ensure payment.
How is a Letter of Credit obtained?
To obtain an LC, the buyer must apply to its bank providing the terms and conditions, notably: the amount of the credit, the expiry date and the documents required. The issuing bank will then send it to the advising or confirming bank, who is in the seller’s country.
When is a Letter of Credit used?
An LC is primarily used in international transactions where the buyer and seller may not know each other well. It provides a secure method of payment that reassures both parties that the transaction will be honored.
Can a Letter of Credit be cancelled or amended?
Once issued, the LC cannot be cancelled or amended unless all parties involved agree to it. In practice, any changes would typically require the agreement of the issuing bank, the applicant (buyer), and the beneficiary (seller).
Related Finance Terms
- Beneficiary: This refers to the individual or company in whose favor the Letter of Credit is issued, and who will receive the payment.
- Applicant: This is the person or business that requests the bank to issue the Letter of Credit, generally, the buyer in a transaction.
- Issuing Bank: The financial institution that issues the Letter of Credit at the request of the applicant.
- Bill of Lading: This is a document issued by the carrier of goods (like a shipping company) which is often used in international trade transactions, and is required to be presented in a Letter of Credit transaction.
- Advising Bank: This is the bank that communicates the Letter of Credit to the beneficiary on behalf of the issuing bank, normally located in the same geographical location as the beneficiary.
