What is a Letter of Credit?

In this post, we dive into the definition of a Letter of Credit. As well, we explore the history and purposes of this powerful financial instrument.

Letter of Credit: A Quick Definition

A letter of credit is a letter from any authorized bank that guarantees for a buyer to a seller. It vouches that the seller will receive the exact selling amount from the buyer on time. In case the buyer is not able to make the payment, the bank will take the responsibility of paying to the seller.

The letter of credit has the power overseas. Since it is used in international financial transactions, various factors come to the forefront such as:

  1. the difficulty in knowing the buyers and sellers personally,
  2. different laws in each country
  3. distance and so on.

These factors make the letter of credit an important element in international trade. Most often, entrepreneurs or small businesses seek help from international supply chains to expand their products or services. The seller may not know the buyer personally but knows the reputed bank. The entrepreneurs may face difficulty due to their inexperience in international trade, thereby failing to pay the seller. In such a scenario, the bank will be responsible to pay the amount on behalf of the buyer. The bank definitely has more resources than individual entrepreneurs.

  1. Letters of credit are mainly used within the internationally acclaimed trade industry.
  2. There are several types of letters of credit. For instance, one of these is called a revolving letter of credit.
  3. Banks receive a fee from the buyers for issuing a letter of credit.

How does a Letter of Credit Work

A letter of credit is basically a negotiable instrument. Here the issued or nominated bank pays for the beneficiary. In case of a transferable letter of credit, the beneficiary can assign it to any other party, say a corporate parent or even a third party. Then these assigned bodies have the right to draw.

For issuing a letter of credit, the banks usually ask for a pledge of security deposit – collateral or cash.

Banks also charge a certain fee for providing the service. Usually, the fees include a percentage of the amount of the letter of credit. The International Chamber of Commerce or ICC supervises the letters of credit utilized in international transactions.

Various types of letters of credit are available in the market. We will discuss them below:

Types of Letters of Credit available in the market

  1. Commercial Letter of Credit

This one is a direct mode of payment. Here the bank makes the payments on behalf of the beneficiary to the seller. As opposed to this a secondary payment mode is the standby letter where the bank pays the beneficiary if the holder is unable to pay.

  1. Revolving Letter of Credit

This sort of letter enables a customer to withdraw any number of times within a specific time limit.

  1. Traveller’s Letter of Credit

This letter of credit is helpful for those going abroad. It will ensure that the bank will honour drafts at several foreign banks tied up with the branch.

  1. Confirmed Letter of Credit

It involves a regular bank instead of an issuing bank. This is mainly a seller’s bank also called as the confirming bank

An instance of a Letter of Credit

Citibank provides the buyers in Africa, Middle East, Latin America and Eastern Europe with the letters of credit. This is for those who have troubles of availing international credits all by themselves. Citibank’s letters of credit allow the exporters to minimize the importer’s country risk. It also mitigates the commercial credit risk of the issuing bank.

Letters of credit are usually offered within two business days. Further, it guarantees the payment by the confirmed Citibank branch. This advantage is valuable for the clients located in any unstable economic conditions.

Crucial Importance of letters of credit

International trade by nature involves several problems including distance, reliability, distinct laws and so on. The letters of credit pose as a reliable payment model.

Here are the parties – involvement in a letter of credit:

  1. Applicant or importer – this person requests the bank to provide the letter of credit
  2. Issuing bank or the importer’s bank – it issues the letterof credit – this is the Opening banker of letter of credit.
  3. Beneficiary or the exporter
  4. Types of credit

The types of credit sanction come in the following categories:

  1. Sight Credit

Here the documents are payable only upon the sight presence of the original documentation.

For instance, a businessman can get the funds only after presenting the original bill of exchange. This type of letter of credit is much more immediate than any other types of letters of credit.

  1. Acceptance Credit or Time Credit

The drawn and payable (after a certain time) Bills of Exchange are insurance bills too. Under this type of credit, these bills are accepted upon the sight or presentation. These honor the beneficiary on a specific date. For instance, a company may purchase materials from a supplier and ideally receives all the items on the very day. The bill is with the shipment of the goods. However, the company will have up to a month to pay for it. This gives more flexibility to businesses in terms of payment. This is preferable to small businesses or entrepreneurs. They receive the goods, sell the items, make a profit and then make the payment with a certain share of the profit. It’s a win-win for all the parties.

  1. Revocable & Irrevocable Credit

A revocable credit has several terms and conditions. The issuing bank can amend and cancel the terms of the credit. This cancellation can even take place without any notice to the beneficiaries. This is troublesome however, it costs less.

On the other hand, you cannot cancel or amend the terms and conditions of an irrevocable credit. So, the bank commits to pay the beneficiary.

Conclusion

A letter of credit plays an important role in the world economy as it helps businesses to thrive even with little capital. That’s why it is gaining wide popularity across the globe these days. To learn more about how we issue letters of credit for our clients, request a consultation through our contact us page!

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Christina Baggins
AMB Content Writer
Christina is a researcher and writer at Agro Merchant Bank and specializes in educating suppliers & brokers in essential trade knowledge.
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