A bank’s promise that a buyer will pay a seller on schedule and in the exact amount is expressed in a letter of credit, also known as a credit letter. The bank will have to pay the whole or remaining price of the transaction if the buyer is unable to make a payment. It could be provided as a facility, which is simply a loan in the form of financial aid.

Owing to the nature of international business, which includes variables like distance, national legal requirements, and the challenge of getting to know every participant in person, the use of letters of credit has grown to be a crucial component of global trade.

A letter of credit could be required by buyers of large goods to guarantee the seller that payment would be made. In essence, a bank assumes responsibility for the seller’s payment by issuing a letter of credit to guarantee the seller’s payment. Before the bank guarantees the seller’s payment, the buyer must demonstrate to the bank that they have sufficient assets or a sufficient line of credit.

Since a letter of credit is usually a negotiable instrument, the beneficiary or any bank that the beneficiary designates receives payment from the issuing bank. The beneficiary may assign the right to draw on a letter of credit to another entity, such as a corporate parent or a third party if it is transferable.

The International Chamber of Commerce’s Uniform Customs and Practice for Documentary Credits oversees letters of credit used in international transactions.

Types of Letters of Credit

Every letter of credit, regardless of type, is written in an official document agreed to by both parties before it is submitted to the guaranteeing financial institution for review. 

Before a letter of credit is acquired for any transaction, both parties must clearly communicate with each other before submitting an application. Both parties must review the terms and conditions on the application and be aware of deadlines, including the expiration date of the credit and any time allowance granted between the dispatch and presentation.

Although most letters of credit involve international exchange, they can be used to help facilitate any type of trade. Before agreeing to back a letter of credit, a financial institution is likely to review the applicant’s credit history, assets, and liabilities and attempt to find proof that the seller has a legitimate operation. 

The buyer often has an existing relationship with the bank. The bank is, therefore, aware of the party’s creditworthiness and general financial status. If the buyer is unable to pay the seller, the bank is responsible for making the full payment. If the buyer has made a portion of the payment, the bank is responsible for paying the remainder.

Commercial letters of credit sometimes referred to as import/export letters of credit, are prominent in the completion of international trades. The International Chamber of Commerce published a Uniform Customs and Practice for Documentary Credits (UCP) with which the majority of commercial letters of credit comply.

Standby letters of credit work slightly differently than most other types of letters of credit. If a transaction fails and one party is not compensated as it should have been, the standby letter is payable when the beneficiary can prove it did not receive what was promised. This is used more as insurance and less as a means of facilitating an exchange.

Revocable letters of credit create leverage for the issuer. It is contractually legal for one party to either amend or cancel the exchange at any time, normally without the consent of the beneficiary. These types of letters are not seen very frequently since most beneficiaries do not agree to them, and the UCP has no provision for them

Irrevocable letters of credit are more common than revocable ones. These stipulate that no amendments or cancellations can occur without the consent of all parties involved. Irrevocable letters of credit can either be confirmed or unconfirmed.

Confirmed letters require that another financial institution guarantees the payment, which is usually the case when the beneficiary does not trust the other party’s bank.

Revolving letters of credit are designed for multiple uses. They can be used for a series of payments. These are common among individuals or businesses that expect to do business together on an ongoing basis. There is usually an expiration date attached to these letters of credit, often one year.

Read Also: The Fair Trade Concept

Red clause letters of credit contain an unsecured loan made by the buyer, which acts as an advance on the rest of the contract. Sometimes one party requests a red clause letter of credit to obtain the funding necessary to buy, manufacture, or transport the goods involved in the transaction.

Citibank offers letters of credit for buyers in Latin America, Africa, Eastern Europe, Asia, and the Middle East who may have difficulty obtaining international credit on their own. Citibank’s letters of credit help exporters minimize the importer’s country risk and the issuing bank’s commercial credit risk.

Letters of credit are typically provided within two business days, guaranteeing payment by the confirming Citibank branch. This benefit is especially valuable when a client is located in a potentially unstable economic environment.

What Are The Benefits of Credit Letters?

A letter of credit is beneficial for both parties as it assures the seller that they will receive their funds upon fulfillment of the terms of the trade agreement, while the buyer can portray his creditworthiness and negotiate longer payment terms by having a bank back the trade transaction.

Letters of credit have several benefits for both the importer and the exporter. The primary benefit for the importer is being able to control their cash flow by avoiding prepayment for goods. Meanwhile, the chief advantage for exporters is a reduction in manufacturing risk and credit risk. Ultimately, since the trade deals are often international, there are factors like location, distance, laws, and regulations of the involved countries that need to be taken into account. The following are advantages of a letter of credit explained in detail.

• LC reduces the risk of late-paying or non-paying importers There might be instances when the importer changes or cancels their order while the exporter has already manufactured and shipped the goods. The importers could also refuse payment for the delivered shipments due to a complaint about the goods. In such circumstances, a letter of credit will ensure that the exporter or seller of the goods receives their payment from the issuing bank. This document also safeguards if the importer goes into bankruptcy.
• LC helps importers prove their creditworthiness Small to midsize businesses do not have vast reserves of capital for managing payments for raw materials, equipment, or any other supplies. When they are in a contract to manufacture a product and send it to their client within a small window, they cannot wait around to free up capital for buying supplies. This is where letters of credit come to their rescue. A letter of credit helps them with important purchases and serves as proof to the exporter that they will fulfill the payment obligations, thus avoiding any transaction and manufacturing delays.
• LCs help exporters with managing their cash flow more efficiently A letter of credit also ensures that payment is received on time for the exporters or sellers. This is especially important if there is a huge period of time between the delivery of goods and payment for them. Ensuring timely payments through the letter of credit will go a long way in helping the exporters manage their cash flow. Furthermore, sellers can obtain financing between the shipment of goods and receipt of payment, which can provide an additional cash boost in the short term.

How to Apply for a Letter of Credit

The ideal people to write letters of credit are trained specialists because errors in the specific documentation needed might result in fines and payment delays. Owing to differences in the industries and types of credit letters, each may require a different strategy.

Here’s an import-export example.

1. The importer’s bank credit must satisfy the exporter and their bank. The exporter and importer complete a sales agreement.
2. Using the sales agreement’s terms and conditions, the importer’s bank drafts the letter of credit; this letter is sent to the exporter’s bank. The exporter’s bank reviews the letter of credit and sends it to the exporter after approval.
3. The exporter ships the goods as the letter of credit describes. Any required documentation is submitted to the exporter’s bank.
4. The exporter’s bank reviews documentation to ensure letter of credit terms and conditions were met. If approved, the exporter’s bank submits documents to the Importer’s bank.
5. The importer’s bank sends payment to the exporter’s bank. The importer can now claim the goods sent.

Importers must adhere to a prescribed process when applying for LCs. Here is a list of the procedures:

1. After a sales agreement is created and signed between the importer and the exporter, the importer applies to their bank to draft a letter of credit in favor of the exporter.
2. The issuing bank (importer’s bank) creates a letter of credit that matches the terms and conditions of the sales agreement before sending it to the exporter’s bank.
3. The exporter and their bank need to evaluate the creditworthiness of the issuing bank. After doing so and verifying the letter of credit, the exporter’s bank approves and sends the document to the importer.
4. After that, the exporter manufactures and ships the goods as per the agreed timeline. A shipping line or freight forwarder assists with the delivery of goods.
5. Along with the goods, the exporter also submits documents to their bank for compliance with the sales agreement.
6. After approval, the exporter’s bank then sends these complying documents to the issuing bank.
7. Once the documents are reviewed, the issuing bank releases the payment to the exporter and sends the documents to the importer to collect the shipment.

Advantages and Disadvantages of a Letter of Credit

Obtaining letters of credit may be necessary in certain situations. However, like anything else related to banking, trade, and business there are some pros and cons to acknowledge.

Advantages

• Can create security and build mutual trust for buyers and sellers in trade transactions.
• Makes it easier to define the specifics of when and how transactions are to be completed between involved parties.
• Letters of credit can be personalized with terms that are tailored to the circumstances of each transaction.
• Can make the transfer of funds more efficient and streamlined.

Disadvantages

• Buyers typically bear the costs of obtaining a letter of credit.
• Letters of credit may not cover every detail of the transaction, potentially leaving room for error.
• Establishing a letter of credit may be tedious or time-consuming for all parties involved.
• The terms of a letter of credit may not account for unexpected changes in the political or economic landscape.

A key point that exporters need to remind themselves of is the need to submit documents in strict compliance with the terms and conditions of the LC. Any sort of non-adherence with the LC can lead to non-payment or delay and disputes in payment.

The issuing bank should be a bank of robust reputation and have the strength and stability to honor the LC when required.

Another point that must be clarified before availing of an LC is to settle the responsibility of cost-bearing. Allotting costs to the exporter will escalate the cost of recovery. The cost of an LC is often more than that of other modes of export payment. So, apart from the allotment of costs, the cost-benefit of an LC compared to other options must also be considered.

Letters of credit can play an important part in trade transactions. There are different types of letters of credit that may be used, depending on the circumstances. If you need to obtain a letter of credit for a business transaction, your current bank may be the best place to begin your search. You may, however, need to expand the net wider to include larger banks if you maintain accounts at a smaller financial institution.