A Letter of Credit is a payment term mostly used for long-distance and international commercial transactions.
Letters of credit are indispensable for international transactions since they ensure that payment will be received. Using documentary letters of credit allows the seller to significantly reduce the risk of non-payment for delivered goods, by replacing the risk of the buyer with that of the banks. Letters of credit have become a crucial aspect of international trade , due to differing laws in each country and the difficulty of knowing each party personally.
After trade between countries made it impossible to do business by traditional payment methods, Letters of credit make it possible to do business worldwide.
Originally, Letter of Credit was literally a letter written by the buyer's bank to the seller's bank promising that they guarantee to pay the seller in case of the buyer's default.
In modern business world, a letter of credit is basically an undertaking by a bank to make a payment to a named Beneficiary within a specified time, against the presentation of documents which is strictly in compliance with the terms of the letter of credit.
That is to say, banks issue letters of credit as a way to ensure sellers that they will get paid as long as they do what they've agreed to do. Hence, in essence, letter of credit is a promise to pay.
This mechanism has its own jargon:
The Buyer is the Applicant or the Account Party and the Seller or the Ultimate Recipient of Funds is the Beneficiary.
The Bank that issues the LC is referred to as the Issuing Bank which is generally in the country of the Buyer.
The Bank that Advises the LC to the Seller is called the Advising Bank which is generally in the country of the Seller
Abbreviations for 'letter of credit' include L/C, LC, and LOC .
In the very beginning, one must note that Letters of credit deal in documents, not goods, thus the Bank scrutinizes the 'documents' and not the 'goods' for making payment which explains why the technical term for Letter of credit is 'Documentary Credit'.
In this context, the process works both in favour of both the buyer and the seller. The instrument is designed to reduce the risk taken by each party. The Seller gets assured that if documents are presented on time and in the way that they have been requested on the LC the payment will be made and Buyer on the other hand is assured that the bank will thoroughly examine these presented documents and make sure that they meet the terms and conditions stipulated in the LC.
Letter of credit advantages for the seller
- The seller has the obligation of buyer's bank's to pay for the shipped goods;
- Reducing the production risk, if the buyer cancels or changes his order
- The opportunity to get financing in the period between the shipment of the goods and receipt of payment (especially, in case of deferred payment).
- The seller is able to calculate the payment date for the goods.
- The buyer will not be able to refuse to pay due to a complaint about the goods
Letter of credit advantages for the buyer
- The bank will pay the seller for the goods, on condition that the latter presents to the bank the determined documents in line with the terms of the letter of credit;
- The buyer can control the time period for shipping of the goods;
- By a letter of credit, the buyer demonstrates his solvency;
- In the case of issuing a letter of credit providing for delayed payment, the seller grants a credit to the buyer.
- Providing a letter of credit allows the buyer to avoid or reduce pre-payment.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.