Letter of Credit (L/C): All You Need to Know

A letter of credit (L/C) is a widely used payment method in international trade. It is a financial instrument that guarantees payment from a buyer to a seller. In this article, we will discuss everything you need to know about letters of credit, including the different types of L/C, the parties involved, and the step-by-step process of using an L/C in international trade.

Table of Contents

• Introduction
• Parties Involved in a Letter of Credit
• Types of Letter of Credit
  • Revocable L/C
  • Irrevocable L/C
  • Confirmed L/C
  • Unconfirmed L/C
  • Standby L/C
• The Step-by-Step Process of Using a Letter of Credit
  • Step 1: Negotiating the L/C
  • Step 2: Issuing the L/C
  • Step 3: Presentation of Documents
  • Step 4: Examination of Documents
  • Step 5: Payment
• Advantages and Disadvantages of Using a Letter of Credit
• Conclusion

Introduction

A letter of credit is a payment method that minimizes the risk for both the buyer and the seller in an international transaction. It is a legally binding document issued by a bank, guaranteeing payment to the seller upon presentation of certain documents as per the terms and conditions of the L/C.

Parties Involved in a Letter of Credit

There are several parties involved in a letter of credit transaction. These include:

• Applicant: The buyer who applies for the L/C and requests their bank to issue it.
• Beneficiary: The seller who will receive payment from the bank upon presentation of complying documents.
• Issuing Bank: The bank that issues the L/C on behalf of the buyer.
• Advising Bank: The bank that advises the L/C to the beneficiary. The advising bank is usually located in the beneficiary’s country.
• Confirming Bank: The bank that adds its confirmation to the L/C, guaranteeing payment to the beneficiary. The confirming bank is usually located in the beneficiary’s country.
• Negotiating Bank: The bank that examines the documents presented by the beneficiary and makes payment on behalf of the issuing bank.

Types of Letter of Credit

There are different types of letters of credit that can be used in international trade. These include:

Revocable L/C

A revocable L/C can be amended or cancelled by the issuing bank without prior notice to the beneficiary. This type of L/C is not commonly used in international trade as it provides little protection for the seller.

Irrevocable L/C

An irrevocable L/C cannot be amended or cancelled without the consent of all parties involved. This type of L/C provides more protection for the seller than a revocable L/C.

Confirmed L/C

A confirmed L/C is guaranteed by both the issuing bank and a confirming bank. This type of L/C provides the highest level of protection for the seller.

Unconfirmed L/C

An unconfirmed L/C is guaranteed only by the issuing bank. This type of L/C provides less protection for the seller than a confirmed L/C.

Standby L/C

A standby L/C is used as a backup payment method in case the buyer fails to fulfill their payment obligations. This type of L/C is commonly used in the construction industry.

The Step-by-Step Process of Using a Letter of Credit

Step 1: Negotiating the L/C The first step in using a letter of credit (L/C) is negotiating its terms between the buyer and seller. The buyer may request a letter of credit as a guarantee of payment, and the seller may require specific conditions for the L/C, such as the required documents, payment terms, and shipping details.

Step 2: Issuing the L/C Once the terms are agreed upon, the buyer’s bank issues the letter of credit and sends it to the seller’s bank, which acts as the intermediary. The L/C outlines the terms and conditions of the transaction, including the amount of the payment, the shipping date, and the required documents.

Step 3: Presentation of Documents The seller then ships the goods and sends the required documents, such as the bill of lading, commercial invoice, and insurance certificate, to their bank. The bank then forwards the documents to the buyer’s bank.

Step 4: Examination of Documents The buyer’s bank examines the documents to ensure they comply with the terms of the L/C. If the documents are correct, the bank releases payment to the seller’s bank. If the documents do not meet the requirements of the L/C, the bank may refuse payment until the seller corrects the issues.

Step 5: Payment Once the documents are approved, the seller’s bank releases payment to the seller, and the transaction is complete.

Advantages and Disadvantages of Using a Letter of Credit:

Advantages:

• Provides security for both the buyer and the seller
• Reduces the risk of non-payment for the seller
• Ensures that the buyer receives the goods they ordered before payment is made
• Helps to establish a good relationship between the buyer and the seller

Disadvantages:

• Can be costly for both parties due to fees and charges associated with L/Cs
• Can be time-consuming to negotiate and issue an L/C
• If the terms of the L/C are not negotiated carefully, it may not protect either party adequately
• If the documents do not meet the requirements of the L/C, it can delay payment and create additional costs for the seller

Conclusion: Using a letter of credit can provide security for both the buyer and the seller, but it is important to negotiate the terms carefully and ensure that the required documents are provided. The process can be time-consuming and costly, but it can also help to establish a good relationship between the parties involved in the transaction.