Letter of credit

Definition

A letter of credit (LC) is a financial instrument commonly used in international trade transactions. It serves as a guarantee from a bank that a buyer’s payment to a seller will be received on time and for the correct amount.

What is a letter of credit?

A letter of credit provides a level of security for both parties involved in the transaction, particularly when they may not have an established business relationship or trust each other’s financial credibility.

Parties involved:

• Applicant (buyer): The party that initiates the issuance of the LC.
• Beneficiary (seller): The party to whom the LC is issued. 
• Issuing bank: The bank that issues the LC on behalf of the buyer. 

For the buyer, an LC provides assurance that payment will only be made when the seller meets the agreed-upon conditions. For the seller, it guarantees that they will receive payment as long as they fulfil their obligations.

Both the buyer and the seller may incur fees related to the issuance and processing of the LC. These fees can include application fees, confirmation fees, and handling charges.

Types of letter of credit

Types of letters of credit include:

• Commercial letter of credit: Used in international trade to make sure payment is received upon delivery of goods, it guarantees that the seller will receive payment once all terms and conditions are met.

• Standby letter of credit: Acts as a safety net for sellers, ensuring payment if the buyer fails to fulfil their contractual obligations.

• Revocable letter of credit: Can be altered or canceled by the issuing bank without prior notice to the beneficiary, offering less security to the seller.

• Irrevocable letter of credit: Cannot be changed or canceled without the consent of all parties involved, providing more assurance to the seller.

• Confirmed letter of credit: A second bank, usually in the seller’s country, adds its guarantee to the letter of credit, making sure payment is received even if the issuing bank defaults.

• Unconfirmed letter of credit: Only the issuing bank guarantees payment, without additional backing from a second bank.

• Transferable letter of credit: Allows the beneficiary to transfer part or all of the credit to another party, often used in transactions involving intermediaries.

• Back-to-back letter of credit: Consists of two letters of credit used to finance a transaction involving an intermediary, where one is issued based on the security of the other.

• Revolving letter of credit: Used for multiple transactions over a specified period, it can be reused under agreed terms without requiring reissuance.

• Red clause letter of credit: Allows the beneficiary to receive an advance on the credit before shipping goods, providing upfront funding for production or procurement.

How to apply for a letter of credit

To apply for a letter of credit, start by contacting your bank or financial institution and informing them of your need for one. You will need to provide necessary documentation, including the sales contract, invoice, and any specific terms and conditions agreed upon with the seller.

Next, complete the bank’s letter of credit application form, detailing the terms, amount, and duration of the credit. Pay any associated fees and provide collateral if required by the bank.

Once approved, the bank will issue the letter of credit and send it to the seller’s bank, making sure that all terms are clearly outlined. The seller then ships the goods and provides the necessary documents to their bank, which forwards them to your bank for verification.

Upon verifying that all terms and conditions are met, your bank processes the payment to the seller’s bank, completing the transaction.

Example of a letter of credit

Let’s consider a scenario involving a letter of credit in an international trade transaction:

Parties involved:

• Buyer: XYZ Electronics (based in the United States)
• Seller: Tech Components Ltd (based in Japan)
• Issuing bank: ABC Bank (based in the United States)
• Advising bank: XYZ Bank (based in Japan)

XYZ Electronics wishes to purchase a shipment of electronic components from Tech Components Ltd in Japan. The total value of the transaction is £200,000. To secure the transaction and reduce the risk for both parties, they agree to use a letter of credit as the method of payment.

XYZ Electronics, the buyer, approaches ABC Bank, its issuing bank in the United States, to open a letter of credit in favour of Tech Components Ltd. ABC Bank issues the letter of credit and sends it to XYZ Bank, the advising bank in Japan.

Tech Components Ltd confirms that it can meet the terms and conditions of the letter of credit. Upon receiving the documents from Tech Components Ltd, XYZ Bank verifies their compliance with the letter of credit terms. If everything is in order, XYZ Bank releases the payment of £200,000 to Tech Components Ltd.

Once the payment is made, XYZ Bank informs ABC Bank that the letter of credit has been fulfilled. The transaction is considered complete, and the letter of credit is closed.