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. 

Types of LCs:

• Revocable LC: Can be modified or cancelled by the issuing bank without the consent of the parties involved.
• Irrevocable LC: Cannot be modified or cancelled without the consent of all parties involved.

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.

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 mitigate 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.