Letter of Credit
What is a Letter of Credit?
A Letter of Credit (L/C) is a payment method that provides buyers and sellers with a guarantee from a financial institution. It is used primarily in international transactions and is one of the preferred methods of payment for buyers and sellers engaging in global trade. In a Letter of Credit, the issuing bank guarantees payment to the exporter under certain specified conditions in accordance with the strict guidelines of International Chamber of Commerce (ICC) Uniform Customs and Practice for Documentary Credits (UCP).
Types of Letters of Credit
Letters of Credit can be classified into revocable and irrevocable. With a revocable Letter of Credit, the issuing bank may alter the terms and conditions of the letter of credit at any time without notifying the seller. An irrevocable letter of credit is an L/C that cannot be modified or canceled without the consent of both the issuing bank and the seller.
How does a Letter of Credit Work?
A Letter of Credit serves as an assurance from the issuing bank to the seller, guaranteeing payment if certain specified terms and conditions are met. The buyer instructs their bank to issue the letter of credit on their behalf and the seller submits an invoice detailing the goods and services provided. The issuer then reviews the invoice to ensure that it meets all the conditions specified in the L/C. When the invoice meets the conditions, the bank will make payment to the seller.
Advantages of Using a Letter of Credit
Letters of Credit can be beneficial for both the buyer and the seller in the following ways:
Buyers:
• Provides financial security by ensuring that payments are made only if all conditions of the letter of credit are met
• Protects the buyer from fraudulent sellers
• Reduces the risk of non-payment
Sellers:
• Reduces the risk of non-payment
• Increases the confidence of the seller in dealing with international buyers
• Allows for larger purchases with a decrease in risk for the seller
Disadvantages of Using a Letter of Credit
Though Letters of Credit can be beneficial for both the buyer and the seller, it can also be costly and time consuming.
• Requires additional fees and charges from the issuing bank
• The document checking process is a lengthy one
• The issuance and negotiation process is complex
Conclusion
Letters of Credit are a payment method that can be beneficial for buyers and sellers engaging in international trade. It is a secure way for both parties to minimize the risk involved in large transactions and can provide peace of mind in the deal. Though it may be costly and the process is a lengthy one, the additional security can be worth the effort.
