Letter of Credit
A Letter of Credit (LC) is a specialized form of banking transaction which can be described as a form of guarantee to ensure one party meets its obligation to another party. It is a widely accepted and utilized form of payment in international business. The LC provides security from the issuing bank to transfer payment on behalf of the buyer to the supplier upon completion of delivery.
The main purpose of a letter of credit is to facilitate international trade by providing assurance to the buyer and seller that the contracted terms of payment for a sale will be fulfilled. This means the buyer cannot default on the transaction, thereby protecting the interests of the seller. If the buyer defaults, the supplier has recourse not to the buyer but to his financial institution, the issuing bank.
The two most important parties in regards to the letter of credit are the issuing bank, sometimes referred to as the buyers bank, and the beneficiary, sometimes referred to as the seller. The issuing bank is the financial institution responsible for issuing the letter of credit and providing the guarantee to the seller in case the buyer fails to fulfil their payment obligations. The beneficiary is the party who will receive the value of the letter of credit in case the buyer defaults on the payment. The beneficiary is typically the seller and therefore will use the LC as a form of cash payment.
The letter of credit is a document drafted by the issuing bank, outlining all the terms and conditions the buyer and seller must meet in order for the LC to be successfully completed and payment to be released. The terms and conditions of an LC include details such as the letter of credits validity, amount to be transferred, currency, and delivery terms. The issuing bank retains the right to review the details of each transaction if a dispute arises.
In order to obtain a letter of credit from an issuing bank, both parties must provide relevant information, proof of delivery, and payment. The buyer’s bank will conduct its due diligence and review the documents to fulfil its responsibility as the issuer.
When the beneficiary has fulfilled their obligations (including timely delivery of the goods or services), they present the documents stated in the letter of credit to the issuing bank, which makes payment to the beneficiary. If the issued documents comply with the conditions of the letter of credit, the payment will be carried out immediately.
For international business, the benefits that letters of credit offer are twofold. They reduce the risk associated with non-payment and non-delivery by providing a secure and reliable form of financing to the buyer and seller. The letter of credit removes the uncertainty of foreign payments and offers a secure form of payment for goods and services.
