Letter of credits (LC)

Table of Contents

Letter of credits
What is a letter of credit?
Understanding letter of credits
Types of letters of credit
Importance of letters of credit
How a letter of credit works
Frequently Asked Questions

Letter of credits

A letter of credit assures that payment will be made to the seller as they meet the specified conditions.

Letters of credit are frequently given within two business days, ensuring payment by the Citibank office providing confirmation. This advantage is especially useful for clients who are situated in areas with uncertain economic conditions.

What is a letter of credit?

A Letter of Credit (LC) is a document that financial institutions issue to guarantee payment to a seller for goods or services a buyer has contracted to purchase.

The LC protects the seller from the buyer defaulting on payment and can be used as a form of financing for the seller. The buyer is typically responsible for paying any fees associated with the LC, such as issuance and confirmation fees. The seller presents the LC to the bank. The buyer’s bank reimburses the seller’s bank.

Letter of credits (LC)

Understanding letter of credits

There are typically three parties in a letter of credit. The beneficiary is the first, who is the individual or business that will receive payment. The purchaser of the product or application for the services comes next. This party requires a letter of credit. The organisation that issues the letter of credit, the issuing bank, is the last party.

Additionally, the beneficiary can request payment be made to an advising bank or a bank that already has the beneficiary as a customer, as opposed to the beneficiary directly. This may be carried out, for instance, if the advising bank funded the transaction on behalf of the recipient until payment was made.

Most frequently used in international commerce, letters of credit are controlled by the UCP which stands for Uniform Customs and Practise for Documentary Credits, a set of guidelines established by the International Chamber of Commerce. But as we’ll see, they may also be applied in other circumstances.

Types of letters of credit

There are four main types of letters of credit: commercial, standby, travel rules, and irrevocable.

Commercial letter of credit

Commercial letters of credit are the most common type of letter of credit. They are typically used in international trade transactions to provide payment assurance between buyers and sellers.

Standby letters of credit

They are similar to commercial letters of credit but are typically used to provide payment assurance for contractual obligations, such as construction contracts.

Traveller’s letter of credit

Travel rules letters of credit are used to provide payment assurance for travel-related expenses, such as hotel reservations and airfare.

Irrevocable letters of credit

They are the most secure letter of credit, as they cannot be cancelled or modified without all parties’ agreement.

Importance of letters of credit

In international commerce transactions, when the buyer and seller are not acquainted, credit letters are applied to reduce risk. If you’re an importer, having a letter of credit will help you make sure that your business will only make payments for purchases once the supplier has supplied proof that the products have been transported.

The letter may indicate that you are prepared to expand your commercial dealings with foreign suppliers. When doing international trade and business, this is essential.

In contrast, a letter of credit might provide reassurance to the seller if the buyer defaults on the payment. Additionally, this letter might shield the seller from any liabilities if the criteria are satisfied.

A letter of credit can assist people and businesses in getting adequate money for significant undertakings in addition to international trade. You may use this letter to check someone’s or a company’s credit standing. The financial firm will bear the costs if the buyer cannot pay for their purchases.

How a letter of credit works

A letter of credit is a contract that allows the issuing bank to operate independently or at the request and direction of the applicant (importer). The issuing bank may pay the beneficiary (or on their behalf) under an LC agreement (the exporter).

Alternatively, the issuing bank may accept the exporter’s draft or bills of exchange. Bills of exchange may also be paid or accepted by advised or nominated banks with permission from the issuing bank.

Frequently Asked Questions

What is a back-to-back letter of credit?

To get funding for a single transaction, back-to-back letters of credit need two letters of credit. These are typically employed in trades with a middleman between the purchaser and the seller.

Back-to-back letters of credit typically consist of two LoCs, one issued to the intermediary by the buyer’s bank and the other to the seller by the intermediary’s bank.

What is a letter of guarantee?

When a bank client (the principal) fails on a payment or other obligation to a beneficiary, the bank (the guarantor) agrees to pay the beneficiary a certain sum of money.

A letter of guarantee aids in the efficient operation of international commerce, as investors are more prepared to invest in riskier bonds due to the bond market’s increased security, thanks to a letter of guarantee. In this case, the bank will reimburse the person that received the guarantee for that amount.

How to apply for a letter of credit?

To apply for a letter of credit (LOC), the buyer must first contact a bank or financial institution and provide the necessary documentation, including the commercial invoice and the contract between the buyer and seller. The bank will then issue the LOC to the seller.

What is an example of a letter of credit?

Citibank provides letters of credit for purchasers in Africa, Latin America, Asia, the Middle East, and Eastern Europe who would struggle to secure foreign credit on their own. Exporters can reduce the importer’s country risk and the issuing bank’s commercial credit risk by using letters of credit from Citibank.

What is the difference between a commercial letter of credit and a revolving letter of credit?

A commercial letter of credit can be used to facilitate international trade transactions. A bank often issues a commercial letter of credit in place of a buyer to pay the vendor of goods or services. The key difference between a commercial letter of credit and a revolving letter of credit is that a commercial letter of credit is a one-time transaction. In contrast, a revolving letter of credit can be used multiple times.

When the buyer and seller are in separate nations, a commercial letter of credit is commonly employed. The commercial letter of credit provides the seller with a guarantee of payment from a reputable financial institution, which can reduce the risk associated with doing business with a new buyer. In contrast, a revolving letter of credit is typically used in situations where the buyer and seller are located in the same country.