What is a Letter of Credit (L/C)?
A Letter of Credit (L/C) is a financial document provided by a bank or another financial institution which guarantees the payment from a buyer to a seller, provided that certain terms and conditions are met. Letters of Credit are predominantly used in international trade to mitigate the risk of non-payment and ensure that transactions between unfamiliar parties proceed smoothly.
Letters of Credit are issued by a bank and stipulate that the bank will cover the cost of the transaction, provided the seller submits documentation as per the agreed terms within a specified timeframe.
Types of Letters of Credit
- Commercial Letter of Credit: A primary payment method in international trade which serves as a straightforward means to process transactions.
- Standby Letter of Credit: Acts as a secondary or backup payment method that kicks in if the buyer fails to complete the payment.
- Revolving Letter of Credit: Allows the purchaser to partake in multiple transactions through a single letter of credit.
- Traveler’s Letter of Credit: Issued for people traveling abroad ensuring that the bearer will be covered for goods or services up to a specified amount.
- Confirmed Letter of Credit: Issued when a second bank confirms the obligation of payment apart from the issuing bank, providing additional security.
Examples
- International Trade: Company A in Country X orders goods from Company B in Country Y. To reduce risk, Company A gets an L/C from its bank guaranteeing that payment will be made once Company B ships the goods and submits all required documentation to the bank.
- Construction Projects: A construction company entering a new market might use an L/C to assure local suppliers that they will be paid for their materials and services upon meeting certain milestones.
Frequently Asked Questions (FAQs)
Q1: What is the primary purpose of a Letter of Credit?
A: The primary purpose of a L/C is to reduce the risk of non-payment between buyers and sellers, particularly in international trade, by providing a financial guarantee that payment will be made once the terms of the agreement are fulfilled.
Q2: Who are the main parties involved in a Letter of Credit?
A: The main parties involved in a L/C are the applicant (buyer), the beneficiary (seller), the issuing bank (buyer’s bank), and usually a confirming bank.
Q3: Can a Letter of Credit be revoked?
A: Most L/Cs are irrevocable, meaning they cannot be amended or canceled without the agreement of all parties involved.
Q4: How does an L/C support the seller?
A: It provides the seller with a guarantee of payment from the bank, reducing the risk of non-payment from the buyer.
Q5: What documents are typically required for an L/C?
A: Common documents include a bill of lading, commercial invoice, insurance certificate, certificate of origin, and packing list.
Related Terms
Trade Finance: Financial products and instruments that facilitate international trade by mitigating risks and providing financing solutions.
Bank Guarantee: A type of financial backstop offered by a lending institution, ensuring the liabilities of a debtor will be met.
Documentary Collection: A process by which banks handle the exchange of documents and payments between buyers and sellers.
International Business: The exchange of goods, services, technology, and capital between various countries.
Online References
Suggested Books for Further Studies
- “International Letters of Credit: In Practice” by John D. Dolan
- “Trade Finance Guide: A Quick Reference for U.S. Exporters” by International Trade Administration
- “UCP 600 - Uniform Customs and Practice for Documentary Credits” by International Chamber of Commerce
- “Letters of Credit Under International Trade Law: UCC, UCP, and ISP” by Dr. Brooke Wunnicke
Fundamentals of Letter of Credit: Finance Basics Quiz
Thank you for exploring the concept of Letters of Credit and tackling our instructional quiz questions. Your understanding of this critical financial instrument is essential for navigating international business and trade finance!
