Definition
A Letter of Credit (L/C) is a financial instrument issued by a bank on behalf of a buyer, guaranteeing that the seller will receive the agreed payment amount under specific conditions. This instrument is widely used in international trade to mitigate risks for the seller, as the bank commits to covering the payment if the buyer is unable to fulfill the contractual obligation.
Examples
- Export/Import Transactions: A US-based company enters into a contract with a manufacturer in China. The US company requests their bank to issue a Letter of Credit in favor of the Chinese manufacturer to assure payment upon shipment of goods.
- Construction Projects: A contractor is required by their client to obtain a Letter of Credit from their bank. This ensures the client that funds are available for the contractor to complete the project.
- Performance Bonds: In the event that a service provider needs to guarantee their performance about certain service levels, a Letter of Credit serves as a financial assurance to the client.
Frequently Asked Questions
What are the different types of Letters of Credit?
- Revocable and Irrevocable L/C: Whether the terms of the L/C can be modified or cancelled without the beneficiary’s consent.
- Confirmed and Unconfirmed L/C: Whether an additional bank, typically in the beneficiary’s country, adds its guarantee to the issuing bank’s L/C.
- Sight and Time L/C: Specifies whether payment is to be made immediately upon presentation of documents (sight) or after a specified period (time).
How does a Letter of Credit mitigate risk for the seller?
The issuing bank’s guarantee replaces the credit risk of the buyer with that of the bank, ensuring that the seller will receive payment as long as they comply with the terms set in the L/C.
What documents are typically required to be presented under a Letter of Credit?
Common documents include a commercial invoice, bill of lading, packing list, certificate of origin, and sometimes insurance certificates.
Who are the parties involved in a Letter of Credit transaction?
- Applicant: The buyer who requests the issuance of the L/C.
- Beneficiary: The seller or exporter entitled to payment under the L/C.
- Issuing Bank: The bank that issues the L/C at the request of the applicant.
- Advising/Confirming Bank: The bank that may add its own guarantee to the L/C and facilitate its communication.
How is a Letter of Credit different from other payment methods like wire transfer or open account?
A Letter of Credit provides a higher level of security compared to wire transfers or open accounts because it involves a bank’s undertaking to ensure payment, reducing the risk for both parties in the transaction.
Related Terms
- Bill of Lading: A document issued by a carrier acknowledging that goods have been received for shipment.
- Standby Letter of Credit (SBLC): A guarantee that a bank will cover payment if the applicant fails to fulfill their contractual obligations.
- Documentary Collection: A method where the seller instructs their bank to forward documents to the buyer’s bank with a request to release the documents to the buyer against payment or acceptance.
- Trade Finance: Financial products and services that support the financing of international trade transactions.
Online References
- Investopedia - Letter of Credit
- Wikipedia - Letter of Credit
- International Chamber of Commerce (ICC) - FAQs on Documentary Credits
Suggested Books for Further Studies
- “Letters of Credit: Theory and Practice” by Matt Penarcic
- “Uniform Customs and Practice for Documentary Credits (UCP 600)” by the International Chamber of Commerce
- “The Law of Letters of Credit and Bank Guarantees” by Agasha Mugasha
Fundamentals of Letter of Credit: International Business Basics Quiz
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