Menu
Menu

Letter of Credit

In today’s fast-paced world, international trade is the backbone of global finance. However, when it comes to building trust between parties often unfamiliar with each other. Trust is incredibly important when agreeing on payment terms. One of the most trusted instruments in mitigating trade risk is the letter of credit.

A letter of credit is bank-issued financial guarantee, which is relevant where there is an importer or an exporter. A letter of credit plays a significant role in safeguarding both importers and exporters in cross-border transactions

Why Letters of Credit Matter

A letter of credit is crucial as trust is vital in trade. While some transactions operate and open account terms, an LC is often a more secure structure. There are many types of LCs, and most of them today. People often get confused between commercial letters of credit and standby letters of credit.

Depending on the perspective of the buyer or seller, there are also:

  • Import letters of credit, which are set up by the importer or the buyer of goods or services

  • Export letters of credit, which are set up by the importer or exporter

Menu

What is a Letter of Credit?

A letter of credit is crucial as trust is vital in trade. While some transactions operate and open account terms, an LC is often a more secure structure. There are many types of LCs, and most of them today. People often get confused between commercial letters of credit and standby letters of credit. Depending on the perspective of the buyer or seller, there are also import letters of credit, which are set up by the importer or the buyer of goods or services, and export letters of credit, which are set up by the importer or exporter.

How Does a Letter of Credit Work?

  1. The buyer requests the bank to issue an LC in favour of the seller
  2. The bank, often in the seller’s country, communicates the LC
  3. The seller ships the goods and submits the documents according to the LC terms and conditions.
  4. Upon the verification of documents, payment is released

Advantages

  • Clarity: All terms and goods in the LC are very specific and clearly defined
  • Security: Payment is only made when all terms are fulfilled, so there is security for the buyer
  • Efficiency: Letters of credit can be raised electronically through an online trade portal
  • Enable global reach: Letters of credit allow companies to trade safely in unfamiliar markets.

Different Types of Letters of Credit

1. Standby LC

This LC is closer to a bank guarantee and is only used if the buyer fails to fulfil payment obligations. Provides extra assurance to the seller.

2. Confirmed LC

In addition to the bank guarantee of LC Ishwar, this LC type is confirmed by the seller’s Bank or any other bank. Adding its guarantee on top of the issuing bank’s commitment.

3. Unconfirmed LC

Only the issuing bank is responsible for the payment. No added security from the second bank.

4. Back-to-Back LC

This LC type considers issuing the second LC on the basis of the first letter of credit. It is often used by intermediaries who buy from third parties to fulfil the original contract.

5. Transferable LC

This LC enables the seller to assign part of the letter of credit to another party. It is useful in multi-supplier or intermediate transactions.

6. Payment at Sight LC

According to this LC, payment is made immediately upon submission, typically within seven days.

7. Red Clause LC

The seller can request an advance for an agreed amount of the LC before shipment of goods and required documents. This red clause is so termed because it is usually printed in red on the document to draw attention to the advance payment term of credit.