What is a Letter of Credit?

A letter of credit, or "credit letter" is a letter from a bank guaranteeing that a buyer's payment to a seller will be received on time and for the correct amount. In the event that the buyer is unable to make a payment on the purchase, the bank will be required to cover the full or remaining amount of the purchase. It may be offered as a facility.

Due to the nature of international dealings, including factors such as distance, differing laws in each country, and difficulty in knowing each party personally, the use of letters of credit has become a very important aspect of international trade.

In short, A letter of credit is a document sent from a bank or financial institution that guarantees that a seller will receive a buyer's payment on time and for the full amount. Letters of credit are often used within the international trade industry. There are many different letters of credit including one called a revolving letter of credit. Banks collect a fee for issuing a letter of credit.

Related Parties

• Applicant
• Issuing Bank
• Beneficiary
• Corresponding Bank
• Negotiating Bank

Standard Process of LC Transaction

1. Buyer and seller finalize their deal and buyer approach bank to open import LC
2. Bank issue LC through advising bank and informs to exporter
3. Exporter exports as per deal and prepare document to the Bank
4. Bank forwards document to issuing bank for payment
5. Issuing bank obtain payment from importer
6. After importer receive goods from exporter issuing bank release payment to advising bank
7. Exporter Receives payment throug bank

How a Letter of Credit Works

A letter of credit is typically a negotiable instrument, the issuing bank pays the beneficiary or any bank nominated by the beneficiary. If a letter of credit is transferable, the beneficiary may assign another entity, such as a corporate parent or a third party, the right to draw.

Banks typically require a pledge of securities or cash as collateral for issuing a letter of credit. Banks also collect a fee for service, typically a percentage of the size of the letter of credit.

Types of Letters of Credit

This is a direct payment method in which the issuing bank makes the payments to the beneficiary. In contrast, a standby letter of credit is a secondary payment method in which the bank pays the beneficiary only when the holder cannot.

This kind of letter allows a customer to make any number of draws within a certain limit during a specific time period.

For those going abroad, this letter will guarantee that issuing banks will honor drafts made at certain foreign banks.

A confirmed letter of credit involves a bank other than the issuing bank guaranteeing the letter of credit. The second bank is the confirming bank, typically the seller's bank. The confirming bank ensures payment under the letter of credit if the holder and the issuing bank default. The issuing bank in international transactions typically requests this arrangement.