What is a letter of credit? How does it work?
The letter of credit (LC) also called “commercial credit” or “documentary credit”, is one of the most reliable means of payment in international trade.
In this article, we will try to understand what is the letter of credit, how does it work, what types there are and some more curiosities of this instrument, that is so common in international trade.
What is the letter of credit in foreign trade?
The letter of credit is an instrument through which an issuing bank, following the instructions of its client – (usually buyer or importer) makes a payment to a third party or beneficiary – (usually seller or exporter) against the delivery of the required documentation.
Generally, these documents evidence that the buyer received the goods in the desired condition. Documents include customs certificates, shipping documents, etc.
Its function is to guarantee the sales contracts in international trade and also the remote sales within the same country.
A letter of credit is a payment method that provides the greatest possible security for the supplier and the buyer of goods in foreign trade.
Who pays the credit?
It is understandable that the importer/ buyer will pay the amount stipulated in the letter of credit. If the conditions of letter of credit are met (products received by the buyer in good condition), the buyer shall pay the credit.
But what if the buyer is unable to pay the credit, he is supposed to? Or maybe he is not paying intentionally!
Here the letter of credit comes in action!
Since the letter of credit is issued by a financial institution that guarantees that the payment from the buyer to the seller will be received on time and in the correct amount, if the buyer is not able to make the payment, it would be the issuing bank obliged to cover the amount of the credit.
Even if a client/ buyer declared bankruptcy, the bank would be obliged to pay, as long as the documents complied with the terms agreed in the letter of credit.
Therefore, the main characteristic of the letter of credit is that it brings confidence and security to commercial transactions made from anywhere in the world.
How does letter of credit works?
Typical sequence of a letter of credit
Step 1: Exporter/ Seller and Importer/ buyer conclude a sales contract. The payments are regulated by letter of credit.
Step 2: The buyer has the letter of credit opened at his bank. Beneficiary is the seller.
Step 3: The buyer’s bank opens the letter of credit and sends it to the seller’s bank.
Step 4: The advising bank informs the seller about the receipt of the letter of credit.
Step 5: The seller delivers the goods.
Step 6: The seller submits the documents prescribed in the letter of credit to his bank.
Step 7: The advising bank checks the documents. If they are ok, the seller will get his money paid out.
Step 8: The documents go from the advising bank to the letter of credit bank. There they will be tested. If you are orderly, the letter of credit bank transfers the open amount to the advising bank.
Finally, The importer receives the documents from his bank. Afterward, he charges his account.