Understand the letter of credit

An irrevocable letter of credit is a financial instrument issued by a bank at the request of a buyer to ensure payment to a seller. Under this arrangement, the seller ships the goods to the buyer, and the bank guarantees payment upon receipt of the necessary documentation, which typically includes a bill of lading or commercial invoice. The bank plays a critical role as an intermediary between the buyer and seller, effectively mitigating the risk of non-payment for the seller and non-delivery for the buyer.

The main properties of an LC are:

1.   Security: The letter of credit provides security for both the buyer and the seller. It assures the seller that payment will be made if they fulfill the terms of the agreement, and it assures the  buyer that payment will not be made until the seller has fulfilled those terms. 

 

2.     Flexibility: An LC can be tailored to meet the specific needs of the parties involved in the transaction. It can be issued in a variety of forms, such as confirmed or unconfirmed, revocable or irrevocable, and transferable or non-transferable.

 

3.     Document-based: The letter of credit is a document-based transaction, meaning that payment is made based on the presentation of specific documents, such as a bill of lading or commercial invoice.

 

4.     Universality: LCs are widely accepted in international trade, making them a preferred payment method for buyers and sellers across the globe.

 

5.     Intermediary involvement: Banks play a critical role in LC transactions, acting as intermediaries between the buyer and seller to ensure that payment is made and the terms of the agreement are met.

 

6.     Cost: The use of an LC involves fees and charges, including application fees, amendment fees, and confirmation fees, which can add to the overall cost of the transaction.

As any other trade finance instrument, LC has its own merits and limitations. Most of them are as follows:

Merits:

Secure payment: LC provides a secure way to ensure payment for goods or services in international trade, reducing the risk of non-payment for the seller.

Risk reduction: The involvement of a bank as an intermediary reduces the risk of non-delivery for the buyer, which is especially helpful when dealing with unfamiliar or overseas trading partners.

Flexibility: Letters of credit can be customized to fit the specific needs of a transaction, providing flexibility for both parties.

Wide acceptance: Letters of credit are widely accepted by most banks and businesses around the world.

Limitations:

Costly: There are fees associated with issuing and processing letters of credit, which can be a significant expense for both the buyer and the seller.

Time-consuming: The process of obtaining an LOC can be time-consuming and complex, which can delay the transaction.

Possible disputes: Disputes can arise between the buyer, seller, and bank over the terms and conditions of the LOC, which can lead to delays and added costs.

Strict compliance: The terms and conditions of an LOC must be strictly followed to ensure payment, which can be challenging for the parties involved.

Letter of credit can be a valuable tool for facilitating international trade and providing peace of mind for both parties involved. However, it's important to carefully consider the costs and requirements before deciding to use it.