What is a Letter of Credit and How Does it Work?

A letter of credit(LC) was first introduced by the European in the late 19th century and was controlled by international rules and procedures.

International Chamber of Commerce survey the preparation of the first Uniform Customs and Practice for Documentary Credits (UCP) in 1933, which lead to the creation of a voluntary framework for commercial banks to apply to transactions worldwide.

A letter of credit (LC) is a significant means of payment in international trade, it involves a buyer and a seller who might not know each other or united by same law or trading customs, meeting up for transaction. A letter of credit is a traditional method use to reduce the risk a seller of goods takes when providing those goods to a buyer. 

Basically, a credit letter is a written document from a bank confirming that a buyer’s payment to a seller will be payed without delay. However, if the payment was not made on time or the buyer failed to meet up, the bank will pay the seller for the goods.

In this article, I’ll be explaining everything you need to know about, What is a letter of credit, how it works, the types of letters of credit, the advantages and disadvantages of letters of credit and more.

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What is a Letter of Credit?

A Letter of Credit, also known as a credit letter or a documentary credit, is a primary method of payment which can be use for making transactions/buying of goods from another country.

A Credit letter is a document written by a bank at the request of the seller, and in this letter the bank guarantees to pay the seller half or the full amount in a specific time frame, and this letter can only be use when the buyer failed to pay up the seller, then the bank will cover the cost.

Letters of credit are used widely in the providing of funds for international traders and the Parties to LC transaction are:

1. The Buyer or Importer; is the customer/applicant requesting for a Letter Credit to be issued.  

2. Seller or Exporter: is the Beneficiary/Recipient of the Letter of credit, and it is the person/company who will be paid under the letter of credit.

3. The Issuing Bank: is the bank that gives the documentary credit.

4. Advising Bank or Seller’s Bank: is the bank that advises the Letter of credit to the recipient.

5. Confirmation: is a promise from a bank different from the issuing bank that adds its official indicator in other to guarantee more security to the recipient.

6. Complying Presentation: are documents that meets the requirements of the letter of credit.

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What are the Documents Required for LCs Presentation?

In order to receive payment, the exporter/seller must understand the terms and condition of international trade, by complying presentation required by the Letter of credit. The documents usually requests an original bill of lading and other documents such as:

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1. Insurance documents — is an insurance policy/certificate.

2. Commercial documents — is an invoice list

3. Shipping documents — usually includes, CMC, bill of lading, lorry or truck receipt, railway receipt, CMCairway bill, forwarder cargo receipt anf others

4. Official documents — usually includes origin certificate, embassy legalization, inspection certificate, and others.

5. Financial documents — usually includes bill of exchange and a co-accepted draft

How Does a Letter of Credit Work?

A credit letter is quite easy to understand and here is how it works:

1. Importer

As an importer/buyer, you play a major role and making use of a credit letter, will serve as a protection and help you conserve your funds. When you send a letter of credit, the bank will charge a fee, to cover the cost.

A letter of credit summarize the terms and conditions under which payment will be made to an exporter.

The issuing bank usually act on behalf of its client the “Importer” to ensure that all conditions are formally met, before the letter of credit are released. Credit letter helps to minimize risk in international trade for both the Importer and the Exporter.

2. Exporter

As an exporter, you’re quite on the safer side because, the letter of credit serves as an insurance that, when a buyer fails to pay for your goods, the issueing bank will cover the outstanding cost of the goods, and a credit letter also saves you the risk of fallen into the wrong hands by ending your payment.

How Can I be Eligible for a Letter of Credit?

You can be eligible, if you are a customer of a bank, and you have a good background as an importer. You’ll work with the bank to issue the letter of credit to the seller/beneficiary, and this will help you conserve your funds.

How to Apply for a Letter of Credit?

You can apply for a letter of credit through your bank. You can request to open a Letter of credit from your bank directly by filling up an application form, and once approved, you can decide to collect a fee or a percentage from the total amount.

The required documents for opening and LC are a copy purchase order, expert contract, or any other important documents.

What is a Discount Rate in the Letter of Credit?

Are you wondering if there is a discount rate for a Letter of credit?

Yes, there is, although not all banks offer a discount rate, but a good percentage of banks offer a discount rate for a Credit letter. 

Types of Letters of Credit

Here are a few types of letters of credit available

1. Revocable/ Irrevocable Credit Letter: 

A credit letter can be revocable or irrevocable, any cancelation or amendment of a credit letter, are you be done through the right channel?

And in this case, it has to be approved by the seller before the buyer can make any corrections.

2. Import/Export (Commercial) Credit Letter: 

This type of credit letter can be referred to as an export/import letter of credit. It can be called an Import Credit letter or an Export Credit letter.

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3. Confirmed/Unconfirmed Credit Letter: 

For a credit of letter to be genuine, it has to be confirmed by another bank in order to acknowledge a complying presentation.

4. Revolving Credit Letter

A revolving letter of credit enables a seller to make many draws within a limit.

And it is single letters of credit that protect various transactions over a long or short time frame.

5. Restricted/ Unrestricted Credit Letter: 

The advising bank can obtain a bill of exchange from the explorer, if there is a restricted letter of credit or if the confirmation bank is not available.

That is, the seller can present the bill of exchange to other banks and still get paid on an unrestricted credit letter.

6. Deferred / Usance: 

This type of credit letter can occur when credit is not paid after its presentation, and it extends the payment date but is later accepted by both the exporter (seller) and the importer (buyer). 

7. Transferable Letter of Credit

This type of credit letter, gives the exporter (seller) the right to make funds available to more beneficiaries.

They can transfer funds from the primary beneficiary to the issuing bank when the primary beneficiary does not provide the documents by him/herself.

8. Traveler’s Letter of Credit

A person or group of people traveling abroad uses this type of letter of credit, and this letter will guarantee that using the bank will give consent to the payment of credit to the seller with the available currency.

9. At Sight: 

This is a type of credit letter, allows the bank to pay for the goods after checking the authenticity of the documents presented by the seller.

10. Standby Letter of Credit (SBLC): 

This type of credit letter is similar to a commercial letter of credit, and it is used to provide a source of payment.

SBLC is a legal document that confirms a bank’s commitment of payment to a seller.

 11. Back to Back Letter of Credit:

They can use this type of credit letter when an exporter has to buy a subcontract or larger part of a product but is not financially buoyant, the importer can then purchase a letter of beneficiary for the exporter to guarantee payment of goods.

Back-to-back letters of credit are mostly used to guarantee commission payments to a third party acting as an agent for the seller.

Pros of a Letter of Credit

1. A letter of credit has lots of advantages and here is a list of the letter of credit advantages:

2. One of the pros of a credit letter is that it lowers the risk of paying and non-paying buyers,

3. A letter of credit protects the seller even when the buyer refuses to pay for the goods.

4. One of the pros of a letter of credit is that the exporter and importer can work on acceptable payment conditions for a transaction i.e they can both agree to customize the Letter of credit.

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5. A letter of credit provides a secure method of payment

6. A letter of credit acts as a safeguard on activities such as quality control, delivery, and more.

7. With a letter of credit, there is a guaranteed payment for the seller

8. Letter of credit is quite easy to apply for, whether you are a big-time or small-time seller. They can easily apply it online or directly from the bank.

Cons of a Letter of Credit

Just as the advantages of a letter of credit are good, there is a downside to a letter of credit. And they include:

1. One disadvantage of a letter of credit is that the issuing bank can be exposed to the risks of various fraudulent transactions by the seller. Fraudsters make use of letters of credit to scam issuing banks via the presentation of false documents. They also use it as a fraudulent investment scheme in which many banks fall victim to these schemes. It also exposed the beneficiary to the risk of failure to agree to the credit conditions and even slow payment from the issuing bank.

2. The Risk Exposure of Letters of Credit usually occurs in international trades. There are also Legal Risks involved where the government’s actions outside the control of the buyer or the seller can limit or prevent the credit letter performance, it is important to understand the legal part of the deal before dealing.

3. When the buyer cannot pay on time or refuses to pay, the applicant becomes exposed to several charges from the bank and if not carefully handled, it can lead to bankruptcy. 

4. Letters of credit are usually costly to get the applicant mostly paid because covering negotiation, Issuance charges, reimbursements, and other charges and the valid date of a letter of credit is not that long as they are time-sensitive.

FAQs

How does it letters of credit helps seller?

Letter of credit from a bank serves as an assurance that a seller (exporter) will receive full payment of their goods, as long as you met the conditions.

Is letter of credit safe?

Yes, letter of credit are secure.

How much does bank charges for Letters of credit?

Depending on bank, charges might differ.

Can I get a discount rate in letter of credit?

Most banks offer more discount rate than others.

Why should I appy for a letter of credit?

A letter of credit can help you cover most of your expenses even when you can’t pay for them.

Conclusion

A letter of credit (LC) can also be referred as a credit letter or a documentary credit, and it is mostly used simply for financing international trade between an importer and exporter. It also serves as an assurance that a seller will get his/her payment after sending the goods.

I am sure this overview will answer most of your questions on “What is a Letter of credit”.

References

  • BDC- https://www.bdc.ca/en/articles-tools/marketing-sales-export/export/what-is-a-letter-of-credit
  • Wikipedia- https://en.m.wikipedia.org/wiki/Letter_of_credit
  • Investopedia- https://www.investopedia.com/terms/l/letterofcredit.asp
  • DBS- https://www.dbs.com/in/sme/businessclass/articles/business-strategy/5-advantages-of-using-a-letter-of-credit.page

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