Letter of Credit
A Letter of Credit (LC), also known as a Documentary Credit, is a letter from a bank or financial institution guaranteeing that a buyer’s payment to a seller will be received on time and for the correct amount. If the buyer is unable to make payment for the purchase, the bank will cover the full or remaining amount of the purchase.
It is a highly effective tool for managing risk in international trade, where distance, differing laws, and difficulties in obtaining reliable information about parties can all make trading risky.
There are several types of letters of credit, including:
- Commercial Letter of Credit: This is a direct payment method in which the issuing bank makes the payments on behalf of the buyer, after the necessary documents have been provided by the seller.
- Standby Letter of Credit: This serves as a secondary payment mechanism. The bank pays the beneficiary only when the holder cannot.
- Revolving Letter of Credit: This is issued for multiple payments over a long period.
- Confirmed Letter of Credit: This involves another bank, apart from the issuing bank, who guarantees the letter of credit. It is used when the issuing bank may not be acceptable to the beneficiary or is unstable.
- Unconfirmed Letter of Credit: An unconfirmed letter of credit does not carry the guarantee of another bank apart from the issuing bank.
These are widely used in international trade for transactions between a supplier in one country and a customer in another because they provide protection for both parties. The seller is assured of payment as long as they comply with the terms of the letter of credit, and the buyer knows that payment won’t be made unless the seller fulfills these terms.
Example of a Letter of Credit
Let’s consider an example of a letter of credit in international trade:
Suppose an auto parts manufacturing company in Germany (the seller) enters into a contract to sell engine components to a car assembly company in China (the buyer). However, due to the geographical distance and different legal jurisdictions, they have concerns about the risks associated with the transaction. The Chinese company is worried about making an advance payment without certainty of delivery, and the German company is hesitant about shipping goods without a guarantee of payment.
To mitigate these risks, they decide to use a letter of credit. Here’s how it works:
- The Chinese company applies for a letter of credit from its bank (the issuing bank) in China. The bank approves the request and issues the letter of credit.
- The letter of credit is sent to a bank in Germany (the advising or confirming bank). This bank verifies the authenticity of the letter of credit and forwards it to the German company.
- The German company now has a payment guarantee from the Chinese bank, so it proceeds with the production of the engine components and then ships them to China.
- Once the goods are shipped, the German company submits the shipping documents (bill of lading, commercial invoice, packing list, etc.) to the German bank.
- The German bank checks the documents against the terms and conditions specified in the letter of credit. If everything is in order, the bank pays the German company.
- The German bank sends the documents to the Chinese bank and requests reimbursement.
- The Chinese bank checks the documents. If everything complies with the terms of the letter of credit, it reimburses the German bank.
- The Chinese bank then debits the account of the Chinese company for the amount paid out and hands over the shipping documents, which the Chinese company uses to clear the goods through customs.
In this way, the German company is assured that it will be paid for the goods it has shipped, and the Chinese company knows that the goods have been shipped before its account is debited. Both parties are protected by the use of the letter of credit.