A commercial letter of credit: Definition, Purpose, Types, and More

Definition:

International trade in such a diversified world is very difficult to manage because one cannot easily trust on the party located at the opposite side of the globe.

A commercial letter of credit like other instruments facilitates the international trade between two different geographically distant countries of the world because this instrument ensures both the parties that the buyer will receive the shipment as per the agreed terms and as per the description on the purchase order, similarly it also ensures the supplier for timely payment for the shipment made.

Both the parties to the transactions are satisfied that they will successfully transact with the help of banks and other financial institutions as per the terms and conditions though located in different countries.

Thus, in short it fulfils the contractual liabilities in case of default, if the buyer will default the issuer bank will pay the amount to the supplier and in other case the confirming bank will pay the amount to the beneficiary.

The commercial letter of credit can be of different periods that is the 90 days, 60 days and 30 days, this period can be calculated according to the time when funds due in this period.

Purpose:

The purpose of commercial letter of credit is crystal clear that it is an instrument in order to successfully complete any commercial transactions without hurting any rights and benefits of either of the party.

Financial organizations play a key role in coordinating the efforts of seller and buyer. This is a direct mode of payment in which the issuing bank pays directly to the beneficiary of the transactions.

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These instruments provide many benefits to the business entities such as risk-free international transactions, highly customizable which means that it can easily be adjusted or amended as per the need and mutual consent of the parties and also smoothens and make easy to transact internationally.

Types:

There are different types of commercial letter of credit, each with have its own pros and cons. This difference mainly created due to the changes made in the instrument as per the needs of contracting parties to the agreement. These types are further elaborated as under:

  • Import commercial letter of credit refers to the instrument in which the account holder of the issuing bank is buyer
  •  Export commercial letter of credit refers to the instrument in which the account holder of the issuing bank is payee to the transaction
  • Transferable letter of credit refers to the instrument in which the original beneficiary may share the benefit to one or among more of the persons, who was/were not party to the contract at the date of inception
  • Non-transferable is the instrument the benefit of which cannot be shared with someone else
  • Confirmed letter of credit refers to the instrument which is further backed by the second bank or a financial institution
  •  Unconfirmed instrument is the one which is not further backed by the second bank or any financial institution. In other words, we can term it as less secured instrument compared to the confirmed letter.
  •  Revocable instrument is the one, in which the issuing bank can amend or cancel the letter of credit without prior notice to the beneficiary
  • Irrevocable instrument is the one, in which the issuing bank cannot amend or cancel the letter of credit without prior notice to the beneficiary
  • Standby letter of credit refers to the guarantee that the payment will be made by the bank even after the client fails to fulfil the payment. This is considered as one the most secured form of instrument because it properly follows all the protocols of the banking sector
  • Revolving letter of credit refers to the instrument which can cover multiple transactions, it means that the benefit of such instrument can be spread over many transactions
  • Back-to-back instrument is the one which involves two letters of credit supporting one transaction.
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Conclusion:

Commercial letter of credit is made in order to make direct payment to the beneficiary on behalf of the client of issuing bank. Such letters of credit are the main drivers of the international trade in the modern era.

This is the only way of exchanging abundant resources to the economies with scarce resources and help in maintaining the balance of resources between the world economies.

These letters of credits reduce the credit risk of the supplier and increase trustworthiness of the buyer, which ultimately benefits to the end user of the product because high increased in competition.

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