What is 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 the party located on the opposite side of the globe.

A commercial letter of credit like other instruments facilitates international trade between two geographically distant countries of the world because this instrument ensures both parties that the buyer will receive the shipment as per the agreed terms and per the description on the purchase order.

Similarly, it also ensures the supplier timely payment for the shipment.

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 they are located in different countries.

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

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

Purpose:

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

Financial organizations play a key role in coordinating the efforts of sellers and buyers. 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 business entities such as risk-free international transactions, highly customizable which means that they can easily be adjusted or amended as per the need and mutual consent of the parties, and also smoothens and make it easy to transact internationally.

Types of Commercial Letters of Credit:

There are different types of commercial letters of credit, and each has its own pros and cons. This difference was 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 the buyer
  •  A commercial export letter of credit refers to the instrument in which the account holder of the issuing bank is the payee of the transaction
  • A transferable letter of credit refers to the instrument in which the original beneficiary may share the benefit with one or among more of the persons, who were/were not a party to the contract at the date of inception
  • Non-transferable is the instrument the benefit of which cannot be shared with someone else
  • A confirmed letter of credit refers to the instrument which is further backed by the second bank or a financial institution
  •  An unconfirmed instrument is one that is not further backed by the second bank or any financial institution. In other words, we can term it as a less secure instrument compared to the confirmed letter.
  •  A revocable instrument is the one, in which the issuing bank can amend or cancel the letter of credit without prior notice to the beneficiary
  • An irrevocable instrument is the one, in which the issuing bank cannot amend or cancel the letter of credit without prior notice to the beneficiary
  • A standby letter of credit refers to the guarantee that the payment will be made by the bank even after the client fails to fulfill the payment. This is considered one of the most secured forms of the instrument because it properly follows all the protocols of the banking sector
  • A revolving letter of credit refers to an instrument that can cover multiple transactions, it means that the benefit of such an instrument can be spread over many transactions
  • A back-to-back instrument is one that involves two letters of credit supporting one transaction.
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Conclusion:

A 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 international trade in the modern era.

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

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