Letter of Credit – Definition, Types, and Examples

Introduction

Modern-day trade involves global integration as a result of digitalization, and globalization. With global trade reaching new heights with every passing day, it is imperative that associated transactions are also likely to increase as a result of this.

With considerable transactions, there is also an added responsibility to ensure that organizations are able to take care of their payment cycles to maintain a seamless relationship with their subordinates.

Therefore, this has subsequently called for increased efforts being made that can protect both, the supplier, as well as the buyer in this regard. Letter of Credit tends to be one such factor that has totally enabled companies to carry out their activities internationally in a much safer manner.

Definition – What is Letter of Credit?

Letter of Credit can be seen as a document that acts as a promise from a bank to make a payment to the given supplier of the client, after verifying that these purchasers of goods and services are actually able to pay for these goods. However, it also clarifies that the payment release is subject to certain terms and conditions that need to be met.

Letter of Credit mainly involves communication between two parties, which are the Sellers Bank, and the Buyers Bank. As far as Buyers Bank is concerned, it can be seen that it plays an integral part in giving a guarantee, that the payment would be processed if the seller is able to abide by the terms and conditions that are mentioned in the Letter of Credit.

How Does a Letter of Credit Work?

After a buyer and seller are able to decide on collaborating for a business deal, they set prices and quantities. Subsequently, the buyer is supposed to send a Letter of Credit to the buyer. The seller asks for a Letter of Credit as a guarantee or an assurance that the buyer will eventually pay for the goods that he has purchased.

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The Letter of Credit, therefore, provides the guarantee to the seller, that the amount is eventually going to be remitted to him, once the given terms and conditions are duly met.

Followed by this, the buyer of goods has to contact the bank, in order to instruct for issuance of a Letter of Credit. In this case, the buyer is supposed to provide information that clearly indicates the payment that needs to be processed, in addition to the details of the seller, the shipping instructions, shipping arrival details, and any other relevant details that should be mentioned.

These particulars should ideally be mentioned in order to ensure that they are able to get a transparent transaction possible, because of which they can easily take responsibility for the payment.

After the bank has issued the relevant payment, it is then the responsibility of the bank to issue and release the funds, once the terms and conditions mentioned in the Letter of Credit have been duly managed.

The deal that takes place is between the sellers’ bank, and the buyers’ bank, where they are in coordination about the status of the goods under transit, and the timeline as to when the payment is going to be released.

Therefore, in order to get the payment that is mentioned in the LOC, it is also important for the seller to ensure that he has abided by all the terms and conditions that are mentioned in the Letter of Credit.

This includes the timeline of delivery, possible inspections (for purposes of quality control), and other relevant documents being submitted at the respective receiving bank.

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After the documents arrive at the seller’s bank, it is important for the bank to verify these documents and if they have subsequently met the requirements of the Letter of Credit.

Therefore, this mainly comprises of communication between the seller’s bank, as well as the buyer’s bank. Based on this communication, the payment is processed and subsequently released by the given bank.

Conclusion

Therefore, it can be seen that Letter of Credit is regarded as one of the most integral documents that are used for facilitating trade between two different companies, which are geographically dispersed.

In this case, a Letter of Credit acts as a mechanism to reinforce trust between both the parties, since they are conducting trade without physically seeing each other, in most cases. Despite the fact that Letter of Credit involves a tedious process, and has a number of moving parts involved, yet it can be seen that it really helps trade to take place in a much safer manner.

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