What is a 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, associated transactions are also likely to increase.

With considerable transactions, there is also an added responsibility to ensure that organizations can 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 enabled companies to carry out their activities internationally much more safely.

Definition – What is a Letter of Credit?

A 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 can 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, 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 will be processed if the seller can abide by the terms and conditions mentioned in the Letter of Credit.

How Does a Letter of Credit Work?

After a buyer and seller decide to collaborate on a business deal, they set prices and quantities. Subsequently, the buyer is supposed to send a Letter of Credit to the buyer.

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The seller asks for a Letter of Credit as a guarantee or an assurance that the buyer will eventually pay for the goods he has purchased.

The Letter of Credit guarantees the seller that the amount will eventually 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, to instruct for issuance of a Letter of Credit.

In this case, the buyer is supposed to provide information that indicates the payment that needs to be processed, in addition to the seller’s details, the shipping instructions, shipping arrival details, and any other relevant details that should be mentioned.

These particulars should ideally be mentioned to ensure that they can get a transparent transaction possible because 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 takes place between the sellers’ bank and the buyers’ bank, where they coordinate the status of the goods under transit and the timeline for when the payment will be released.

Therefore, to get the payment mentioned in the LOC, it is also important for the seller to ensure that he has abided by all the terms and conditions 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 communication between the seller’s bank and the buyer’s bank. Based on this communication, the payment is processed and released by the given bank.

Conclusion

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

In this case, a Letter of Credit is a mechanism to reinforce trust between both parties, since they are conducting trade without physically seeing each other, in most cases.

Even though a Letter of Credit involves a tedious process and has several moving parts, it can be seen that it helps trade take place in a much safer manner.