Before we talk about the advantages and disadvantages of using a Letter of Credit in International Transactions lets find out what A Letter of Credit Means.
A letter of credit, or “credit letter” is a letter from a bank guaranteeing that a buyer’s payment to a seller will be received on time and for the correct amount. In the event that the buyer is unable to make a payment on the purchase, the bank will be required to cover the full or remaining amount of the purchase. It may be offered as a facility.
Due to the nature of international dealings, including factors such as distance, differing laws in each country, and difficulty in knowing each party personally, the use of letters of credit has become a very important aspect of international trade.
Advantages of Using Letter of Credit in International Transactions
A Letter of Credit is a payment term mostly used for long-distance and international commercial transactions.
Letters of credit are indispensable for international transactions since they ensure that payment will be received. Using documentary letters of credit allows the seller to significantly reduce the risk of non-payment for delivered goods, by replacing the risk of the buyer with that of the banks. Letters of credit have become a crucial aspect of international trade , due to differing laws in each country and the difficulty of knowing each party personally.
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After trade between countries made it impossible to do business by traditional payment methods, Letters of credit make it possible to do business worldwide.
Originally, Letter of Credit was literally a letter written by the buyer’s bank to the seller’s bank promising that they guarantee to pay the seller in case of the buyer’s default.
In modern business world, a letter of credit is basically an undertaking by a bank to make a payment to a named Beneficiary within a specified time, against the presentation of documents which is strictly in compliance with the terms of the letter of credit.
That is to say, banks issue letters of credit as a way to ensure sellers that they will get paid as long as they do what they’ve agreed to do. Hence, in essence, letter of credit is a promise to pay.
This mechanism has its own jargon:
The Buyer is the Applicant or the Account Party and the Seller or the Ultimate Recipient of Funds is the Beneficiary.
The Bank that issues the LC is referred to as the Issuing Bank which is generally in the country of the Buyer.
The Bank that Advises the LC to the Seller is called the Advising Bank which is generally in the country of the Seller
Abbreviations for ‘letter of credit’ include L/C, LC, and LOC .
In the very beginning, one must note that Letters of credit deal in documents, not goods, thus the Bank scrutinizes the ‘documents’ and not the ‘goods’ for making payment which explains why the technical term for Letter of credit is ‘Documentary Credit’.
In this context, the process works both in favour of both the buyer and the seller. The instrument is designed to reduce the risk taken by each party. The Seller gets assured that if documents are presented on time and in the way that they have been requested on the LC the payment will be made and Buyer on the other hand is assured that the bank will thoroughly examine these presented documents and make sure that they meet the terms and conditions stipulated in the LC.
LC is a complex product for new importers & exporters. It’s ideal to check the advantages and disadvantages of a letter of credit (LC) before opting for it. A letter of credit is highly customizable and enables new trade relationships by reducing credit risk, but it can add to the cost of doing business in the form of bank fees and formalities. Let’s see its benefits and drawbacks in details:
Advantages of Using Letter of Credit in International Transactions
Letter of credit advantages for the seller
- The seller has the obligation of buyer’s bank’s to pay for the shipped goods;
- Reducing the production risk, if the buyer cancels or changes his order
- The opportunity to get financing in the period between the shipment of the goods and receipt of payment (especially, in case of deferred payment).
- The seller is able to calculate the payment date for the goods.
- The buyer will not be able to refuse to pay due to a complaint about the goods
Letter of credit advantages for the buyer
- The bank will pay the seller for the goods, on condition that the latter presents to the bank the determined documents in line with the terms of the letter of credit;
- The buyer can control the time period for shipping of the goods;
- By a letter of credit, the buyer demonstrates his solvency;
- In the case of issuing a letter of credit providing for delayed payment, the seller grants a credit to the buyer.
- Providing a letter of credit allows the buyer to avoid or reduce pre-payment.
How a Letter of Credit Works
Because a letter of credit is typically a negotiable instrument, the issuing bank pays the beneficiary or any bank nominated by the beneficiary. If a letter of credit is transferable, the beneficiary may assign another entity, such as a corporate parent or a third party, the right to draw.
Banks also collect a fee for service, typically a percentage of the size of the letter of credit. The International Chamber of Commerce Uniform Customs and Practice for Documentary Credits oversees letters of credit used in international transactions. There are several types of letters of credit available.
Types of Letters of Credit
Commercial Letter of Credit
This is a direct payment method in which the issuing bank makes the payments to the beneficiary. In contrast, a standby letter of credit is a secondary payment method in which the bank pays the beneficiary only when the holder cannot.
Revolving Letter of Credit
This kind of letter allows a customer to make any number of draws within a certain limit during a specific time period.
Traveler’s Letter of Credit
For those going abroad, this letter will guarantee that issuing banks will honor drafts made at certain foreign banks.
Confirmed Letter of Credit
A confirmed letter of credit involves a bank other than the issuing bank guaranteeing the letter of credit. The second bank is the confirming bank, typically the seller’s bank. The confirming bank ensures payment under the letter of credit if the holder and the issuing bank default. The issuing bank in international transactions typically requests this arrangement.
An Example of a Letter of Credit
Citibank offers letters of credit for buyers in Latin America, Africa, Eastern Europe, Asia, and the Middle East who may have difficulty obtaining international credit on their own. Citibank’s letters of credit help exporters minimize the importer’s country risk and the issuing bank’s commercial credit risk.
Letters of credit are typically provided within two business days, guaranteeing payment by the confirming Citibank branch. This benefit is especially valuable when a client is located in a potentially unstable economic environment.