Letter of Credit is a payment mechanism meant for long-distance and overseas commercial transactions. It is meant to provide an economic guarantee from a creditworthy bank to the exporter and provides them the assurance that they would receive their rightful payments. The usage of such a documentary letter of credit enables the exporters to considerably reduce the risks associated with non-payment of delivered goods by essentially replacing the importer’s risk with that of the banks.

The usage of letter of credit

A letter of credit can be considered an undertaking by a bank to make payment to the specific beneficiary within a particular period, against the presentation of proper documentation in compliance with their terms. In simpler terms, banks issue letters of credit as a means to see to it that the exporters get paid as long as they complete their agreed job.

Today, letters of credit are considered to be a crucial aspect of overseas trade. They have a vital role to play in minimizing issues that may take place, owing to the varying laws of each country and having no personal knowledge of the parties involved. It is widely preferred in international transactions, majorly because the letter of credit favors both the importers and the sellers and reduces the risks taken by both parties.

Advantages for the exporters:

  • They get assurance from the bank of the importers that the payment shall be made properly for the goods delivered
  • They get to lower their production risks associated with the eventuality that the importer changes or entirely cancels their order
  • They can effectively calculate the payment date for the goods
  • The importer would not be able to turn down payment by making complaints about the goods

Advantages to the importers:

  • Payments would be made by the bank to the exporter only after they present proper documentation that signifies that they have met all the terms underlined in the letter of credit
  • The importers can control the period for shipping of the goods
  • They can effectively demonstrate their solvency through the letter of credit
  • The exporter grants credit to the importer in case of issuing a letter of credit providing for delayed payment
  • They can avoid or reduce prepayment

There are several types of letters of credit used today, each of them being ideal for distinguished trading situations. The most popular ones are standby letters of credit, revocable letters of credit, commercial letters of credit, and revolving letters of credit. Every letter of credit, no matter its type, has to be agreed to by both parties before it is submitted to the guaranteeing bank for review.