A letter of credit (also known as an LC or letter of undertaking) is a financial instrument commonly used in international trade. Typically issued by a bank, it’s a binding agreement between the bank, a buyer (applicant), and a seller (beneficiary). It serves as a guarantee that the seller will get paid for contracted goods upon fulfillment of all conditions stipulated in the document.
What are letters of credit used for?
A letter of credit is a useful tool for mitigating risk in business transactions where the parties may not have worked with one another previously or do not operate under common regulations and customs.
For importers, letters of credit have several benefits. They can help to seal the deal by demonstrating that the buyer is serious and has the capacity to pay. They ensure that buyers won’t have to pay for goods until they receive confirmation of shipment. And by eliminating the need for advance deposits, they enable buyers to maximize working capital.
Letters of credit also protect the interests of exporters. They safeguard against the possibility that exporters won’t get paid once the goods are shipped – in such a situation, the issuing bank will cover the amount due. Letters of credit can also be used as collateral to secure short-term loans – an especially valuable benefit in economic climates where liquidity is constrained and borrowing options are limited. This can help ensure an order is fulfilled in a timely fashion.
Types of letters of credit
There are several different types of letters of credit. Each type can help to support specific business and trade scenarios.
Commercial
Sometimes known as an import/export letter of credit or a documentary credit (DC), the commercial letter of credit is the most common type of letter of credit. It involves a bank serving as a neutral third party and making direct payment to the beneficiary when all contractual agreements have been met. Commercial letters of credit are frequently used for one-off transactions.
Revolving
Firms with an ongoing relationship with a partner may opt for a revolving letter of credit. Unlike a standard commercial letter of credit, the revolving letter of credit can cover multiple transactions – or multiple phases of a complex project – over a specified period (often between one and three years).
Confirmed
A confirmed letter of credit is guaranteed by a second (confirming) bank, usually one that is familiar to the seller and is located in their home country. In the unlikely event that the issuing bank for a letter of credit fails to disburse funds once all terms of sale have been fulfilled, the confirming bank agrees to cover the bill (and then pursue subrogation from the issuing bank). Confirmed letters of credit can help to promote trust between buyers and sellers with little common ground.
Traveler's
When importers go abroad on business, they will sometimes obtain a traveler’s letter of credit. Rather than having a named beneficiary, this letter is addressed to one or more correspondent banks across national borders. Backed by the issuing bank’s credit, the bearer can withdraw specified amounts of money from those correspondent banks. This eliminates the need for carrying large amounts of money and paying hefty foreign exchange fees.
Standy
Normally, a letter of credit ensures timely payment unless something goes awry with the transaction. Conversely, a standby letter of credit (SLBC or SLOC) guarantees payment only if the buyer defaults on the agreement. This means that the majority of standby letters of credit are never acted upon, so the process and paperwork may be streamlined.
Irrevocable
Today, most letters of credit are irrevocable, meaning that they can’t be changed without authorization from all parties. This provides an extra layer of assurance for beneficiaries and applicants alike.
Read Clause
Rather than using a letter of credit as collateral for a loan from a separate bank, beneficiaries can get immediate access to cash with a letter of credit containing a red clause. In this scenario, an unsecured loan is extended by the buyer to the seller as part of the letter of credit, usually in the form of a percentage advance. This can enable sellers to finance materials and other related costs, thus facilitating the deal. The loan amount is then deducted as a credit against the invoice presented by the seller.
Deferred Payment
Also known as term letters of credit or usance letters of credit, a deferred payment letter of credit makes sellers wait to receive funds until a specified period has passed. This is primarily an advantage for buyers, because it gives them more time to determine that they are fully satisfied with the transaction or to resell the goods received in order to cover payment for the transaction.
Sight
With a sight letter of credit, payment occurs immediately once the beneficiary has submitted the required documents to the issuing bank and those documents are reviewed.
Back-to-Back
A back-to-back letter of credit is a more complex strategy that involves an issuing bank, an applicant, a beneficiary, an intermediary, and two separate letters of credit. The applicant (or buyer) secures a letter of credit to pay the intermediary. The intermediary then secures a letter of credit to pay the beneficiary (or seller). Back-to-back letters of credit can be used to guarantee payments to suppliers, subcontractors, or sales agents.
Parties involved in a letter of credit transaction
In a letter of credit transaction, there are several parties involved. Understanding who is who throughout this process can help you better navigate the process and the roles and responsibilities of each party.
Applicant
An applicant is a buyer who requests that their bank issues a letter of credit.
Beneficiary
A beneficiary is a seller to whom payment is disbursed once all contractual obligations have been performed.
Issuing bank
Sometimes referred to as the opening bank, the issuing bank generates the letter of credit at the request of the applicant and, in most cases, makes direct payment to the beneficiary when conditions are met.
Advising bank
An advising bank may transfer documents to the issuing bank on behalf of the beneficiary. In instances of international transactions, the advising bank is normally located in the beneficiary’s home country.
Confirming bank
In the case of a confirmed letter of credit, the confirming bank is typically a financial institution located in the beneficiary’s home country that provides an additional guarantee to that party.
Negotiating bank
A negotiating bank handles the documents submitted by the beneficiary. In some cases, it may make payments to the beneficiary and then claim repayment from a reimbursing bank.
Reimbursing bank
A reimbursing bank hosts the paying account set up by the issuing bank and honours reimbursement claims made by the negotiating bank.
Secondary beneficiary
A second (or secondary) beneficiary is a specified party, such as a corporate parent or broker, to whom a beneficiary can transfer all or part of the value of a letter of credit. This party may also be known as the transferee.
How does a letter of credit work?
When an applicant requests a letter of credit from a bank, they’re asking the bank to assume some of the key risks and responsibilities of the deal. To mitigate these risks, the issuing bank may require the applicant to pledge securities or cash, or to obtain a commercial line of credit.
The bank will also charge the applicant one or more fees, which may be flat or percentage-based.
Once the request is approved and the fees are paid, the bank will issue the letter of credit, payable to the named beneficiary or a bank of their choice when all conditions of the purchase agreement have been satisfied.
Advantages and disadvantages of a letter of credit
Letters of credit are useful and sometimes necessary tools for facilitating global commerce. But it’s important to know the pros, cons, and alternatives.
Advantages of letter of credit
Letters of credit can:
● Promote trust between buyers and sellers across national borders
● Help parties to clearly outline the terms and conditions of the deal
● Offer security and cash flow benefits to both the buyer and seller
● Be customized according to the needs and goals of both parties
● Streamline the payment process in challenging trade environments
Disadvantages of letter of credit
Letters of credit do have certain limitations, which can:
● Place transactional costs disproportionately on the buyer’s side
● Be a complex and time-consuming process for all involved parties
● Leave key aspects of transactions (like speed and quality) uncovered
● Be unresponsive to changes in the legal or economic environment
● Provide a less comprehensive solution than trade credit insurance
Differences between letters of credit and trade credit insurance
Although both letters of credit and trade credit insurance help mitigate risk for parties involved in international transactions, there are a few key differences.
Trade credit insurance, specifically, offers businesses protection against risk of non-payment due to customer insolvency or credit-related defaults. While a letter of credit typically provides coverage for a single transaction, trade credit insurance can cover a variety of transactions with a given customer over a period of time.
Additionally, letters of credit involve multiple parties (including an applicant/buyer, beneficiary/seller, and a variety of banks including an issuing bank, advising bank, confirming bank, reimbursing bank, and negotiating bank). Conversely, trade credit insurance has fewer parties involved – typically, focused on a business and their insurance provider.
For more unique needs, you may be interested in alternatives to letters of credit to help you gain greater peace of mind for your business and tap into world-leading solutions.