What Is A Letter Of Credit And When To Use It? Find The Guide
A letter of credit is a legal document that guarantees the on-time payment to the exporter. It is issued by the importer’s bank on the behalf of the importer to ensure full payment to the exporter but in the event, if the importer is unable to make a payment, the full or the remaining amount will be paid by the issuing bank on the behalf of the importer. It is widely used in international dealings due to factors involved such as distance, different laws of countries, and unfamiliarity of parties with each other. It facilitates global trade & transactions as well as reduces the risk of default of non-payment and non-performance by importer and exporter.
Parties Involved In The Issuance Of LC:
There are several parties involved in the issuance of a letter of credit. They are:
- Beneficiary / Exporter
- Issuing Bank
- Advising Bank
- Confirming Bank
When To Use A Letter Of Credit?
Any business which trades in large volumes either domestically or internationally is advised to use a letter of credit. It not only reduces the risks of fraud due to non-payment from the buyer but also assures the performance of the terms & conditions of the contract and cash flow of a company.
Here are some cases where using a letter of credit is essential. Let’s have a look:
International Trade & Transactions - As the name suggests, import & export LC are used in international transactions due to increased probability of fraud, different laws & time-zones, and unfamiliarity of the parties to the contract. So, international purchasers or wholesale producers of goods use LC primarily to ensure on-time payment for the delivered goods & services to overseas buyers that have not met with. In the event, if the buyer of the goods is unable or unwilling to make the payment, the LC takes effect and the bank covers the missing payment.
For Performance Transactions - The exporters or beneficiaries can use Standby LC in cases where the nature of the transaction is expected to take a significant amount of time to perform and requires inspection until the completion. For example, if a beneficiary hired a contractor for a building project but it is not completed on-time. Then the exporter can show the non-fulfillment of the obligations to the bank. As a result, the bank pays the beneficiary.
Recommended Read: What Is The Difference Between Bank Guarantee And Letter Of Credit?
Last Resort Payment - A Standby LC can also be used to assure the importer’s creditworthiness to the exporter and make him carry out the end of the bargain without any stress. It serves as a last resort payment for the exporters. In simple words, here the beneficiary can show his part of fulfillment to the bank and assure that payment would be released subsequently.
Payment for Intermediary’s Transactions - A LC can be essentially used in situations where a transferable LC is issued and the bank is responsible to make the payment to the secondary beneficiary nominated by the original beneficiary. It is essential in these transactions that involve middlemen and credit is transferable.
For Payment Security - It is highly recommended to use an irrevocable LC as revocable LC is associated with high risks for the exporters. The issuing bank can cancel, change, or modify the terms of LC without any prior notice to the beneficiary.
Using a letter of credit can significantly help your international business grow and improve, regardless if you are a buyer or seller of goods and services. Emerio Banque is a leading private institution providing global financial assistance and investment opportunities to all the corporate clients in need.