The world that we live in today is interconnected and totally dependent on trade of goods. You can get an idea of this by noticing your own surroundings. The products that we use on a daily basis come from different parts of the world.
But have you ever wondered how this works? How do two transporters from the same country or different parts of the world are able to trust each other with the transport of the goods? Especially when they are mostly unknown to each other?
An agreement known as a letter of credit plays a huge role in this. In today’s blog, we will discuss what a letter of credit is, what role does it play and what are its types. So, let us get started.
What is a Letter of Credit?
A letter of credit is a document which is responsible for guaranteeing the seller of goods that he/she will be receiving a payment for transporting the goods. This document is issued when the buyer of goods contacts a financial institution. A seller is assured of the payment as this document is backed by a reputed bank.
A letter of credit is issued when a buyer pledges his/her securities or cash. This way, when the buyer is unable to make a payment to the seller, the bank will be able to recover the total or remaining amount from the pledged securities or cash.
Most commonly, a letter of credit gets issued when the transportation of goods is international and both the parties involved in this trade (Buyer and seller) do not know each other.
How does a Letter of Credit work?
Let’s take an example for better understanding. There are 2 parties involved in this transportation of goods example. Mr. A (Who is the buyer) and Mr. B (Who is the seller). Now, Mr. B does not know Mr. A personally, so he wants some sort of guarantee of payment before the deal is made. This is why Mr. A approaches his bank to get a letter of credit.
Once Mr. A’s bank issues a letter of credit, Mr. B contacts his own bank (Which acts as the intermediary in this transaction) contacts the issuer bank (Mr. A’s bank) to call the letter of credit. Then, the issuer bank credits the funds into Mr. B’s bank (Also called as the Advising bank) through international payments networks such as SWIFT.
In case Mr. A does not have the money to pay to its bank, the issuer bank will use the pledged security and cash and use it to make the payment to the advising bank.
Types of Letter of Credit
Letter of Credit can be categorised into following types –
Sight Credit
A sight credit is a type of credit which requires immediate payment upon presentation of the required documents by the seller.
Acceptance Credit
Unlike sight credit, an acceptance credit allows the buyer a pre-decided time (Which is usually when the goods have been received) for making the payment.
Revocable and Irrevocable Credit
A revocable credit is a type of credit which can be amended or cancelled by the issuing bank at any given point of time. Whereas, an irrevocable credit assures a firm commitment by the bank to pay the necessary dues under any circumstances.
Advantages and Disadvantages of Letter of Credit
| Advantages | Disadvantages |
| Letter of Credit provides an additional layer of financial security for the seller of the goods. | Issuing a letter of credit can be costly as banks charge for issuing, confirming and handling letters of credit. |
| Letter of Credit builds trust between the two parties within a transaction | The process of issuing a letter of credit can be lengthy and hectic due to all the documentation. |
| The terms of a letter of credit can be customised as per the requirements and necessities of both the parties | Letter of credit does not guarantee the quality and quantity of the goods. It simply insures the terms contained within it. |
Conclusion
To summarize, Letters of credit are a crucial tool that helps in facilitating secure both national and international trade. They promote peace of mind between the both parties involved in a transaction by guaranteeing payment upon or before fulfillment of specific conditions.
Also, by understanding the different types of letters of credit, traders can use and leverage this instrument in effectively navigating the global marketspace with greater confidence.
Also Read : How To Claim Input Tax Credit For E-Invoices
FAQs (Frequently Asked Questions)
Are letters of credit always necessary for international trade?
No, you need not use letter of credits for international trades always. They are most commonly used for highly valued transactions or when the both parties (Buyer and Seller) within a transaction are unknown to each other.
What are the costs associated with a letter of credit?
Banks can charge fees for issuing, confirming and handling the letter of credit. These fees vary from transaction to transaction.
How long does the letter of credit process typically take?
The LC process can get time consuming. This is because it involves document preparation, verification and communication between banks. The exact timeframe for cannot be told due to varying circumstances
