Understanding the Letter of Credit Process: From Issuance to Payment

Business transactions often require a certain level of trust, which a Letter of Credit (LC) provides. This document serves as a guarantee in international trade, ensuring the rights of both the buyer and the seller. In this article, we'll delve into the steps involved in the LC process, from issuance to payment.

The Role of the Issuing Bank in Letters of Credit

When a buyer requests a Letter of Credit from their bank, the issuing bank is responsible for ensuring payment to the seller based on the stipulated documents. The key point to remember is that the banker deals in documents, not goods. Thus, as long as the seller submits the required documents to the LC opening bank, the issuing bank is obligated to honor the payment, regardless of whether the goods themselves have been received by the buyer.

The Four Main Types of Letters of Credit

Letters of Credit can be categorized into four main types:

1. Revocable Letter of Credit (LC)

A revocable LC allows the issuing bank to cancel or modify the terms without permission from the buyer, seller, or advising bank. Due to the lack of strictness and security, this type is less commonly used. However, a revocable LC can be reversed into an irrevocable LC under certain conditions.

2. Irrevocable Letter of Credit (LC)

Irrevocable LCs cannot be cancelled or modified without the explicit consent of all parties involved. This ensures a level of transparency and commitment, making it a preferred choice for most international transactions.

3. Revolving Letter of Credit (LC)

Revolving LCs allow for multiple transactions, typically for a specific period. Each transaction is determined by the documents received, and such an LC might be used by buyers requiring multiple shipments from the same seller.

4. Standby Letter of Credit (LC)

A standby LC is essentially a Bank Guarantee (BG). It is used to secure performance in financial transactions, such as ensuring that a party reimburses a buyer if the seller fails to fulfill obligations.

Confirmation of a Letter of Credit

If the LCB (LC Opening Bank) is not deemed credible by the exporter, a confirmation of the LC can be sought. During this process, the buyer's bank adds a confirmation clause to the LC, directing any other bank to accept the commitment made by the LCB. The confirming bank then undertakes to make the payment according to the stipulated conditions, effectively shifting the payment risk from the LCB to the confirming bank.

Letters of Credit vs Guarantees

Unlike guarantees, letters of credit are not legally binding agreements but rather documents ensuring payment based on the submission of documents. While a guarantee is a legally binding agreement that provides security to a creditor, a letter of credit provides security based on the submission of specific documents.

Strategies for Sellers if a Buyer Does Not Open an LC

Market dynamics and transaction specifics influence whether a seller should rely on an LC or other forms of payment. Sellers often seek alternative risk mitigation strategies if a buyer does not open an LC. This may include:

Insuring the transaction against default risk Entering into firm contracts with a high risk tolerance Assessing the buyer's creditworthiness before initiating a transaction

Many importers and exporters choose to trade on the basis of large firm contracts, with transactions insured against default risk. The decision ultimately depends on the seller's risk-taking capacity, willingness to bear risks, and the potential profit against the risk assumed.

Conclusion

Letters of Credit play a pivotal role in international trade by providing a secure way for both buyers and sellers to conduct transactions. Understanding the four types of LCs, the role of confirming banks, and the distinction between guarantees and LCs can help businesses make informed decisions and navigate the complexities of international trade smoothly.