A letter of credit is a financial instrument that helps facilitate trade. When two parties don't know each other, it can be difficult for the seller to trust that the buyer is going to pay. A letter of credit guarantees payment and facilitates the purchase.
Understanding Letters of Credit
There are two kinds of letters of credit (LC). A commercial LC is a direct guarantee of payment. Once the buyer receives the goods, the bank transfers payment to the seller. A standby LC is a backup guarantee. It states that if the buyer doesn't follow through with the payment, the bank will pay instead.
Protection for Sellers
LCs are used to encourage trade, especially internationally. Some nations are not as developed or financially stable as others. As a result, exporters are cautious about extending credit to buyers. Different laws, customs, and political and financial circumstances mean that it can be hard to buy large-ticket items internationally. An LC from a reputable bank can put an exporter at ease and allow buyers to get the goods they need.
Protection for Buyers
A letter of credit can also protect a buyer. By using an LC, the customer can delay payment until the goods have been shipped. There may also be additional conditions a seller has to meet before they can receive payment.
A letter of credit allows the bank to guarantee payment without sending it until the transaction meets all requirements. Requirements may include providing paperwork that proves what the seller shipped, when it was sent, and the quality of the shipment.
Banks require collateral and charge service fees for setting up letters of credit. An LC can also be secured by a bond or certificate of deposit (CD) owned by the bank customer. The payment goes to the beneficiary or someone the beneficiary designates, such as a parent company. The letter of credit may also assignable, meaning that the seller can sign the note over to someone else and they would receive the payment.
Banks interpret letters of credit literally, so any tiny mistake, misspelling, or omission must be corrected before the deal moves forward.
Letters of Credit Illustrated
Letters of credit are available from many well-known banks that offer international services, including Wells Fargo, Citibank, TD Bank, and U.S. Bank. Whichever bank you choose to work with, there are several specific ways letters of credit can be used.
LC Requested by an Exporter
If an American exporter had a potential buyer in Venezuela, they might be nervous about agreeing to ship goods before payment is received. Venezuela is in a very volatile financial and political situation. The buyer agrees to set up a letter of credit through a trusted, well-known bank. The exporter agrees to the deal, sends the goods, and receives the money from the bank.
LC Requested by a Buyer
In another situation, it may be the buyer who's concerned. Perhaps they are importing some essential products from the Middle East and fear that political problems might cause delays. To prevent delays, the buyer may choose to pay using a letter of credit. The LC stipulates that payment is only due if the seller can provide proof that the goods were delivered within a specific date range. The seller follows through and then provides the bank documentation that the goods arrived on time and in good condition. With the requirements met, the bank sends payment to the seller.
Standby LC Used Within the U.S.
A standby LC is often used within the United States for large construction projects. The contractor promises to complete paid work by a specified due date. A letter of credit is created to provide a type of 'refund' if the contractor does not meet the conditions. If the buyer can show that the specified work was not complete by the agreed date, the LC is activated, and the contractor's bank sends money to the purchaser of the service. Using an LC in this way helps keep things on track and secure investors because there's a financial guarantee if the project does not finish on time.
Confirmed Letters of Credit
A confirmed letter of credit is an LC that is guaranteed by a bank other than the issuing institution. The confirming bank ensures payment under the LC if the letter holder and the issuing bank default. Sometimes a confirming bank is requested by the seller if the issuing bank has questionable creditworthiness.
It is also possible for an issuing bank to ask for a confirming bank to limit the bank's commercial credit risk. Citibank is an example of a bank that offers letter of credit confirmations. They are willing to confirm LCs from particular partner banks.
A confirmed letter of credit reduces the risk of the transaction to an absolute minimum for the buyer and seller. However, the confirming bank will charge for the service and may refuse to confirm a risk they consider too great.
Protection for Buyers and Sellers
Whether you're a buyer or a seller, you want to be able to do business with as many people as possible. Using letters of credit allows you to run an international business, even trading within volatile markets. With a letter of credit, especially a confirmed LC, both the buyer and seller can rest assured that the deal will be executed exactly as agreed.