🔹What is Letter of Credit?
In the logistics industry, a Letter of Credit (LC) is a financial document that serves as a guarantee of payment for international trade transactions. It is a widely used method to minimize the risk associated with cross-border transactions between importers and exporters.
🔹How Letter of Credit works?
1. Buyer and Seller Agreement: The buyer and seller agree to use a Letter of Credit for payment. This agreement is usually mentioned in the sales contract.
2. Issuing Bank: The buyer applies for a Letter of Credit from their bank. The bank assesses the buyer's creditworthiness and, if approved, issues the Letter of Credit.
3. Letter of Credit Terms: The Letter of Credit specifies the conditions for payment, including the payment amount, required shipping documents, and document submission deadline.
4. Shipment and Document Preparation: The seller ships the goods and prepares the necessary shipping documents like invoices, packing lists, and bills of lading, as stated in the Letter of Credit.
5. Presentation of Documents: The seller submits the shipping documents to the issuing bank or an advising bank. The documents must meet the requirements stated in the Letter of Credit.
6. Document Examination: The bank reviews the submitted documents to ensure they comply with the requirements specified in the Letter of Credit. If everything is in order, the bank makes the payment to the seller as per the Letter of Credit terms.
7. Payment and Document Transfer: After approving the documents, the issuing bank makes the payment to the seller. Simultaneously, the documents are given to the buyer, allowing them to take possession of the goods.
🔹There are several common types of letters of credit (LCs) commonly used in international trade transactions. Here are some of the main types:
Revocable Letter of Credit: This type of LC can be changed or canceled by the issuing bank without telling the seller beforehand. It is not commonly used because it doesn't provide much security for the seller.
Confirmed Letter of Credit: In a confirmed LC, an extra bank (usually in the same country as the seller) confirms that the issuing bank will make the payment. This confirmation gives the seller more security because it ensures they will be paid even if the issuing bank doesn't fulfill its responsibilities.
Standby Letter of Credit: Standby LCs are different from LCs used for normal trade transactions. They are mainly used as a financial guarantee. If the buyer doesn't fulfill their commitments, the standby LC acts as a backup payment method. These LCs are often used in construction contracts or to secure loans.
🔹Key Advantages for businesses using a Letter of Credit:
Payment Security: LCs provide a high level of security by ensuring that the seller will receive payment as long as the terms and conditions are met, reducing the risk of non-payment or payment delays.
Risk Mitigation: Buyers benefit from LCs as they only release payment when the seller fulfills the agreed-upon terms and conditions, reducing the risk of receiving substandard or non-compliant goods.
Trust and Credibility: The involvement of a reputable financial institution in the LC transaction adds credibility and trust, instilling confidence in both parties that the agreement's terms will be upheld.
International Trade Facilitation: LCs are widely accepted in international trade, making it easier for parties from different countries to engage in transactions, thereby bridging trust and regulatory gaps.
Legal Recourse: LCs provide a legally binding agreement, ensuring that in the case of a dispute, there's a clear path for resolution through legal channels, which can protect the interests of both the buyer and seller.