Letter of Credit: Uses, Benefits and Examples

How Does a Letter of Credit Work?

The letter of credit meaning, refers to a bank's guarantee that a buyer's payment to a vendor will be paid on schedule and for the correct amount. The letter of credit process is quite straightforward. It's used when the buyer and seller may not know each other personally and operate under different legal systems. In this scenario, the bank steps in as a neutral third party in a business transaction, providing assurance to both sides.

When you, as the buyer, request a letter of credit from your bank, you agree to reimburse the bank if the seller fulfills the terms of the deal. The bank then sends the letter of credit to the seller's bank, assuring payment once the seller presents specific documents, usually proof of shipment of the goods.

Parties Involved

A letter of credit transaction involves three key stakeholders, including:

• Buyer (Applicant): The buyer is the person or entity who initiates the letter of credit process. They request that their bank provide a letter of credit in favor of the vendor. The buyer takes responsibility for ensuring that payment is provided to the seller upon completing the terms and conditions indicated in the letter of credit.
• Seller (Beneficiary): The seller is the one who benefits from the letter of credit. The seller receives money after submitting the relevant documentation and meeting the terms and conditions of the letter of credit. 
• Issuing Bank: The issuing bank provides the letter of credit at the buyer's request. It agrees to pay the seller upon receipt of documentary evidence that the seller has met the terms and conditions of the letter of credit.

In addition to the main parties, a transaction may involve another bank, known as the advising bank or confirming bank.

• Advising Bank: The advising bank notifies the beneficiary (seller) that a letter of credit has been issued in their favor. Although it is not committed to paying the beneficiary, it verifies the authenticity of the letter of credit and forwards it to the seller.

• Confirming Bank: The confirming bank, often based in the seller's country, adds a layer of security and guarantees the letter of credit given by the issuing bank. By securing a commitment from a confirming bank to ensure payment, the seller effectively mitigates the risk of non-payment due to issues like insolvency of the issuing bank, political unrest, or foreign exchange restrictions.

Different Types of Letter of Credit

There are several types of letters of credit, each designed to suit different transaction requirements. Here are some examples:

Standby Letter of Credit

This is used as a backup plan for the seller. If a buyer fails to pay the seller, the bank will bear the cost. A standby letter of credit is essentially an insurance policy that gives the seller confidence in the transaction's reliability. This is especially useful in international trading, as it bridges trust gaps between parties from different nations and guarantees sellers a financial safety net.

Confirmed Letter of Credit

A confirmed letter of credit includes a second bank (the confirming bank) in addition to the issuing bank. The confirming bank guarantees payment if the issuing bank and buyer fail to meet their obligations. It provides additional security for the seller, which is especially important when the issuing bank's dependability is called into doubt. This arrangement benefits the seller by reducing the risk of payment default due to the buyer's or issuing bank's financial insolvency or geopolitical uncertainty. 

Revolving Letter of Credit

A revolving letter of credit facilitates regular deliveries over a designated period and is designed to "revolve" in one of two ways:

• By Value: Once the specified amount is utilized, it becomes available again.
• By Time: A certain amount is available for use within a specific time frame.

This secondary payment method is particularly suitable for maintaining ongoing business relationships and streamlining financial transactions for numerous shipments, eliminating the need to renegotiate credit terms with each delivery.

Transferable Letter of Credit

A transferable letter of credit allows the seller to 'transfer' part or all the credit to another party. This type of credit letter benefits intermediaries in trading operations where the first beneficiary does not supply the goods but procures them from other suppliers. It enables the intermediary to secure goods from suppliers without using their own funds.

Back to Back Letter of Credit

In a back to back letter of credit, the seller acquires a letter of credit from the buyer and then issues a second letter of credit to another seller. This arrangement is often used when the initial seller does not have the resources or contacts to source the goods. A back to back letter of credit facilitates complex trade deals by ensuring the final supplier is paid when they’ve fulfilled the order, even if the intermediary lacks direct access to the product.

Irrevocable Letter of Credit

An irrevocable letter of credit must not be canceled or changed without all parties' consent. This type provides more security for the seller as the buyer or the bank cannot alter the terms once the letter has been issued and is used to minimize the risk of non-payment. 

Documentary Letter of Credit

This refers to a transaction requiring specific documentation, like an invoice or a bill of lading, before payment. It ensures that the transaction follows the agreed-upon terms and conditions. A documentary letter of credit adds a layer of verification, ensuring that products are shipped, and terms are met before funds are paid. 

In addition to these types of letters of credit, sellers can benefit from a financial arrangement known as 'letter of credit discounting.' This payment method enables sellers to receive payment immediately after presenting compliant documents, thereby improving their cash flow.

Examples of Letter of Credit

Let's consider an example of a letter of credit in action. 

Example: Importing Electronics

A business in Singapore wishes to import electronics from Japan. Due to the high value of the transaction and the distance between the two parties, there's a mutual demand for security. The Singaporean company requests a letter of credit from its bank outlining the transaction's parameters, including delivery and payment information. The Singaporean buyer's bank releases the payment when the Japanese supplier ships the electronics and submits the relevant shipping paperwork (such as the bill of lading) to their bank. This ensures that the Japanese supplier is paid after fulfilling their portion of the deal, while the Singaporean company receives the items as specified.

Applying for a Letter of Credit

Applying for a letter of credit involves several steps and thorough documentation. 

Things to Note

When applying for a letter of credit, it is important to understand the rules and limitations governing its use. This includes understanding which sort of letter of credit is most suited for your transaction, such as irrevocable or revocable, documentary or standby.

Also, all parties must agree on the terms, which include payment conditions, shipment deadlines, and required documentation. To avoid future misunderstandings or noncompliance, all concerned parties, including banks and beneficiaries, must be fully informed of the payment term letter of credit conditions.

How to Apply

To apply for a letter of credit, provide your bank or financial institution with a thorough transaction proposal, including the purpose, amount, and counterparties. You will need to supply comprehensive documents, such as contracts or agreements outlining the transaction, proof of your ability to pay the charges, and possibly collateral.

The bank will then evaluate your creditworthiness and the risks involved in the transaction. Upon approval, you will sign an agreement with the bank outlining the terms and conditions under which the letter of credit will be given. Following this, the bank will issue the letter of credit to the seller’s bank, officially starting the process.

Cost/Fees

The cost and expenses for obtaining a letter of credit can vary based on the complexity of the transaction, the amount of money involved, and the issuing bank's risk assessment. In general, the cost of letter of credit can range from 1% to 8% of the amount stated on the letter of credit. 

There may also be additional fees for advising if another bank is involved, amendment fees if terms need to be amended after issuance, and handling fees when the documents are presented for payment. Discussing these costs with your bank upfront is important to fully understand the financial implications of obtaining a letter of credit for your transaction.

Letter of Credit vs. Bank Guarantee

A bank guarantee and letter of credit serve as financial securities in transactions, yet they differ in function and protection. A commercial letter of credit favoring the seller guarantees payment upon meeting certain conditions. In contrast, a bank guarantee offers a broader safety net, ensuring compensation to the beneficiary if the opposing party defaults on the contract. Thus, while a letter of credit safeguards the seller's interests, a bank guarantee extends protection to both contractual parties.

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