Letter of credit is a secure payment method, mostly utilized by sellers and buyers while importing and exporting.
A contract moderated by banks the letter of credit mitigates the risk of non-payment by buyers after the execution of the trade. The buyer makes the payment to the moderating bank, which withholds the payment until the terms and conditions mentioned in the sales contract are met. The buyer’s bank issues the letter of credit and takes the responsibility of honoring the agreement. When customers or merchants are unknown, a letter of credit allows for a secure and customizable mode of cash transfer, which enables new trade relationships to transact with reduced risk.
A bank usually issues a letter of credit to guarantee payments on behalf of a beneficiary. This beneficiary could be a business or merchant customer of the bank who issues the letter of credit. Banks may also give a letter of credit to prominent citizens to allow people to travel without carrying any cash. The only requirement is that the issuing bank trusts the individual or merchant to make good on their financial obligations.
Additional Read: What is Letter of Credit? All you need to Know about LC
Types of letter of credit
There are several types of letters of credit. Letter of credit can be a direct payment. It can also act as a backup payment option where the failure of the beneficiary to make payment initiates liquidation of the letter of credit.
A letter of credit is authorized by a foreign bank on behalf of the buyer and is accepted as a guarantee by the seller’s domestic bank. A commercial letter of credit allows payment for goods to a seller upon presentation of satisfactory documentation. A letter of credit is an irrevocable guarantee assuring payment by the issuing bank if the beneficiary meets the contract terms. In contrast, a revocable letter of credit is a payment mode that can be modified or canceled by the bank.
Letters of credit also cover particular circumstances. Transferable letters of creditallow the beneficiary to transfer the letter of credit and its payment guarantee to someone else. Deferred payment letters of credit stipulate payment after a definite time has expired. A back-to-back letter of credit is where the first letter of credit acts as collateral for the second letter of credit, which the beneficiary issues to the supplier of products or service. A red-clause letter of credit gives funds to the seller before the delivery of products or services. A revolving line of creditallows the beneficiary to receive the specified amount of credit a specified number of times. Simultaneously, the issuing bank restores the credit to the original amount after completion of each transaction.
Additional Read: How do Letter of Credits Work?
Benefits of a Letter of Credit
Financial Institutional Banking
When a letter of credit is issued by a bank, the bank bears the weight of creditworthiness in place of the importer. The backing of an established financial institution will enable a seller to do multiple transactions at a time.
Reduced risk of International Trade
The ability to conduct business and perform transactions with an unknown or newly established business or trade partners globally is made possible through a letter of credit. This feature gives confidence to companies and allows expansion into new geographical locations. The buyer and the seller can arrive at a list of clauses that they agree upon before releasing funds. Additionally, a letter of credit removes the need for up-front cash payments.
Customizable to suit unique transactions
Letter of credit is customizable. Depending on the trade agreement between the buyer and the seller, the banker can issue an appropriate letter of credit to suit the requirements. The terms of the letter of credit can also be varied based on the trust and agreement between the trading partners.
However, trading partners must note that attempts to modify the terms of a letter of credit may cause delays and disruptions in the transaction. Also, any discrepancies in the documents or contracts presented by the seller may lead to the issuing bank voiding the letter of credit. There are possibilities of disputes that can arise if the quality of goods delivered differs from what was expected and agreed initially.
Letter of credit is an excellent instrument that securely facilitates international trade. If you’d like to protect your trade from potential risks with a letter of credit, reach out to Tata Capital’s Trade Finance experts for further guidance.