March 16, 2020 Last updated March 25th, 2020 723 Reads share

What Is a Letter of Credit and What Are They Used For?

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Letters of Credit are commonly used in international trade deals. They essentially give a bank guarantee to the seller that the buyer will pay for the goods.

International trade can be tricky at the best of times – not only do we have to deal with issues of culture, language, currency and time differences, but there can also be questions of trust. How does a manufacturer in China, for example, know that they will receive full payment for shipped goods? Or if payment is made in advance, how does the purchaser know that the correct goods will appear on time and at the right quality.

Trade finance is often used to make payments between buyers and sellers, but letters of credit can be part of that or stand-alone tools. Trade finance often includes invoice factoring, but the focus of this article will be on the letter of credit as a promise-to-pay.

When Is a Letter of Credit Used?

Letters of credit are used in international trade where there is a long gap between dispatch and delivery of goods. While the exporter wants payment early, the importer likes to see the product before paying.

If your company trades overseas frequently, you may have come across them before. But did you also know that some funders for trade finance or import/export finance might require one from you as well?

While using a finance provider for trade finance or import/export finance to improve your company’s cash flow, there’s essentially another party involved who will need a guarantee that the money they are providing for the financing agreement will be repaid.

Different Types of Letter of Credit

Not all letters of credit are the same, just a not all international business trades are the same.

1. Confirmed
Once the letter of credit has been issued by the buyer’s bank, the seller can opt to have it confirmed by a bank of their choosing. This also provides more security than leaving it unconfirmed.

2. Unconfirmed
This is still a valid letter of credit issued by a bank, it simply hasn’t been confirmed by a second bank.

3. Revocable
This can be changed or canceled at any time by the issuer.

4. Irrevocable
An irrevocable letter of credit cannot be canceled or changed, unless everyone in the process agrees. This means it provides a little more security than a revocable one.

5. Transferable
If there are intermediaries working in the transaction between buyer and seller, the letter of credit can be passed between parties on the receiving end of payment.

6. Back-to-Back
A back-to-back letter of credit can be used when intermediaries are involved beyond just the buyer and seller. Those intermediaries might be brokers or other beneficiaries for example.

7. Revolving
A revolving letter is useful for covering more than one transaction. It might be used if the buyer and seller expect to have a longer-lasting relationship and multiple transactions.

8. Stand-by
If the seller doesn’t expect to have to draw on a letter of credit but would like security just in case, they can have this in the form of a standby letter of credit from the buyer.

Benefits for Buyers

Buyers with a letter of credit can guarantee that they’ll receive the goods they’re paying for. Therefore, the risk of being out of pocket with nothing to show for it is reduced.

Benefits of a Letter of Credit for Sellers

As a seller, a letter of credit is a guarantee that you’ll receive all the money due, on time. You have a sense of security surrounding the payment. Provided that all terms and conditions are met, as all the risk is transferred to the bank or financer providing the letter instead.

They’re also useful if you’re looking to secure financing. Some trade finance providers will ask for one before finalizing the facility. Once you have it all in place, you could be in a better position to purchase materials and supplies to fulfill orders.

Costs for a Letter of Credit

As you might expect, your bank will almost certainly charge a fee for issuing a letter of credit. This is usually a percentage of the amount covered by the letter of credit.

So your bank or lender charges 1% for the letter of credit and the amount the letter is covering is £100,000, you’ll pay £1,000 in fees.

It may seem a lot, but if it has the ability to seal your trade deal, it could be a very valuable tool.

Summary

Letters of credit are commonly used in international trade deals.
They offer security for the seller and confidence that they will get paid for their products
And they make international trade easier for the end buyer. Having a letter of credit also gives the buyer confidence to proceed with a trade.

Commonly used in conjunction with import or export finance and with Trade Finance, letters of credit are important tools in international business.

 

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Richard Leader

Richard Leader

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