What is a Letter of Credit? | Definition, Working, Types, Pros and Cons

The letter of credit is a document, also called a credit letter which is given by a bank or financial services. A letter of credit guarantees a seller receives the agreed payment from the buyer. The bank pays the stipulated amount either full or the remaining portion to the seller in case the buyer is unable to pay the amount.

International transactions can be carried out using a letter of credit. Many different factors like distance, respective country laws, and unknown trade parties usually affect business, letter of credit is popular as it doesn’t get affected by these factors. Banks charge 0.25 to 2 % depending on the type of letter of credit margin, customer credit rating, tenure, and other such factors.

How does it work?

  1. Letter of credit is issued by the beneficiary or any bank nominated by the beneficiary.
  2. The letter of credit can be transferable.
  3. If the letter of credit is transferable, another entity can be assigned like a third parent or corporate who has the right to draw.
  4. The collateral by the bank is usually in the form of cash or any other form of security before a letter of credit is issued.
  5. The service charge is dependent on the bank; it can be also a percentage of the letter of credit.
  6. The International Chamber of Commerce Uniform Customs and Practice for Documentary Credits monitors letter of credit used for international transactions.

Types of Letters of Credit

Commercial Letter of Credit

This letter credit is issued by the bank for direct payment to the beneficiary.

A standby letter of credit

This letter of credit is issued by the bank only when the account holder is unable to clear beneficiary dues.

Revolving Letter of Credit

This letter of credit is issued by the bank which allows a customer to make any number of draws within a certain limit during a specific time period.

Traveller’s Letter of Credit

This letter of credit is for travelers planning to go abroad.

Confirmed Letter of Credit

This letter of credit is given by the second bank, confirming the payment. The second bank is usually the seller’s bank. The confirming bank ensures that the letter of credit is honored in case the issuing bank defaults payment. This letter is usually issued for international transactions.

Advantages and Disadvantages of Letter of Credit

AdvantagesDisadvantages
A letter of credit is useful for making transactions with unknown partners or establish new trades.  The letter of credit is very costly, banks charge fees for providing services; additional features cost extra.  
The letter of credit offers safety for the seller or exporter in case the buyer or importer goes bankrupt. The bank ends up paying as the issuing banks act as guarantors for the importer.  The letter of credit is based on quantity and not quality. The bank may end in dispute if the exporter’s product quality is different from the sample.  
A letter of credit allows both trading parties to dictate clauses in the letter of credit. It can be also customized for every transaction.  The letter of credit comes with an expiry date, and the exporter has a time frame limitation.  
Letter of credit also helps to resolve disputes by allowing the exporter to withdraw funds.   

References

https://www.jstor.org/stable/1336141?seq=1