Letter of Credit (LC, LoC)
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A Letter of Credit (LC or LoC) is a mode of making payments for trade transactions. An LC is a highly popular payment mode because it allows an importer or buyer to make secure payments to the exporter or seller. The processing of the LC involves the banking institutions of both the buyer and the seller. The financial term used for a Letter of Credit is ‘Documentary Credit’. This term originates from the fact that the LC deals in documents only and not cash in the actual transaction undertaken.
How Letter Of Credit Works
When a buyer requests the shipment of goods, the seller will require a guarantee of payment. This process assumes a bigger role in international trade, where the buyer asks his banking institution to deliver a letter of credit of a specified amount, say $300,000. The bank will issue the letter of credit on either the direct payment of the amount along with the processing fees or through the loan underwriting method. The buyer can then send a copy of the LC to the seller. Also, the issuing bank sends another copy to the specified bank of the seller. When the seller produces the essential business documents as mentioned in the LC, the issuing bank will transfer the LC amount to the seller’s bank account.
Types of Letters of Credit
There are two types of Letters of Credit issued by banking institutions:
- Documentary LC: This type of LC can be further divided into revocable LC or irrevocable LC. The buyer has the authority to modify or cancel a revocable LC without prior notification to the seller. However, an irrevocable LC cannot be modified without due agreement, which makes them more acceptable in international trade. Any changes to the irrevocable LC have to be approved by both the buyer and the seller in writing.
- Standby LC: This letter of credit is a popular trade instrument in the US. The standby LC is also called a ‘non-performing letter of credit,’ since they can only be used as backup if the buyer defaults on payment. Standby LCs are far less complicated and involve lesser documentation than an irrevocable LC.
Although a letter of credit guarantees the credit-worthiness of the buyer, the payment often gets delayed due to the legal proceedings of banking institutions. Hence, it is important to frame the terms and conditions of the letter of credit with due consideration.
