What is an L/C? Understanding Letters of Credit and Their Types and Procedures

In the world of international trade, trust between buyers and sellers is paramount, as transactions often involve significant distances and unfamiliar parties. A Letter of Credit (L/C) is a crucial financial instrument that helps mitigate risks for both buyers and sellers by ensuring payment and delivery. This article explains what an L/C is, its different types, and the step-by-step procedure involved in its use.

 

What is an L/C?

A Letter of Credit (L/C) is a document issued by a bank on behalf of the buyer (importer) that guarantees payment to the seller (exporter), provided that the seller meets the terms and conditions specified in the L/C. Essentially, it acts as a promise of payment backed by the bank, reducing the risk of non-payment for exporters and ensuring compliance with the agreed terms for importers.

L/Cs are widely used in international trade because they offer security to both parties in the transaction.

 

Types of Letters of Credit

There are several types of L/Cs, each suited to specific trading scenarios. Here are the most common ones:

1. Revocable L/C

• Can be amended or canceled by the issuing bank without prior notice to the beneficiary (seller).
• Rarely used due to the lack of security for exporters.

2. Irrevocable L/C

• Cannot be changed or canceled without the consent of all parties involved.
• Provides higher security to the seller and is commonly used in international trade.

3. Confirmed L/C

• A second bank, usually in the seller’s country, guarantees payment in addition to the issuing bank.
• Beneficial in cases where the seller doubts the reliability of the issuing bank.

4. Unconfirmed L/C

• Only the issuing bank guarantees payment.
• The seller assumes a higher risk if the issuing bank's credibility is uncertain.

5. Sight L/C

• Payment is made immediately upon the presentation of compliant documents.
• Quickens the payment process for the exporter.

6. Deferred Payment L/C

• Payment is made at a future date specified in the L/C, even if the seller submits documents immediately.
• Suitable for transactions with agreed-upon credit terms.

7. Transferable L/C

• The beneficiary (seller) can transfer the credit, either fully or partially, to another party (such as a supplier).
• Common in cases where the seller acts as an intermediary.

8. Back-to-Back L/C

• Two separate L/Cs are used: one issued by the buyer to the seller and another issued by the seller to their supplier.
• Used in complex supply chains.

9. Standby L/C

• Acts as a secondary payment method; the issuing bank will pay the seller if the buyer fails to fulfill their obligations.
• Common in service contracts and trade finance.

10. Red Clause L/C

• Allows the seller to receive advance payment before shipping the goods.
• Useful for sellers who need upfront capital to procure goods.

 

L/C Procedure

The process of using a Letter of Credit involves several steps, ensuring that both parties adhere to the agreed terms:

1. Agreement Between Buyer and Seller

• The buyer and seller negotiate and agree on the terms of the trade, including the use of an L/C as the payment method.

2. Buyer Requests an L/C

• The buyer applies to their bank (issuing bank) to issue an L/C in favor of the seller (beneficiary).

3. Issuing Bank Issues the L/C

• The issuing bank prepares and sends the L/C to the seller’s bank (advising bank), ensuring it reflects the agreed terms.

4. Advising Bank Notifies the Seller

• The advising bank verifies the authenticity of the L/C and informs the seller.

5. Seller Ships the Goods

• The seller ships the goods and gathers the required documents, such as the bill of lading, invoice, and packing list, as specified in the L/C.

6. Seller Submits Documents

• The seller submits the documents to the advising bank for verification.

7. Advising Bank Sends Documents to the Issuing Bank

• After verifying the documents, the advising bank forwards them to the issuing bank.

8. Issuing Bank Reviews Documents

• The issuing bank checks the documents against the terms of the L/C. If compliant, payment is initiated.

9. Payment is Made

• The issuing bank releases the payment to the advising bank, which then credits the seller.

10. Buyer Collects Goods

• The buyer collects the documents from the issuing bank, enabling them to take possession of the goods.

 

Advantages of Using an L/C

• For Sellers (Exporters):
• Guaranteed payment if terms are met.
• Reduced risk of non-payment.
• Access to funds through advance payment clauses.
• For Buyers (Importers):
• Assurance that payment will only be made upon receipt of correct documents.
• Mitigation of risks associated with fraudulent sellers.

 

Conclusion

A Letter of Credit is a vital tool for fostering trust and reducing risks in international trade. By understanding its types and procedures, both buyers and sellers can ensure smooth transactions and build long-term business relationships. Mastering the L/C process is essential for any professional dealing with global trade, ensuring secure and successful business dealings.