What is a Letter of credit in International Trade?

Letter of credit (LC)

Letter of credit is a type of payment term opted by importers and exporters. Letters of credit (LCs) are one of the most secure instruments accessible to international traders. An LC is a commitment by a bank on behalf of the buyer that payment will be made to the exporter, provided that the terms and conditions stated in the LC have been met, as confirmed through the presentation of all required documents.

In other words, we can explain that a Letter of Credit is an undertaking issued by a Bank, at the request of a importer, affirming the payment to the exporter on presentation of complying documents as stated in the LC.

It is an assurance from the bank that a buyer's payment to a seller will be received on time and for the correct amount and thus makes elimination of possible risks. If the buyer is unable to make payment on the purchase, the bank will be required to cover the full or remaining amount of the purchase. Due to the nature of international dealings, including factors such as distance, contrasting laws in each country, and difficulty in knowing reliability of each party personally, the use of letters of credit has become a vital aspect of international trade. A letter of credit is typically a negotiable instrument, the issuing bank pays the beneficiary or any bank nominated by the beneficiary. If a letter of credit is transferrable, the beneficiary may assign another entity, such as a corporate parent or a third party, the right to draw. Banks typically require a pledge of securities or cash as collateral for issuing a letter of credit. Banks also collect a fee for service, typically a percentage of the size of the letter of credit.

An LC is useful when reliable credit information about a foreign buyer is hard to get, but the exporter is satisfied with the creditworthiness of the buyer’s foreign bank. An LC also secures the buyer because no payment obligation arises until the goods have been shipped or delivered as promised or guaranteed.


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