What Is a Letter of Credit – Definition, Types and Process

What Is a Letter of Credit?

A Letter of Credit (LC), is a formal document issued by a bank or financial institution on behalf of a buyer. 

The bank guarantees that the seller will receive payment for goods or services, provided the seller meets the terms and conditions specified in the LC. 

This payment mechanism protects both parties in a transaction by substituting the creditworthiness of a reputable bank for that of the buyer.

It is particularly important in international trade, where differing legal systems, currency fluctuations, and logistical challenges create additional risks.

Understanding Letters of Credit

Letters of credit operate through a structured process involving multiple parties and precise documentation. The typically begins when a buyer and seller agree on the terms of a transaction and decide to use an LC as the payment method.

This standardisation ensures that letters of credit function reliably across borders and legal jurisdictions.

How Much Do Letters of Credit Cost?

The cost of obtaining a letter of credit varies based on several factors, including the transaction amount, the buyer's creditworthiness, the type of LC, and the banks involved. Businesses must account for these expenses when planning international transactions.

The issuance fee is typically calculated as a percentage of the LC amount and depends on the buyer's creditworthiness. Buyers with strong credit profiles may pay lower fees, while those with limited credit history face higher charges. The bank may also require collateral or a security deposit before issuing the LC.

Confirmation fees apply when the seller requests additional security from a second bank in their country. This provides extra protection if the issuing bank fails to honour payment. Amendment fees are charged whenever changes are made to the LC after issuance, such as extending the validity period or modifying shipment terms.

Businesses should review these costs carefully and factor them into pricing negotiations. In some transactions, the buyer and seller may agree to share LC costs, while in others, one party bears the full expense.

Different Types of Letters of Credit

Letters of credit come in various forms, each designed to address specific transaction needs and risk profiles. Understanding these types helps businesses select the most appropriate instrument for their trade requirements.

Commercial Letter of Credit

A commercial letter of credit is the standard form used in most international trade transactions. It facilitates direct payment from the buyer's bank to the seller upon presentation of compliant documents. This type is widely used for the import and export of goods where the seller requires payment assurance before shipping products.

Standby Letter of Credit

A standby letter of credit functions as a backup payment mechanism rather than a primary payment method. It is invoked only if the buyer fails to fulfil their payment obligations under the contract. This type serves as insurance for the seller, providing a guarantee that payment will be made even if the buyer defaults.

Revolving Letter of Credit

A revolving letter of credit allows multiple transactions within a specified period without requiring a new LC for each shipment. This type is beneficial for businesses engaged in regular trade with the same partner, such as monthly shipments of goods over a year-long contract.

Traveler's Letter of Credit

A traveler's letter of credit was historically used by individuals travelling abroad to access funds at foreign banks. The issuing bank guaranteed payment to foreign banks that honoured drafts presented by the traveler. This type has largely been replaced by traveler's cheques, credit cards, and international ATM networks in modern banking.

Confirmed Letter of Credit

A confirmed letter of credit involves a second bank (the confirming bank) adding its guarantee to the LC issued by the buyer's bank. This provides the seller with dual assurance of payment—both from the issuing bank and the confirming bank. If the issuing bank fails to honour payment, the confirming bank steps in to fulfil the obligation.

Example of a Letter of Credit in Action

To understand how letters of credit work in practice, consider the following scenario involving an international trade transaction.

The Scenario:

An Indian textile manufacturer (the seller) receives an order from a retail company in Germany (the buyer) for ₹50 lakh worth of cotton fabric. The two companies have not conducted business together before, and the seller is concerned about payment risk. 

The buyer agrees to arrange a commercial letter of credit to secure the transaction. 

Step-by-Step Process:

Step 1: Agreement and LC Application The buyer and seller finalise the sales contract, specifying product details, quantity, price, shipment terms, and delivery timeline. The contract stipulates that payment will be made through a letter of credit. The German buyer approaches their bank and applies for an LC in favour of the Indian seller.

Step 2: Creditworthiness Assessment The German bank evaluates the buyer's financial standing, reviewing credit history, cash flow, and collateral. After approval, the bank issues the LC for ₹50 lakh with specific terms: shipment within 60 days, presentation of a bill of lading, commercial invoice, packing list, and certificate of origin within 21 days of shipment.

Step 3: LC Transmission The German issuing bank sends the LC to the seller's bank in India through the SWIFT network. The Indian bank (advising bank) reviews the LC and notifies the textile manufacturer. The seller examines the terms to confirm they match the sales agreement.

Step 4: Production and Shipment Satisfied with the LC terms, the seller proceeds with fabric production. Once completed, the seller arranges shipment via a freight forwarder. The goods are loaded onto a vessel bound for Germany, and the seller receives a bill of lading from the shipping company as proof of shipment.

Step 5: Document Preparation The seller prepares the required documents:

• Commercial invoice showing ₹50 lakh value

• Bill of lading issued by the shipping company

• Packing list detailing the fabric quantities and specifications

• Certificate of origin issued by the Indian chamber of commerce

Step 6: Document Submission The seller submits these documents to their Indian bank within the specified timeframe. The bank examines the documents against the LC terms, checking for accuracy, completeness, and compliance.

Step 7: Payment Processing Finding the documents compliant, the Indian bank forwards them to the German issuing bank. The German bank verifies the documents and, upon confirmation, releases payment of ₹50 lakh to the Indian bank. The Indian bank credits the seller's account, completing the transaction.

Step 8: Document Delivery to Buyer The German issuing bank delivers the shipping documents to the buyer, who uses the bill of lading to claim the goods from the shipping company upon arrival in Germany. The buyer's account is debited for ₹50 lakh plus any agreed-upon fees.

Outcome: The seller received guaranteed payment before the buyer took possession of the goods, while the buyer obtained assurance that payment would only be made upon proof of shipment. The letter of credit successfully mitigated payment risk for both parties, enabling a smooth international transaction despite the absence of a prior business relationship.

How to Apply for a Letter of Credit

Preparation of Letters of Credit demands adept handling by professionals due to the intricate nature of the required documentation, as inaccuracies can result in payment delays and additional fees. Given the diversity across industries and types of Letters of Credit, each case necessitates a tailored approach.

Consider the scenario of import-export transactions:

• To facilitate smooth transactions, the importer's bank must ensure compliance with the terms and conditions outlined in the sales agreement, satisfying both the exporter and their bank.

• Following the completion of a sales agreement between the importer and exporter, the importer's bank initiates drafting the Letter of Credit, incorporating the agreed-upon terms. Once finalised, this document is transmitted to the exporter's bank for review and approval.

• Upon receipt and approval of the Letter of Credit by the exporter's bank, the exporter proceeds with the shipment of goods by the stipulations outlined in the Letter of Credit.

• Subsequently, the exporter submits any requisite documentation to their bank, which meticulously assesses the documents to ensure conformity with the terms and conditions specified in the Letter of Credit.

• Upon satisfactory review and verification of the submitted documentation, the exporter's bank forwards the documents to the importer's bank.

• The importer's bank, upon receipt of the compliant documentation, initiates the transfer of payment to the exporter's bank, thereby fulfilling the financial obligations stipulated in the Letter of Credit.

• With payment secured, the importer gains the rightful claim to the goods dispatched by the exporter, concluding the import-export transaction easily.

Pros and Cons of Letters of Credit

Letters of credit offer significant advantages for international trade but also come with limitations that businesses must consider.

Conclusion

Letters of credit serve as a fundamental tool in international trade, providing payment security for sellers and delivery assurance for buyers. 

By involving banks as intermediaries, LCs reduce the risks associated with cross-border transactions, enabling businesses to expand into new markets with confidence.

Businesses engaged in international trade should evaluate whether letters of credit align with their transaction requirements, risk tolerance, and partner relationships. 

Consulting with trade finance specialists and banks can help determine the most appropriate payment mechanism for specific situations.