A letter of credit (LC) is a financial document issued by a bank or financial institution that guarantees payment to a seller (beneficiary) upon the fulfillment of specific conditions or the presentation of required documents. It is a common tool used in international trade to ensure that payments will be made as agreed between the buyer and the seller.

A letter of credit works as follows:

1. Agreement: The buyer and seller agree on the terms of the sale, including that payment will be made through a letter of credit.
2. Issuance: The buyer applies to their bank (issuing bank) to issue a letter of credit in favor of the seller.
3. Notification: The issuing bank sends the letter of credit to the seller’s bank (advising bank), which informs the seller.
4. Shipment and Documentation: The seller ships the goods and presents the required documents (such as bill of lading, invoice, packing list) to their bank.
5. Verification and Payment: The advising bank verifies the documents and, if they meet the letter of credit conditions, forwards them to the issuing bank. The issuing bank then releases payment to the seller.
6. Reimbursement: The buyer reimburses the issuing bank.

There are several types of letters of credit, including:

1. Documentary Letter of Credit: Used for international trade transactions, ensuring that payment is made when documents are presented.
2. Standby Letter of Credit: Acts as a backup payment method, used when the primary payment method fails.
3. Revolving Letter of Credit: Used for multiple transactions over a period of time, with the amount renewing after each use.
4. Transferable Letter of Credit: Allows the beneficiary to transfer part or all of the credit to another party.
5. Confirmed Letter of Credit: A second bank guarantees the payment in addition to the issuing bank.
6. Irrevocable Letter of Credit: Cannot be amended or canceled without the consent of all parties.
7. Revocable Letter of Credit: Can be amended or canceled by the issuing bank without the beneficiary’s consent.
8. Back-to-Back Letter of Credit: Used when an intermediary is involved, involving two separate letters of credit.

The primary purpose of a letter of credit in international trade is to mitigate the risk of non-payment for the seller and the risk of non-delivery for the buyer. It provides a secure payment mechanism, ensuring that the seller receives payment as long as the terms and conditions of the letter of credit are met. This enhances trust between parties in different countries who may not know each other well.

Key components of a letter of credit include:

1. Applicant: The buyer who requests the letter of credit.
2. Beneficiary: The seller in whose favor the letter of credit is issued.
3. Issuing Bank: The bank that issues the letter of credit on behalf of the buyer.
4. Advising Bank: The bank that advises the seller that the letter of credit has been issued.
5. Amount: The maximum value covered by the letter of credit.
6. Expiry Date: The date by which the documents must be presented for payment.
7. Documents Required: Specific documents that the seller must present to receive payment.
8. Terms and Conditions: The conditions under which payment will be made.

The main parties involved in a letter of credit transaction are:

1. Applicant: The buyer who applies for the letter of credit.
2. Beneficiary: The seller who receives the payment under the letter of credit.
3. Issuing Bank: The bank that issues the letter of credit at the request of the applicant.
4. Advising Bank: The bank that receives the letter of credit from the issuing bank and informs the beneficiary.
5. Confirming Bank (if applicable): A bank that adds its guarantee to the letter of credit, ensuring payment if the issuing bank fails to pay.
6. Negotiating Bank (if applicable): The bank that examines the documents and negotiates (pays) the beneficiary before forwarding the documents to the issuing bank.

The main difference between a letter of credit and a bank guarantee lies in their purpose and function:

• Letter of Credit: Primarily used in trade transactions, it ensures payment to the seller if the terms and conditions are met.
• Bank Guarantee: Acts as a safety net, where the bank guarantees compensation to the beneficiary if the applicant fails to fulfill contractual obligations. It’s used in a broader range of financial transactions, not just trade.

A letter of credit protects both parties as follows:

• Seller Protection: The seller is assured of payment as long as they present the required documents that comply with the letter of credit terms.
• Buyer Protection: The buyer knows that the payment will only be made if the seller meets all the conditions and presents the correct documents, ensuring that the goods are shipped as agreed.

Common terms and conditions in a letter of credit include:

1. Detailed Description of Goods: Specifications of the goods or services to be provided.
2. Shipment Date: The deadline by which the goods must be shipped.
3. Expiry Date: The latest date by which documents must be presented.
4. Required Documents: A list of documents (e.g., invoice, bill of lading, packing list) that must be presented for payment.
5. Inspection Requirements: Any pre-shipment or post-shipment inspection requirements.
6. Insurance Requirements: Details of any insurance coverage needed.
7. Partial Shipments: Whether partial shipments are allowed.
8. Transshipment: Whether transshipment is permitted.

The process of issuing a letter of credit involves several steps:

1. Agreement: The buyer and seller agree on the use of a letter of credit and the specific terms.
2. Application: The buyer applies for a letter of credit at their bank, providing details of the transaction and required documents.
3. Issuance: The issuing bank reviews the application and issues the letter of credit, sending it to the advising bank.
4. Notification: The advising bank verifies the authenticity of the letter of credit and informs the seller.
5. Shipment and Documentation: The seller ships the goods and presents the required documents to the advising bank.
6. Verification and Payment: The advising bank checks the documents, and if they comply, forwards them to the issuing bank. The issuing bank then makes the payment, and the buyer reimburses the issuing bank.