Introduction

A Letter of Credit (LC) is a crucial financial instrument used in international and domestic trade to ensure payment security between buyers and sellers. It acts as a guarantee issued by a bank on behalf of a buyer, ensuring that the seller receives payment as long as the specified conditions are met.

In this guide, we will explore the different types of Letters of Credit, their importance, how they work, and the process involved in obtaining one.

Definition of a Letter of Credit

A Letter of Credit (LC) is a document issued by a bank that guarantees a buyer’s payment to a seller. If the buyer fails to make the payment, the bank covers the amount on behalf of the buyer, provided that the terms and conditions outlined in the LC are fulfilled.

Lenders use LCs primarily in international trade transactions, where the risk of non-payment is higher due to different legal systems, unfamiliarity between the parties, or unstable economies.

How Does a Letter of Credit Work?

The process of using a Letter of Credit generally follows these steps:

1. Agreement Between Buyer & Seller – The buyer and seller agree to use an LC as a payment method.
2. Buyer Requests LC from Their Bank – The buyer applies for an LC from their bank (issuing bank).
3. Bank Issues the LC – The issuing bank provides the LC to the seller’s bank (advising bank).
4. Seller Ships Goods – The seller fulfills the contract by shipping goods and providing necessary documents.
5. Documents Verified – The advising bank verifies that the shipment matches the LC requirements.
6. Payment is Released – Upon successful verification, the bank releases the payment to the seller.

This process ensures the seller gets paid only if all the terms of the LC are met, reducing the risk of default.

Types of Letters of Credit

There are several types of LCs based on the nature of the transaction and the level of security required:

1. Commercial Letter of Credit

This is the most common type used in trade transactions where banks directly pay the seller upon document verification.

2. Standby Letter of Credit (SBLC)

SBLC serves as a backup payment method in case the buyer defaults. It is often used as a guarantee in service contracts.

3. Revocable & Irrevocable Letter of Credit

• Revocable LC: Can be modified or canceled by the issuing bank without prior notice.
• Irrevocable LC: Cannot be changed without mutual agreement from all parties, providing stronger security.

4. Confirmed & Unconfirmed Letter of Credit

• Confirmed LC: A second bank guarantees the payment in addition to the issuing bank.
• Unconfirmed LC: Only the issuing bank guarantees payment.

5. Transferable Letter of Credit

Allows the original beneficiary (seller) to transfer all or part of the payment guarantee to another party.

6. Back-to-Back Letter of Credit

Used in transactions involving intermediaries, where a second LC is issued based on the first LC.

7. Red Clause & Green Clause Letter of Credit

• Red Clause LC: Provides an advance payment to the seller before shipment.
• Green Clause LC: Includes a provision for pre-shipment warehousing expenses.

Advantages of a Letter of Credit

Using an LC provides several benefits for both buyers and sellers:

For Buyers:

✔ Ensures goods are shipped before payment. ✔ Protects against fraud and delivery risks. ✔ Helps in maintaining good business relationships.

For Sellers:

✔ Guarantees payment upon compliance with LC terms. ✔ Minimizes risks associated with international trade. ✔ Enables access to working capital through financing.

Documents Required for a Letter of Credit

To process an LC, banks require the following documents:

• Bill of Lading (proof of shipment)
• Commercial Invoice
• Packing List
• Insurance Certificate
• Inspection Certificate (if applicable)
• Other Trade Documents as required

How to Apply for a Letter of Credit?

Follow these steps to obtain an LC:

1. Choose a Bank – Select a reputed bank that offers LC services.
2. Provide Transaction Details – Submit necessary documents and details of the trade.
3. Pay the Bank Fee – Banks charge fees based on the LC type and amount.
4. Bank Issues LC – The bank processes and issues the LC to the seller.

Letter of Credit vs. Bank Guarantee

Both LCs and Bank Guarantees (BGs) serve as financial security instruments, but they differ in functionality:

Conclusion

A Letter of Credit is a vital financial tool that promotes secure trade transactions by eliminating the risks of non-payment. It provides assurance to sellers while allowing buyers to conduct business confidently. Understanding different types of LCs and their usage can help businesses navigate the complexities of domestic and international trade.

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