Letter of Credit Examples
A letter of credit (LOC) is a document issued by a bank that guarantees the payment from a buyer to a seller in an international trade transaction. It is a useful tool for reducing the risks and uncertainties involved in cross-border transactions, as it ensures that the seller will receive the payment as long as they comply with the terms and conditions of the LOC.
But how does a letter of credit work in practice? What are the steps and documents involved in using a LOC? And what are the benefits and challenges of using a LOC for both buyers and sellers? In this blog post, we will answer these questions by looking at some real-life examples of letter of credit transactions.
Example 1: Importing Goods from China
Let’s say you are a buyer based in the US and you want to import some goods from a seller based in China. You have never done business with this seller before, and you are not sure about their reliability and reputation. You also want to avoid any delays or disputes in the payment process. How can you use a letter of credit to facilitate this transaction?
First Step:
The first step is to negotiate and sign a sales contract with the seller, specifying the details of the goods, the price, the delivery terms, and the payment method. As part of the contract, you agree to use a letter of credit as the payment method, and you specify the documents that the seller needs to provide to receive the payment, such as the invoice, the bill of lading, the certificate of origin, and the inspection certificate.
Second Step:
The second step is to apply for a letter of credit from your bank, providing the information required by the bank, such as the name and address of the seller, the amount and currency of the payment, the expiry date of the LOC, and the list of documents required by the LOC. Your bank will charge you a fee for issuing the LOC, which may vary depending on the bank and the amount of the LOC. Your bank will also require you to provide some collateral or security for issuing the LOC, such as cash, securities, or a line of credit.
Third Step:
The third step is to send the letter of credit to the seller, either directly or through an intermediary bank in the seller’s country. The seller will review the LOC and make sure that they can comply with all the terms and conditions of the LOC. If the seller agrees to the LOC, they will proceed to ship the goods to you according to the delivery terms specified in the contract and the LOC.
Fourth Step:
The fourth step is to present the documents required by the LOC to the bank that issued the LOC, or to another bank nominated by the issuing bank. The bank will verify that the documents are authentic and consistent with the terms and conditions of the LOC. If the documents are satisfactory, the bank will make the payment to the seller, either immediately or at a later date depending on the type of the LOC. The bank will then send the documents to you, and you will receive the goods from the carrier.
Example 2: Exporting Services to India
Let’s say you are a seller based in the UK and you want to export some services to a buyer based in India. You have a long-term relationship with this buyer, and you trust them to pay you on time. However, you are concerned about the fluctuations in the exchange rate and the political and economic stability in the buyer’s country. How can you use a letter of credit to mitigate these risks?
First Step:
The first step is to negotiate and sign a service contract with the buyer, specifying the details of the services, the price, the delivery terms, and the payment method. As part of the contract, you agree to use a letter of credit as the payment method, and you specify the documents that you need to provide to receive the payment, such as the invoice, the service completion certificate, and the proof of delivery.
Second Step:
The second step is to receive the letter of credit from the buyer, either directly or through an intermediary bank in your country. The buyer will apply for a letter of credit from their bank, providing the information required by the bank, such as your name and address, the amount and currency of the payment, the expiry date of the LOC, and the list of documents required by the LOC. The buyer’s bank will charge them a fee for issuing the LOC, which may vary depending on the bank and the amount of the LOC. The buyer’s bank will also require them to provide some collateral or security for issuing the LOC, such as cash, securities, or a line of credit.
Third Step:
The third step is to review the letter of credit and make sure that you can comply with all the terms and conditions of the LOC. If you agree to the LOC, you will proceed to deliver the services to the buyer according to the delivery terms specified in the contract and the LOC.
The fourth step is to present the documents required by the LOC to the bank that issued the LOC, or to another bank nominated by the issuing bank. The bank will verify that the documents are authentic and consistent with the terms and conditions of the LOC. If the documents are satisfactory, the bank will make the payment to you, either immediately or at a later date depending on the type of the LOC. The bank will then send the documents to the buyer, and they will receive the proof of delivery of the services.
Benefits and Challenges of Using a Letter of Credit
As we can see from the examples above, using a letter of credit can have several benefits for both buyers and sellers in international trade transactions, such as:
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- Reducing the risk of non-payment or late payment by the buyer, as the payment is guaranteed by the bank as long as the seller complies with the terms and conditions of the LOC.
- Reducing the risk of non-delivery or defective delivery by the seller, as the payment is conditional on the presentation of the documents that prove the delivery and quality of the goods or services.
- Reducing the risk of currency fluctuations, political instability, or legal differences in the buyer’s or seller’s country, as the payment is made in a stable and agreed currency and according to the rules and regulations of the issuing bank and the International Chamber of Commerce.
- Enhancing the trust and confidence between the buyer and the seller, as the letter of credit provides a clear and transparent framework for the transaction and the payment.
However, using a letter of credit can also have some challenges and drawbacks for both buyers and sellers, such as:
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- Increasing the cost and complexity of the transaction, as the letter of credit involves additional fees, documents, and procedures that may vary depending on the bank and the country involved.
- Increasing the risk of discrepancies or errors in the documents, as the letter of credit requires strict compliance with the terms and conditions of the LOC, and any deviation or inconsistency may result in the rejection or delay of the payment.
- Increasing the dependence on the bank and its creditworthiness, as the letter of credit is only as good as the bank that issues it, and the bank may face financial or operational difficulties that may affect its ability to honor the LOC.
Conclusion
A letter of credit is a powerful and versatile tool for facilitating international trade transactions, as it provides a guarantee of payment from a bank to a seller in exchange for the presentation of the documents that prove the delivery and quality of the goods or services. However, a letter of credit also entails some costs and risks that need to be carefully considered and managed by both buyers and sellers. Therefore, it is important to understand how a letter of credit works in practice, and to choose the type and terms of the LOC that best suit the needs and preferences of both parties.
