A letter of credit (LC) is a financial instrument that facilitates international trade by providing a guarantee of payment from a bank to a seller on behalf of a buyer. It is a useful tool for both buyers and sellers who want to reduce the risks and uncertainties involved in cross-border transactions. In this blog post, we will explain the anatomy of a letter of credit, including its main components, types, advantages, and disadvantages.
What are the main components of a letter of credit?
A letter of credit consists of several elements that define the terms and conditions of the payment. The main components of a letter of credit are:
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- Applicant: The buyer or importer who requests the letter of credit from a bank.
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- Beneficiary: The seller or exporter who receives the payment from the bank upon fulfilling the letter of credit requirements.
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- Issuing bank: The bank that issues the letter of credit on behalf of the applicant and promises to pay the beneficiary.
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- Advising bank: The bank that advises the beneficiary of the letter of credit and verifies the documents presented by the beneficiary.
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- Amount: The maximum amount that the issuing bank will pay to the beneficiary under the letter of credit.
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- Validity: The expiry date of the letter of credit, after which the issuing bank is no longer obligated to pay the beneficiary.
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- Documents: The list of documents that the beneficiary must present to the advising bank or the issuing bank to receive the payment. These documents may include invoices, bills of lading, certificates of origin, inspection certificates, etc.
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- Terms and conditions: The specific requirements that the beneficiary must comply with to receive the payment, such as the description of the goods, the shipping terms, the delivery date, etc.
What are the types of letter of credit?
Different types of letter of credit suit different situations and needs. Some of the common types of letter of credit are:
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- Revocable letter of credit: A letter of credit that can be modified or canceled by the issuing bank at any time without the consent of the beneficiary. This type of letter of credit offers little protection to the beneficiary and is rarely used in international trade.
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- Irrevocable letter of credit: A letter of credit that cannot be modified or canceled by the issuing bank without the consent of the beneficiary and the applicant. This type of letter of credit offers more security to the beneficiary and is the most common type of letter of credit in international trade.
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- Confirmed letter of credit: A letter of credit that is confirmed by another bank, usually in the beneficiary’s country, that adds its guarantee of payment to the issuing bank’s guarantee. This type of letter of credit provides extra assurance to the beneficiary in case the issuing bank or the applicant fails to pay.
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- Unconfirmed letter of credit: A letter of credit that is not confirmed by another bank and relies solely on the issuing bank’s guarantee of payment. This type of letter of credit is less costly but also less secure for the beneficiary.
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- Transferable letter of credit: A letter of credit that allows the beneficiary to transfer all or part of the rights and obligations under the letter of credit to another party, such as a supplier or a subcontractor. This type of letter of credit enables the beneficiary to use the letter of credit as a means of financing the transaction.
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- Standby letter of credit: A letter of credit that acts as a backup or a guarantee in case the applicant fails to fulfill its contractual obligations to the beneficiary. This type of letter of credit is not intended to be used as a primary method of payment, but rather as a last resort in case of default or dispute.
What are the advantages and disadvantages of letter of credit?
A letter of credit has both advantages and disadvantages for the parties involved in the transaction. Some of the advantages and disadvantages of letter of credit are:
Advantages of letter of credit
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- Provides security for both buyer and seller: A letter of credit reduces the risk of non-payment, fraud, or delivery failure for both parties, as the payment is guaranteed by a reputable bank and is contingent on the fulfillment of the terms and conditions of the letter of credit.
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- Facilitates international trade: A letter of credit enables buyers and sellers to conduct business across borders and jurisdictions, as the letter of credit is governed by a set of internationally recognized rules and standards, such as the Uniform Customs and Practice for Documentary Credits (UCP 600).
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- Allows access to financing: A letter of credit can help buyers and sellers to obtain financing from their banks or other sources, as the letter of credit serves as a proof of creditworthiness and a collateral for the loan.
Disadvantages of letter of credit
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- Costly and complex: A letter of credit involves fees and charges from the banks, such as issuance fees, confirmation fees, advising fees, negotiation fees, etc. Moreover, a letter of credit requires a lot of paperwork and documentation, which can be time-consuming and error-prone.
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- Sensitive to discrepancies: A letter of credit is subject to strict compliance, meaning that the documents presented by the beneficiary must match exactly with the terms and conditions of the letter of credit. Any discrepancy or inconsistency, no matter how minor, can result in the rejection or delay of the payment by the bank.
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- Subject to political and legal risks: A letter of credit may be affected by the political and legal environment of the countries involved in the transaction, such as sanctions, embargoes, currency restrictions, regulatory changes, etc. These risks may prevent or impair the performance of the letter of credit.
Conclusion
A letter of credit is a powerful tool for international trade that can benefit both buyers and sellers by providing a guarantee of payment and reducing the risks and uncertainties of cross-border transactions. However, a letter of credit also has some drawbacks, such as high costs, complexity, and sensitivity to discrepancies. Therefore, before using a letter of credit, it is important to weigh the pros and cons and to consult with a bank or a trade finance expert to choose the best type of letter of credit for your specific situation.
