equirus-logo

Letter of Credit

Letter of Credit.webp

Key Highlights

  • It refers to a bank’s commitment to pay the seller on the buyer’s behalf, provided the seller submits the required documents as agreed - ensuring a secure and trusted transaction for both parties.

  • Key players include buyer, seller, issuing bank and advising/confirming bank.

What is Letter of Credit (LC)?

It refers to a bank’s commitment to pay the seller on the buyer’s behalf, provided the seller submits the required documents as agreed - ensuring a secure and trusted transaction for both parties. It’s like a safety net commonly used in international trade to ensure the seller gets paid and the buyer gets what they ordered.

Key Players

  • Buyer (Applicant): Asks their bank to issue a Letter of Credit on their behalf.

  • Seller (Beneficiary): Gets paid under the LC.

  • Issuing Bank: The buyer’s bank that provides the Letter of Credit and assures the seller of payment, as long as the terms are met.

  • Advising/Confirming Bank: The seller’s bank, which may double-check or add its own payment guarantee.

How It Works?

  • Buyer’s bank issues an LC promising to pay the seller.

  • Seller ships the goods and sends required documents (like invoices or shipping proof).

  • If the documents match the LC’s terms, the bank pays the seller.

Types

  • Documentary LC: Needs specific documents to release payment.

  • Clean LC: Only requires a simple payment request, no extra documents.

  • Sight LC: Pays the seller right away when documents are correct.

  • Deferred LC: Allows payment to the seller at a later, pre-agreed date instead of immediately.

Why It Matters?

LCs reduce risk in trade by ensuring the seller gets paid only if they meet the deal’s terms, while the buyer knows the goods are shipped before payment. They include details like the payment amount, expiration date, and document requirements.

Example: A U.S. buyer wants to purchase goods from a Chinese seller. The buyer’s bank issues an LC promising to pay $50,000 once the seller provides a shipping document and invoice. The seller ships the goods, submits the documents, and gets paid, keeping both sides secure.