Letter of Credit is a crucial and vital topic in international trade. Buyers and sellers, importers, and exporters make use of it. This article will cover the definition of a letter of credit, an example of what a letter of credit is, and also a sample and how to write a letter of credit.
Now let us get started, shall we?
Letter Of Credit (LOC)
A letter of credit has some elements of international dealings. Factors such as distance, differing laws in each country, and difficulty knowing each party personally, using it have become a crucial aspect of international trade.
However, its economic effect introduces a bank as an underwriter, where it allows the counterparty risk of the buyer paying the seller for goods.
Of course, there are various types, and they can give security when buying and selling products or services.
Seller protection:
If the requirements in a letter are accomplished, the buyer fails to pay a seller. The bank must pay the seller. Hence, it provides security when the buyer and seller are in different countries.
Buyer protection:
It can also defend buyers. For instance, if you pay somebody to provide a product or service and they fail to deliver, you might be able to get paid using a standby letter of credit.
That payment can be a fine to the company that was unable to perform, and it’s similar to a refund. With the money you receive, you can pay somebody else to provide the product or service needed.
Nevertheless, because it is generally a negotiable means, the issuing bank pays the recipient or any bank chosen by the recipient. If it is transferable, the receiver may assign another entity, like a corporate parent or a third party, the right to draw.
Letter Of Credit Definition
There are several definitions of a letter of credit. However, let us take a look at few of them.
A letter of credit is also called a credit letter. A bank’s LOC guarantees that a buyer’s payment to a seller will be received on time and for the correct amount.
Additionally, according to Wikipedia, “it is a payment mechanism used in international trade to provide an economic guarantee from a creditworthy bank to an exporter of goods.”
Basically, a LOC is a promise from a bank to make a payment. The person must meet certain conditions.
Examples Of Letter Of Credit
Citibank grants letters of credit for buyers in Latin America, Africa, Eastern Europe, Asia, and the Middle East who may have difficulty obtaining international credit independently. Citibank’s LOC aid exporters reduce the importer’s country risk and the issuing bank’s commercial credit risk.
They are generally granted within two business days, guaranteeing payment by the confirming Citibank branch. This benefit is precious when a client stays in a potentially unstable economical environment.
Another example is
- A producer gets an order from a new buyer overseas. The producer does not know if this customer can (or will) pay for the goods after manufacturing and sending the products.
- In other to manage risk, the trader employs an agreement that requires the buyer to pay with a letter of credit as soon as the shipment arrives.
- The customer needs to ask for a letter of credit at a bank in their home country to move forward. The customer may need to have funds on hand at that bank or get permission for the bank’s financing.
- The bank will only issue funds to the producer after he proves that the shipment happened. To do so, the seller typically presents documents showing how goods were shipped (with details like the exact dates, destination, and contents).
- However, the customer also has protection: Customers might prefer to pay a bank with an extensive legal authority rather than send the money directly to an unknown seller.
- If the customer is concerned about a fraudulent seller, additional options are available for the buyer’s protection. For example, somebody can examine the shipment before the payment is cleared.
How To Write A Letter Of Credit
There are several ways on how to write a letter of credit. Here are some few ways.
For added security, you must insert a list of terms with your letter of credit that both individuals can agree on. If the exporter agrees but does not meet these terms, you may be qualified to get some or all of your money back.
Additionally, it is an instruction; hence, you only need to add basic details, including the sum to be transferred and the details of the exporter and their receiving bank.
Also, sign the letter to give legal authorization for the business to occur.
Sample Letter Of Credit
AMOUNT: $50,000
APPLICANT:
Warrington Electronics, 9410 Wishing Landing,
Spirit Lake, AZ, 86578-5065, US, (602) 446-2278
BENEFICIARY:
Peace Electronics, 22 Silicon Industrial,
Central, China
LETTER OF CREDIT ISSUED BY:
American Banking Council, 2677 Amber Row,
texas, 12546-7874, US, (315) 547-2588
RECEIVING BANK:
Bank of China, 10 Corporate Square, Beijing
The following is an instruction to grant Peace Electronics $50,000 upon the receipt of export documentation. I am attaching the full letter of credit terms for this transaction.
Signed
Mr. peace
Peace Electronics
Sample 2
Mr. Amahjosh
Shining Star Import/Export Co.
New York, NY
Dear Adell Exports,
We have authorized you, Adell Exports, to draw on account of Shining Star Import/Export Co. for the sum of $900,000 if the payment for transaction #41914191 has insufficient funds. This letter is valid until acquisition or until the successful closing of transaction #41914191
We agree that this letter of credit will be honored upon presentation at the appropriate time and location. It has no expiry date.
Signature
Underwriting party
Types Of LOC
These are the various types. Let us take a look at few of them.
Commercial LOC
It is a standard letter of credit commonly used in international trade and may also be called a documentary credit or an import/export LOC. Banks act as a neutral third party to release funds when all the conditions of the agreement have been met.
Standby LOC
This type of letter of credit is different from the others. It grants payment if something fails to happen. Again, instead of approving a transaction, a standby LOC offers compensation when something goes wrong.
Back-to-Back LOC
A back-to-back LOC permits intermediaries to combine buyers and sellers. These slightly complicated tactics use two letters of credit so that each party gets paid individually.
Revolving LOC
A revolving LOC is helpful for many payments. If a buyer and seller require to do business repeatedly, they may prefer not to get a new letter of credit for every transaction. However, this type allows companies to use a single letter of credit for various transactions until the letter expires, and letters might be valid for three years or less.
Conclusion
In conclusion, the definition and how to write a letter of credit and its examples are vital in international trade.
What is the purpose of the letter of credit?
They are generally granted within two business days, guaranteeing payment by the confirming Citibank branch. This benefit is precious when a client stays in a potentially unstable economical environment.
What is a letter of credit and how does it work?
A letter of credit is also called a credit letter. A bank’s LOC guarantees that a buyer’s payment to a seller will be received on time and for the correct amount.
