What is a Letter of Credit?

In the business world, it is important to understand the different terminology used to describe various financial transactions. For example, the terms "line of credit" and "letter of credit" are often used interchangeably, but they represent two very different kinds of transactions. A line of credit can be something as simple as the credit card in your wallet. A letter of credit often represents a much more complex transaction.

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A letter of credit is a more precise financial tool that is used by buyers to purchase products from sellers. The most common use of a letter of credit is in an international transaction. Let us look at a sample international transaction using a letter of credit to understand what a letter of credit is and how it is used.

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The letter of credit is initiated by a buyer who wants to buy product from a company located overseas. For example, let us say that a Japanese company wants to purchase a larger piece of equipment from an American company. The Japanese company would work with a bank to secure a letter of credit that promises the American company that payment will be provided for the transaction. Once the bank has drafted the letter of credit, it sends the letter to the American company.

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It is important to note that the letter of credit will contain very specific terms for the transaction. If the seller does not satisfy all of the terms of the letter of credit, then the seller will not be paid. The payment will only be supplied after the seller has satisfied all of the conditions of the letter.

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Once the seller receives the letter of credit, it satisfies all of the conditions of the letter. In this case, the seller would ship the piece of equipment through an international carrier who supplies the seller with a bill of lading to prove that the product has been shipped and has arrived at the destination.

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The seller then sends the bill of lading to the buyer's bank, who then reviews the documents to make certain that all of the conditions of the sale have been met. In most cases, the seller will actually do the transaction through its bank so that the funds can be instantly transferred to its account. In this instance, the bill of lading would go to the seller's bank, which would then send it on to the buyer's bank.

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When the buyer's bank is satisfied that the conditions of the letter of credit have been met, the buyer's bank then pays the seller's bank. Then the buyer's bank asks for payment from the buyer. The bank will wait until full payment is made before it completes the execution of the letter of credit. This is the point where some transactions fall apart and the product is left sitting on a shipping dock in Japan. The bank will often auction unclaimed property off to try and get some of its money back.

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Once the buyer pays on the letter of credit, the bank will release the bill of lading and the buyer can pick up the product. This process gets the buyer and seller's banks directly involved in the transaction and speeds it up considerably. Without the letter of credit, the product may never be shipped and the transaction may never take place. A letter of credit can also be used for a domestic transaction, but it is much more common in international commerce. It has become a popular tool that is used to increase commerce across oceans and international borders.

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What Are The Different Types Of Letter Of Credit?

• ‍Commercial letters of credit — also known as a letter of credit for importers and exporters, play a fundamental role in the fulfillment of overseas commercial transactions. Although commercial banks are very skillful, common loopholes in accepting letters of credit can be found in a commercial letter of credit such as an outdated letter of credit, or a letter's supporting invoice revealing changes that are not in agreement with the letter of credit.
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• ‍Standby letters of credit — operate in a somewhat different manner than most other forms of letters of credit. If a transaction does not occur and one party is not properly compensated, the beneficiary is entitled to a standby letter if the beneficiary can demonstrate that it did not get what was promised. This is more of an insurance policy than a way of completing a transaction.
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• Revocable letters of credit — Revocable letters of credit provide the issuer with leverage. It is contractually permissible for one party to modify or discontinue the exchange at any moment, usually without the beneficiary's permission. These letters are uncommon since most recipients do not consent to them and the UCP makes no provision for them.
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• Irrevocable letters of credit — Irrevocable letters of credit need the permission of all parties involved before any modifications or cancellations may take place. Irrevocable letters of credit can be approved or denied. Approved letters need the payment being guaranteed by another financial institution, which is frequently the case when the recipient does not trust the other party's bank.
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• Red clause letters of credit — The buyer makes an unsecured loan in the form of a red clause letter of credit, which works as an advance on the rest of the contract. A red clause letter of credit may be requested by one party in order to secure the financing required to purchase, manufacture, or transport the assets involved in the transaction.
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• Revolving letters of credit — Revolving letters of credit are intended to be used for a variety of purposes and can be used to make multiple payments. These are frequent among individuals or firms who intend to conduct business with one other on a regular basis. These letters of credit generally have an expiration date (usually one year).